A Short & Happy Guide to Corporate Taxation (Short & Happy Guides) 9781647087906, 1647087902

Table of contents :
Chapter 1 Preface
Chapter 2 Models of Corporate Taxation, a Brief History Lesson, and the Current State of Affairs
A. The Classical Model
B. Integration
C. The Evolution of Integration
Chapter 3 Indirect Taxation and Incidence
Chapter 4 Dividends as Income
A. Post-Acquisition Earnings
B. Pre-Acquisition Earnings
C. Phellis
D. The Proper Procedure: Bifurcation
Chapter 5 Dividends Received Deduction
A. Basics
B. Distribution of Pre-Acquisition Earnings
C. Congressional Reactions
1. Section 246(c)
2. Section 1059
D. Debt-Financed Portfolio Stock
Chapter 6 Sale of Shares
A. Introduction
B. Bootstrap Sales
1. The Plan (Avoiding Double Taxation)
2. The Man (the Commissioner’s Position)
3. The Proverbial Fan (the Cases Hit the Courts)
Chapter 7 Individual Shareholders
A. Bifurcation
B. Congressional Response
Chapter 8 Dividends and Distributions From Capital
A. Introduction
B. Distribution of Capital
C. Earnings and Profits—Definition
D. Current and Accumulated E&P
E. Current E & P
1. The “Nimble Dividend”
2. “The Rule of Imaginary Time”
F. Accumulated E&P
1. No Current E&P
2. Positive Current E&P
3. Negative Current E & P
G. Effects of Distributions on E&P
Chapter 9 Distribution of Property
A. Introduction
B. General Utilities and Its Aftermath
C. Distribution of Property Encumbered by a Debt
1. From the Perspective of the Corporation
2. From the Perspective of the Shareholders
D. Effect of Property Distributions on Earnings and Profits
1. FMV Exceeds Adjusted Basis
2. Adjusted Basis Exceeds FMV
3. Encumbered Property
Chapter 10 Disguised Distributions
A. Not Every Transfer Is a Distribution
B. Why the Designation Matters
C. Classifying the Payment
Chapter 11 Stock Distributions
A. Introduction
B. Case Law
1. Eisner v. Macomber
2. “Common on Preferred”
3. “Preferred on Preferred”
4. “Preferred on Common”
5. Summing Up the Case Law
C. Section 305
D. Quantification
E. Basis
F. Stock Dividends as a Tax Planning Tool
G. Section 306: Tainting the Stock
H. Section 306: What’s Really Going On?
Chapter 12 Redemptions
A. Introduction
B. Why Does It Matter?
1. Basics
2. Section 1059(e)(1)(A)
3. Earnings and Profits
4. Which Treatment Is Better?
C. Attribution Rules
1. Statutory Framework
2. First Attribution Rule: Family Members
3. Second Attribution Rule: From an Entity
4. Third Attribution Rule: To an Entity
5. Fourth Attribution Rule: Option Holders
6. Operating Rules
a. Basic Operating Rule
b. First Exception: “Adam and Eve”
c. Second Exception: To and From an Entity
D. Classifying the Redemption
E. Substantially Disproportionate Redemptions
1. The 80% Requirements: Non-Voting Shares and Non-Common Shares
a. Non-Voting Shares
b. Non-Common Shares
2. The 50% Requirement
3. Series of Redemptions
F. Complete Termination
1. Avoiding Family Attribution
2. Splitting Stock Among Family Members
3. Prohibited Interests
a. Creditors
b. Lessors
c. Service Providers
4. Prohibited Interests of Related Parties
G. Redemptions Not Essentially Equivalent to a Dividend
1. Potential Coalitions
2. Indirect Ownership
3. Family Hostility
H. Partial Liquidations
1. Partial Liquidation—Definition
2. Qualified Trade or Businesses
3. Why and Wherefore
I. Redemptions Through Related Corporations
1. Step One: Control
2. Step Two: Applying the § 302 Tests
3. Hold On, I’m a Bit Confused
4. Step Three: Earnings and Profits
Chapter 13 Complete Liquidations
A. Liquidation of a Corporation That Is Not a Subsidiary
1. Tax Consequences to the Shareholders
2. Tax Consequences to the Corporation
B. Liquidation of a Subsidiary
1. Distributions to Minority Shareholders
2. Distributions to the Parent Corporation
Chapter 14 Section 351
A. Introduction
B. Group Transfers
C. Mechanics of § 351
D. Property Containing Unrealized Loss
E. Avoiding § 351
F. Boot
1. Basis
a. Basis of the Shares in the Hands of the Transferor
b. Basis of the Property in the Hands of the Corporation
2. Assumption of Liabilities
a. General
b. Tax Avoidance
c. Escaping Through an IOU
Chapter 15 Corporate Divisions
A. Introduction and Terminology
B. Tax Consequences of a Division (Without Boot)
1. Basic Statutory Provisions
2. Corporate-Level and Shareholder-Level Taxation
3. Gregory
a. Judicial Response
b. Congressional Responses
C. Requirements
1. Business Purpose
a. Shareholder Purpose
b. Transfers Following a Divisive D Reorganization
c. Alternative Arrangements
2. Continuity of Proprietary Interest (COPI)
3. Active Trade or Business (ATB)
a. Active Conduct
b. Separate Affiliated Group
c. Five-Year Requirement
d. Trade or Business Acquired Indirectly
e. Division and Expansion of an Existing Trade or Business
4. Distribution of All the Stocks and Securities
D. Boot
1. From the Perspective of the Shareholder
a. Recognizing Gain and Loss
b. Characterizing Gain
c. Basis
2. From the Perspective of the Corporation
E. Divisions in the Nature of Sale
1. Section 355(d)
2. Section 355(e)
Chapter 16 Reorganizations
A. Overview
B. Non-Statutory (“Common Law”) Requirements
1. Continuity of Proprietary Interest (COPI)
2. Continuity of Business Enterprise (COBE)
3. Business Purpose
C. Reorganizations, From A to G
D. “A” Reorganizations
1. Definition
2. Divisive Mergers
3. Tax Consequences of an “A” Reorganization
E. “B” Reorganizations
1. Definition
2. “Solely for. . .Voting Stock”
3. Creeping “B” Reorganizations
4. Tax Consequences of “B” Reorganizations
F. “C” Reorganizations
1. Definition
2. “Substantially All”
3. “Solely for. . .Voting Stock”
a. Assumption of Liabilities
b. Other Boot
4. Liquidation of the Target Corporation
5. Tax Consequences of a Type “C” Reorganization
G. Triangular Reorganizations and Drop-Downs
1. Drop-Downs
2. Triangular Reorganizations: General
3. Triangular B Reorganizations
a. Qualifying as a Triangular B Reorganization
b. Tax Consequences of a Triangular B Reorganization
4. Triangular C Reorganizations
a. Qualifying as a Triangular C Reorganization
b. Tax Consequences of a Triangular C Reorganization
5. Forward Triangular Mergers
a. Qualifying as a Forward Triangular Merger
b. Tax Consequences of a Forward Triangular Merger
6. Reverse Triangular Merger
a. Qualifying as a Reverse Triangular Merger
b. Tax Consequences of a Reverse Triangular Merger
H. Other Reorganizations
1. Acquisitive “D” Reorganizations
2. Type “E” Reorganizations
3. Type “F” Reorganizations
4. Type “G” Reorganizations
I. Tax Consequences of Boot
1. From the Perspective of T’s Shareholders
a. Recognition of Gain
b. Characterization of Gain
c. Effect of Boot on Basis
2. From the Perspective of T
a. Exchange of Property in the Reorganization
b. Disposition of Property Following the Exchange
3. From the Perspective of P
Chapter 17 Carryover of Tax Attributes
A. Introduction
B. Tax Attributes
C. Which Corporation Inherits the Tax Attributes?
D. Blending the Tax Attributes of the Target and Acquiring Corporations
1. Earnings and Profits
a. In General
b. Year of Liquidation or Reorganization
2. Net Operating Losses
Chapter 18 Restrictions on Use of Tax Attributes
A. Introduction
1. Corporate Identity and Trafficking in Tax Attributes
B. Section 382: Net Operating Losses
1. Ownership Change
2. Consequences of an Ownership Change
a. Eliminating the NOL: Continuity of Business Enterprise
b. Section 382 Limitation: Deferring Deduction of the NOL
c. Section 382 Limitation: Anti-Stuffing Rules
d. Section 382 Limitation: Built-In Gains and Losses
C. Section 383
1. Net Built-In Capital Losses
2. Credits
D. Section 269
E. Section 384
Chapter 19 Final Words

Citation preview

West Academic Publishing’s Emeritus Advisory Board ————— JESSE H. CHOPER Professor of Law and Dean Emeritus University of California, Berkeley

YALE KAMISAR Professor of Law Emeritus, University of San Diego Professor of Law Emeritus, University of Michigan

MARY KAY KANE Professor of Law, Chancellor and Dean Emeritus University of California, Hastings College of the Law

LARRY D. KRAMER President, William and Flora Hewlett Foundation

JAMES J. WHITE Robert A. Sullivan Emeritus Professor of Law University of Michigan

West Academic Publishing’s Law School Advisory Board ————— JOSHUA DRESSLER Distinguished University Professor Emeritus Michael E. Moritz College of Law, The Ohio State University

MEREDITH J. DUNCAN Professor of Law University of Houston Law Center

RENÉE MCDONALD HUTCHINS Dean and Joseph L. Rauh, Jr. Chair of Public Interest Law University of the District of Columbia David A. Clarke School of Law

RENEE KNAKE JEFFERSON Joanne and Larry Doherty Chair in Legal Ethics & Professor of Law, University of Houston Law Center

Professor of Law, University of Houston Law Center

ORIN S. KERR Professor of Law University of California, Berkeley

JONATHAN R. MACEY Professor of Law, Yale Law School

DEBORAH JONES MERRITT Distinguished University Professor, John Deaver Drinko/Baker & Hostetler Chair in Law Michael E. Moritz College of Law, The Ohio State University

ARTHUR R. MILLER University Professor, New York University Formerly Bruce Bromley Professor of Law, Harvard University

GRANT S. NELSON Professor of Law Emeritus, Pepperdine University Professor of Law Emeritus, University of California, Los Angeles

A. BENJAMIN SPENCER Dean & Chancellor Professor of Law William & Mary Law School

Corporate Taxation David Elkins Professor and Distinguished Teaching Fellow Netanya College School of Law (Israel) A SHORT & HAPPY GUIDE® SERIES

The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional. a short & happy guide series is a trademark registered in the U.S. Patent and Trademark Office. © 2021 LEG, Inc. d/b/a West Academic 444 Cedar Street, Suite 700 St. Paul, MN 55101 1-877-888-1330 Printed in the United States of America ISBN: 978-1-64708-790-6

Short? Happy? Corporate Taxation?? You have got to be kidding. This book is dedicated to my grandchildren: Eitan, Roi, Hila, Yael, Tzvi, Michal, Eyal, Noam, and Lavi. OK, also to my grand-dog, Leo. And from the Give Credit Where Credit is Due Department: heartfelt thanks to Christopher Hanna, Richard Reinhold, and Joel Elkins for their helpful comments.

Table of Contents Chapter 1Preface Chapter 2Models of Corporate Taxation, a Brief History Lesson, and the Current State of Affairs A. The Classical Model B. Integration C. The Evolution of Integration Chapter 3Indirect Taxation and Incidence Chapter 4Dividends as Income A. Post-Acquisition Earnings B. Pre-Acquisition Earnings C. Phellis D. The Proper Procedure: Bifurcation Chapter 5 Dividends Received Deduction A. Basics B. Distribution of Pre-Acquisition Earnings C. Congressional Reactions 1. Section 246(c) 2. Section 1059 D. Debt-Financed Portfolio Stock Chapter 6Sale of Shares A. Introduction B. Bootstrap Sales 1. The Plan (Avoiding Double Taxation) 2. The Man (the Commissioner’s Position) 3. The Proverbial Fan (the Cases Hit the Courts) Chapter 7Individual Shareholders A. Bifurcation B. Congressional Response Chapter 8Dividends and Distributions From Capital A. Introduction B. Distribution of Capital

C. Earnings and Profits—Definition D. Current and Accumulated E&P E. Current E & P 1. The “Nimble Dividend” 2. “The Rule of Imaginary Time” F. Accumulated E&P 1. No Current E&P 2. Positive Current E&P 3. Negative Current E & P G. Effects of Distributions on E&P Chapter 9Distribution of Property A. Introduction B. General Utilities and Its Aftermath C. Distribution of Property Encumbered by a Debt 1. From the Perspective of the Corporation 2. From the Perspective of the Shareholders D. Effect of Property Distributions on Earnings and Profits 1. FMV Exceeds Adjusted Basis 2. Adjusted Basis Exceeds FMV 3. Encumbered Property Chapter 10Disguised Distributions A. Not Every Transfer Is a Distribution B. Why the Designation Matters C. Classifying the Payment Chapter 11Stock Distributions A. Introduction B. Case Law 1. Eisner v. Macomber 2. “Common on Preferred” 3. “Preferred on Preferred” 4. “Preferred on Common” 5. Summing Up the Case Law C. Section 305 D. Quantification

E. Basis F. Stock Dividends as a Tax Planning Tool G. Section 306: Tainting the Stock H. Section 306: What’s Really Going On? Chapter 12Redemptions A. Introduction B. Why Does It Matter? 1. Basics 2. Section 1059(e)(1)(A) 3. Earnings and Profits 4. Which Treatment Is Better? C. Attribution Rules 1. Statutory Framework 2. First Attribution Rule: Family Members 3. Second Attribution Rule: From an Entity 4. Third Attribution Rule: To an Entity 5. Fourth Attribution Rule: Option Holders 6. Operating Rules a. Basic Operating Rule b. First Exception: “Adam and Eve” c. Second Exception: To and From an Entity D. Classifying the Redemption E. Substantially Disproportionate Redemptions 1. The 80% Requirements: Non-Voting Shares and Non-Common Shares a. Non-Voting Shares b. Non-Common Shares 2. The 50% Requirement 3. Series of Redemptions F. Complete Termination 1. Avoiding Family Attribution 2. Splitting Stock Among Family Members 3. Prohibited Interests a. Creditors b. Lessors c. Service Providers

4. Prohibited Interests of Related Parties G. Redemptions Not Essentially Equivalent to a Dividend 1. Potential Coalitions 2. Indirect Ownership 3. Family Hostility H. Partial Liquidations 1. Partial Liquidation—Definition 2. Qualified Trade or Businesses 3. Why and Wherefore I. Redemptions Through Related Corporations 1. Step One: Control 2. Step Two: Applying the § 302 Tests 3. Hold On, I’m a Bit Confused 4. Step Three: Earnings and Profits Chapter 13Complete Liquidations A. Liquidation of a Corporation That Is Not a Subsidiary 1. Tax Consequences to the Shareholders 2. Tax Consequences to the Corporation B. Liquidation of a Subsidiary 1. Distributions to Minority Shareholders 2. Distributions to the Parent Corporation Chapter 14Section 351 A. Introduction B. Group Transfers C. Mechanics of § 351 D. Property Containing Unrealized Loss E. Avoiding § 351 F. Boot 1. Basis a. Basis of the Shares in the Hands of the Transferor b. Basis of the Property in the Hands of the Corporation 2. Assumption of Liabilities a. General b. Tax Avoidance

c. Escaping Through an IOU Chapter 15Corporate Divisions A. Introduction and Terminology B. Tax Consequences of a Division (Without Boot) 1. Basic Statutory Provisions 2. Corporate-Level and Shareholder-Level Taxation 3. Gregory a. Judicial Response b. Congressional Responses C. Requirements 1. Business Purpose a. Shareholder Purpose b. Transfers Following a Divisive D Reorganization c. Alternative Arrangements 2. Continuity of Proprietary Interest (COPI) 3. Active Trade or Business (ATB) a. Active Conduct b. Separate Affiliated Group c. Five-Year Requirement d. Trade or Business Acquired Indirectly e. Division and Expansion of an Existing Trade or Business 4. Distribution of All the Stocks and Securities D. Boot 1. From the Perspective of the Shareholder a. Recognizing Gain and Loss b. Characterizing Gain c. Basis 2. From the Perspective of the Corporation E. Divisions in the Nature of Sale 1. Section 355(d) 2. Section 355(e) Chapter 16Reorganizations A. Overview B. Non-Statutory (“Common Law”) Requirements

1. Continuity of Proprietary Interest (COPI) 2. Continuity of Business Enterprise (COBE) 3. Business Purpose C. Reorganizations, From A to G D. “A” Reorganizations 1. Definition 2. Divisive Mergers 3. Tax Consequences of an “A” Reorganization E. “B” Reorganizations 1. Definition 2. “Solely for. . .Voting Stock” 3. Creeping “B” Reorganizations 4. Tax Consequences of “B” Reorganizations F. “C” Reorganizations 1. Definition 2. “Substantially All” 3. “Solely for. . .Voting Stock” a. Assumption of Liabilities b. Other Boot 4. Liquidation of the Target Corporation 5. Tax Consequences of a Type “C” Reorganization G. Triangular Reorganizations and Drop-Downs 1. Drop-Downs 2. Triangular Reorganizations: General 3. Triangular B Reorganizations a. Qualifying as a Triangular B Reorganization b. Tax Consequences of a Triangular B Reorganization 4. Triangular C Reorganizations a. Qualifying as a Triangular C Reorganization b. Tax Consequences of a Triangular C Reorganization 5. Forward Triangular Mergers a. Qualifying as a Forward Triangular Merger b. Tax Consequences of a Forward Triangular Merger 6. Reverse Triangular Merger

a. Qualifying as a Reverse Triangular Merger b. Tax Consequences of a Reverse Triangular Merger H. Other Reorganizations 1. Acquisitive “D” Reorganizations 2. Type “E” Reorganizations 3. Type “F” Reorganizations 4. Type “G” Reorganizations I. Tax Consequences of Boot 1. From the Perspective of T’s Shareholders a. Recognition of Gain b. Characterization of Gain c. Effect of Boot on Basis 2. From the Perspective of T a. Exchange of Property in the Reorganization b. Disposition of Property Following the Exchange 3. From the Perspective of P Chapter 17Carryover of Tax Attributes A. Introduction B. Tax Attributes C. Which Corporation Inherits the Tax Attributes? D. Blending the Tax Attributes of the Target and Acquiring Corporations 1. Earnings and Profits a. In General b. Year of Liquidation or Reorganization 2. Net Operating Losses Chapter 18Restrictions on Use of Tax Attributes A. Introduction 1. Corporate Identity and Trafficking in Tax Attributes B. Section 382: Net Operating Losses 1. Ownership Change 2. Consequences of an Ownership Change a. Eliminating the NOL: Continuity of Business Enterprise b. Section 382 Limitation: Deferring Deduction of the NOL

c. Section 382 Limitation: Anti-Stuffing Rules d. Section 382 Limitation: Built-In Gains and Losses C. Section 383 1. Net Built-In Capital Losses 2. Credits D. Section 269 E. Section 384 Chapter 19Final Words

A Short & Happy Guide to Corporate Taxation

1

CHAPTER 1

Preface It may surprise you to learn that you already know quite a bit about corporate taxation. Think back to your basic income tax course. You probably spent most of your time learning about things like gross income, gains and losses from the sale of property, ordinary and necessary business expenses—you remember the drill. Well, most of what you learned there applies to corporations as well as to individuals. As evidence, recall the cases that you studied. A great many of them involved corporate taxpayers. More than likely, you did not even pay much attention to the identity of the taxpayer. In fact, in at least one sense, computing the taxable income of a corporation is easier than computing the taxable income of an individual. As artificial entities, corporations cannot consume. Therefore, the extremely difficult problem of classifying expenses as personal or business (think about commuting, travel, meals, clothing, childcare, and so forth) simply does not exist in the case of a corporate taxpayer. Furthermore, as corporations receive no capital gains preference, the distinction between short-term and long-term capital gain is irrelevant, and the distinction between 2 capital gain and ordinary income is important only because of the restrictions on the deduction of capital losses.

Okay, so what then is the field of corporate taxation all about? Try this: What can corporations do that individuals cannot? One thing they can do is distribute earnings and capital to their shareholders (individuals don’t have shareholders). Another is merge, divide, be acquired, and so forth (individuals can’t do that either). Thus, corporate taxation primarily concerns the tax consequences of those two phenomena: (a) the distribution of earnings and capital and (b) corporate restructuring. In this book, Chapters 1–13 deal with the former, and Chapters 14–18 deal with the latter. Ready? Here we go.

3

CHAPTER 2

Models of Corporate Taxation, a Brief History Lesson, and the Current State of Affairs A. The Classical Model Until the turn of the twenty-first century, U.S. corporate taxation was based on what is commonly referred to as the “classical model.” The idea behind this model is that a corporation is a legal person. Like a natural person, it can own property, it can incur debt, and, what is particularly important for our purposes, it can earn income. Now, the reasoning goes, if a corporation can earn income like a natural person, it can also pay taxes like a natural person. Therefore, the first element in the classical model is the imposition of income tax on the corporation. The second element of the classical model concerns the distribution of earnings to the corporation’s shareholders. When 4 shareholders receive a dividend, they report the dividend as income and pay the appropriate tax.1 Superficially, the classical model seems conceptually sound. The corporation is a person. Its shareholders are separate persons. Each person pays tax on his,

her, their, or its income. Each dollar of income is taxed once and only once. However, if we dig a little deeper, we may notice a problem. The payment of tax by the corporation reduces the earnings available for distribution to shareholders. This means that shareholders bear the indirect burden of the corporate-level tax. Imposing an additional shareholder-level tax effectively amounts to double taxation of the corporation’s earnings.

B. Integration Due to this fundamental flaw in the classical model, many other countries abandoned the classical model during the course of the twentieth century and adopted in its stead one of the various “integration models.” As their name indicates, the idea behind these models is to integrate the corporate-level tax and the shareholder-level tax. Some, known as full integration models, seek to impose the same tax burden on income derived through a corporation as that which is imposed on income earned directly by an individual. For example, they might permit corporations to deduct the dividends they distribute or allow shareholders a full credit for tax paid by the corporation.2 Others, known as partial integration models, are located somewhere along the spectrum between full integration and 5 the classical model. On either the corporate level or the shareholder level (or possibly both), they take the other level of tax into account, but do not totally neutralize the sting of double taxation. The total tax burden under a partial integration model is less than under the classical model but greater than under full integration. Continuing along the spectrum from double taxation past partial integration and full integration, we come to super-integration. In a super-integrated tax structure, the total tax burden on distributed corporate earnings is less than the ordinary individual tax rates. Often, the question of whether a given regime is partially integrated, fully integrated, or super-integrated does not admit of a simple answer. For example, assume that corporations pay tax on their income and that shareholders are exempt from tax on the dividends they receive. If the corporate tax rate is greater than the marginal rate of a particular individual shareholder, then from the perspective of that individual, the regime is partially integrated. If the corporate tax rate is equal to the shareholder’s marginal rate, the regime is fully integrated. If the corporate tax rate is less than the shareholder’s marginal rate, the regime is super-integrated.

C. The Evolution of Integration

During the first two decades of the twenty-first century, U.S. corporate taxation has gradually moved from a classical structure to one approaching full integration. The opening salvo in the battle for integration was fired in 2003 by President George W. Bush. He proposed that dividends distributed out of earnings on which taxes were paid at the corporate level be exempt from tax on the shareholder level. If, for whatever reason, tax was not paid at the corporate level, shareholders would be liable for tax on the dividend. The result 6 would have been that any income earned by a corporation would be taxed once and only once. Congress refused to go that far and instead enacted a compromise formula. Dividends received by individuals would be taxed at the same rate as long-term capital gains, which was then 15%. The result was a partially integrated corporate tax structure: the overall burden was less than under a classical model, but more than under a fully integrated model. Under the Obama administration, the principle of partial integration was preserved. Although tax rates rose for high-end taxpayers, dividends continued to be subject to tax at the same rate as long-term capital gains. The only difference was that the top rate for long term capital gain was raised to 20% and an expanded Medicare tax tacked on an additional 3.8%. Thus, dividends were effectively subject to a top rate of 23.8%. The next step toward full integration occurred under President Trump in 2018, when the corporate tax rate was lowered to 21%. For capital gains and dividends, the top individual rate of 23.8% was retained. Let’s run some numbers and see how this works. Assume that a corporation earns $100,000 and distributes its entire after-tax earnings as a dividend: Corporate Level

Shareholder Level

Income

$100,000

Tax (21%)

($21,000)

After-tax income

$79,000

Income

$79,000

Tax (23.8%)

($18,802)

After-tax income

$60,198

7 The overall tax burden of about 39.8% is very close to the top individual tax rate of 40.8% (including Medicare tax). So, if our goal is full integration, then that may not be perfect, but it’s pretty good.3 Nevertheless, as you might expect, things are much more complicated than that. Full integration means that the overall tax burden imposed on income earned via a corporation equals the tax on income earned directly by an individual. Even under the new rates, there could be a significant difference between the two. Here are a few pertinent examples: 1. Individuals are currently entitled to deduct up to 20% of their “qualified business income” (§ 199A). For individuals able to take full advantage of this deduction, the top effective rate of tax is 33.4%, which is considerably less than the 39.8% on distributed corporate earnings. 2. Although the overall tax burden of 39.8% on distributed corporate earnings is close to the top individual tax rate of 40.8%, there could be a significant difference in timing. When income is earned directly by an individual, the entire tax is due immediately. When income is earned via a corporation, only the 21% corporate-level tax is payable immediately. The shareholder-level tax is payable when the income is distributed. The deferral means that the present value of the shareholder-level tax liability might be less than the nominal liability. 8 3. For taxpayers in the lower brackets, the total tax burden on distributed corporate earnings is much higher than their marginal rates. For example, although individuals in the lowest two brackets are exempt from tax on dividends and long-term capital gains, the 21% corporatelevel tax by itself greatly exceeds their effective marginal tax rate. 4. Whereas long-term capital gain in the hands of an individual is taxed at preferential rates, no such allowance is made for long-term capital gain earned by a corporation. Capital gain is subject to the usual 21% corporate tax rate and, upon distribution, to the usual shareholderlevel tax. Thus, instead of bearing a total tax burden of between 0% and 23.8%, long-term capital gain accrued by a corporation bears a total tax burden of between 21% and 39.8%.

Having reached this stage, can we conclude that this is more-or-less the final word on the corporate income tax structure? Not likely. Depending upon political constellations and budgetary exigencies, a future Congress could move back toward a more classical structure or forward toward one that is more fully integrated. Stay tuned. To quote the inimitable Yogi Berra, it’s hard to make predictions, especially about the future. 1 Section 61(a)(7). 2 Another common method to achieve full integration is simply to ignore the existence of the entity and tax the equity owners directly on the entity’s earnings. However, if you want to learn more about that, I’m afraid you’ll have to register for a course in partnership taxation. 3 Why the discrepancy? My guess is that the framers of the 2017 legislation for some reason ignored the Medicare tax, despite the fact that it is an income tax in all but name. A 21% corporate-level tax combined with a 20% shareholder-level tax produces a total tax burden of 36.8%. The top individual rate (not including Medicare tax) is 37%.

9

CHAPTER 3

Indirect Taxation and Incidence I’ve mentioned a few times that the corporate-level tax is an indirect tax on shareholders and that the overall tax burden on distributed corporate profits is composed of the corporate-level tax together with the shareholder-level tax. This will be crucial to understanding the structure of corporate taxation. A different issue that is much discussed in the literature is the incidence of corporate taxation, that is, who ultimately bears the economic burden of the corporate income tax? The question of incidence is not unique to corporate taxation. With regard to every tax we can ask who ultimately bears the economic burden. However, the fact that we can ask the question does not mean that we can satisfactorily answer it. If people did not change their behavior in response to taxation, it would be easy to determine who bore the economic burden of any particular tax. When tax is imposed upon an individual, that individual would bear the economic burden of the tax: after paying a tax of $x, the individual would have $x less to consume or invest. When tax is imposed upon a corporation, the corporation’s 10 shareholders would bear the economic burden of the tax: after paying a tax of $x, the corporation would have $x less to distribute to its shareholders. However, people do change their behavior in response to taxation, and this makes the determination of incidence extraordinarily complicated. Their change

in behavior affects the supply and demand curves for goods and services and consequently the market price for those goods and services. If persons other than the formal taxpayer end up paying more for what they purchase or receiving less for what they sell, these other persons essentially bear some of the economic burden of the tax. As an example, consider a wage tax. Because what motivates workers is their after-tax income, a wage tax will tend to reduce the supply of labor. This will cause wage rates to rise (when supply goes down, prices go up), meaning that employers will bear some of the burden of the tax. However, that is far from the end of the story. Given the increased cost of labor, economic activity that would have been marginally profitable in the absence of the tax may no longer be profitable. Some firms that would have produced certain goods or services in the absence of the tax may no longer be able to do so. The curtailment of production of those goods and services will reduce their supply in the market and will cause the price of those goods and services to rise. What then is the incidence of the wage tax? Some of it is borne by workers (the nominal taxpayers), some of it is borne by employers, and some of it is borne by consumers. Note that this analysis is just the tip of the iceberg (in technical terms, it is a microeconomic analysis of a macroeconomic problem). If the wage tax reduces the overall level of employment, then aggregate consumer demand for goods and services might drop. Working out whether and to what extent the prices of goods and services will rise (due to reduced supply) or fall (due to reduced demand) and how whatever change in price will loop back and affect 11 overall economic activity, employment, and. . .well, you get the idea. As I indicated earlier, determining incidence is not easy. Who bears the ultimate economic burden of corporate income taxation? One occasionally hears the claim that the corporate income tax causes corporations to hire fewer employees and to reduce the wages of those that they do hire because after paying taxes they have less money left over to pay employees. This simplistic analysis is clearly misguided. Because wages are almost always deductible (i.e., paid out of pretax income), the presence or absence of a corporate income tax should not materially affect the corporation’s employment policy. Determining the incidence of corporate income taxation requires a considerably more complicated analysis. As noted, to determine the incidence of tax we need to know how the tax affects behavior and how that change in behavior affects the supply and demand curves. What motivates investors is after-tax profit. Therefore, a corporate income tax will tend to make investment in corporate equity less attractive than alternative investments. For example, in a closed economy the corporate income

tax may cause some investors to prefer, say, real estate to corporate equity. This could reduce employment (as corporations have fewer funds to finance their operations), and drive up the price of real estate. The corporate tax would at least partially be borne by workers and by those paying for housing or investing in real estate. It might also be partially borne by consumers if the curtailment of corporate activity results in fewer goods and services being produced (some models currently suggest that 75% of the corporate income tax is borne by shareholders and 25% is borne by workers). If not just corporate income but all income from capital is subject to tax (and at the same effective rates), there would be no tax advantage to investing in real estate or other instruments over 12 investing in corporate equity. In other words, a broad-based tax on all capital income would not likely skew investors’ decisions with regard to type of investment. As the tax would not affect behavior (and consequently would not affect the supply and demand curves), the economic burden of both the corporate-level tax and the shareholder-level tax would be borne by shareholders. However, the analysis in the previous paragraph implicitly assumes a constant level of aggregate investment with and without the tax. This assumption is far from certain. On the one hand, a broad-based tax on investment income would reduce somewhat the advantage of deferring consumption and could therefore reduce aggregate investment. To the extent it reduces investment in corporate stock, workers and consumers may bear some of the cost. On the other hand, a great deal of investment is motivated not by the anticipated return, but by a desire to spread out consumption over the course of one’s lifetime. In many cases the return on that investment is simply a windfall, and if so, then the tax might not reduce aggregate investment. In fact, a decrease in the rate of return might actually increase investment as individuals need to save more to meet their retirement goals (known in the economic literature as “the income effect”). Did I mention that determining incidence is not simple? Perhaps paradoxically, in a globalized economy with a high degree of capital mobility, the incidence of corporate taxation may be easier to determine than in a closed economy. When a country imposes tax on corporate profits—whether on the corporate level or on the shareholder level—the tax makes investment in that country less attractive relative to other venues. If some corporations opt to pursue alternative projects (or ship their operations overseas), there will be less demand for local labor and for local real estate. Consequently, wages and rent will likely be less than in the absence of the corporate tax. Some economists claim that the corporate tax 13

13 is effectively a (politically palatable) tax on domestic workers and landowners. Of course, this chapter is not intended as a definitive explication on the incidence of taxes in general or of corporate taxes in particular. Its purpose is simply to clarify the distinction between indirect taxation and incidence, concepts that the literature on corporate taxation often confuses. For example, one might read that as artificial entities, corporations are incapable of bearing tax burdens. The question then is who bears the economic burden of the corporate tax and the argument is made that because the corporation can shift some or all of the tax to employees, suppliers, customers, and so forth, shareholders bear little if any of the corporate income tax. Therefore, it is concluded, it is inaccurate to add the corporate-level tax to the shareholder-level tax. To determine the tax borne by shareholders, one should add only a portion of the corporate-level tax to the shareholder-level tax. The problem with this line of reasoning is that it confuses two distinct concepts. The first is that only individuals are capable of bearing tax burdens. This statement is certainly true. When the artificial entity known as a corporation incurs a tax liability (or any other expense), the immediate effect of the liability is to reduce what is available for distribution to shareholders. This is what is meant when we say that the corporate income tax is an indirect tax on shareholders. The second concept is that the economic burden of a tax is not necessarily borne by the formal taxpayer. This is true with regard to all taxes, whether the formal taxpayer is a corporation or an individual. Shareholders may ultimately bear only a small portion of the corporate-level tax. In the same vein, shareholders may ultimately bear only a small portion of the tax that they pay on dividends (and sole proprietors and workers may bear only a small portion of the individual income tax). 14 To misquote Forrest Gump, that is the last thing I am going to say about incidence. For our purposes, the shareholder-level tax is a direct tax on shareholders, the corporate-level tax is an indirect tax on shareholders, and the combination of these two is the total tax burden on distributed corporate earnings. A thorough analysis of who actually bears the burden of any particular tax might be of interest to economists, but it would make this book not quite as short and, at least for us lawyers, perhaps not quite as happy.

15

CHAPTER 4

Dividends as Income Our analysis of the structure of corporate taxation in Chapter 2 relied upon a tacit assumption that dividends constitute income in the hands of the shareholder. Do they? Should they? Let’s check.

A. Post-Acquisition Earnings Essentially, income means accession to wealth. Following the distribution of a dividend, is the shareholder any wealthier? Well, if markets are at all rational then presumably the value of the share will decrease by the amount of the dividend, and the shareholder will be no better off economically after the distribution than before. However, in order to answer the question of whether dividends constitute income, we need to broaden our perspective. It isn’t enough to consider the taxpayer’s position before and after the distribution of the corporation’s profits. We need to begin before the corporation earned the profits and end after it distributes those profits. Over this time period, the shareholder has indeed experienced an accession to wealth. Note, however, when the shareholder became wealthier. The shareholder experienced an increase in wealth, not when the corporation distributed its 16 earnings, but rather when the corporation accrued those earnings. Such being

the case, why was the shareholder not taxed when the corporation accrued its earnings? You probably know the answer to that one. Accession to wealth may be a necessary condition for the imposition of income tax, but it is not a sufficient condition. The accession to wealth must be realized. Therefore, the correct analysis is that the distribution of a dividend is a realization event. At that point we tax the shareholder’s prior accession to wealth.

B. Pre-Acquisition Earnings The above analysis works if the shareholder in question owned shares in the corporation when the latter earned its income. But now let’s assume that the current shareholder purchased her shares after the earnings had already accrued. In this case, is there a taxable accession to wealth? We already know that the actual distribution does not constitute an accession to wealth. Nor did the shareholder experience an accession to wealth when the corporation accrued its income, because she was not then a shareholder. Clearly those who benefited economically from those earnings were the corporation’s shareholders at that time. So, if the receipt of a dividend neither increases the current shareholder’s wealth nor constitutes a realization event, in what sense is it taxable income? The real answer is that it shouldn’t be. The price of shares reflects, among other things, the right to participate in the distribution of accrued earnings. Actual receipt of those earnings is simply getting something for which one has already paid in full.

C. Phellis The question of whether a shareholder should be taxed on the distribution of earnings that accrued before she acquired her stock was addressed by the Supreme Court in U.S. v. Phellis, way back in 17 1921.1 The Court recognized that a shareholder does not gain economically from the actual distribution of a dividend. However, it went on to state that a dividend nonetheless constitutes income “if it represents gains previously acquired by the corporation.”2 The Court did not explain why that should be so. Had it added the proviso that the gain was acquired by the corporation “during the time that the taxpayer owned stock,” or words to that effect, then, as we have seen, the dividend could and should be viewed as a realization event. But absent such a proviso, it is not at all clear why the distribution of previously acquired earnings constitutes income in the hands of the shareholder. The Court then dealt explicitly with the issue of a shareholder who had purchased shares after the corporation had already earned the income that it

subsequently distributed:3 The possibility of occasional instances of apparent hardship in the incidence of the tax may be conceded. Where, as in this case, the dividend constitutes a distribution of profits accumulated during an extended period and bears a large proportion to the par value of the stock, if an investor happened to buy stock shortly before the dividend, paying a price enhanced by an estimate of the capital plus the surplus of the company, and after distribution of the surplus, with corresponding reduction in the intrinsic and market value of the shares, he were called upon to pay a tax upon the dividend received, it might look in his case like a tax upon his capital. Not only might it look like a tax upon his capital, it actually is a tax upon his capital! As the Court’s own analysis lays bare, where 18 the stock price includes payment for accumulated profits, the subsequent receipt of those profits in the form of a dividend is, from the shareholder’s perspective, a return of capital. So why is the hardship involved in imposing tax on such a shareholder only “apparent”? Why does it only “look. . .like a tax upon his capital?” The Court explained as follows:4 In buying at a price that reflected the accumulated profits, he of course acquired as a part of the valuable rights purchased the prospect of a dividend from the accumulations—bought “dividend on,” as the phrase goes—and necessarily took subject to the burden of the income tax proper to be assessed against him by reason of the dividend if and when made. He simply stepped into the shoes, in this as in other respects, of the stockholder whose shares he acquired, and presumably the prospect of a dividend influenced the price paid, and was discounted by the prospect of an income tax to be paid thereon. In short, the question whether a dividend made out of company profits constitutes income of the stockholder is not affected by antecedent transfers of the stock from hand to hand. Because the dividend would have constituted income in the hands of the previous shareholder, it also constitutes income in the hands of the current shareholder, who “stepped into the shoes” of his predecessor. The Court then assumed that everything will come out okay, because the buyer and the seller will work it out between them. However, it does not come out okay. The primary problem is that imposing tax on the buyer does not relieve the seller of his own tax liability for the accumulated earnings. On the sale of the shares, 19

19 the “amount realized” (which serves as the starting point for calculating the seller’s taxable gain) includes the value of the stock’s share of accumulating earnings. So, the seller effectively pays tax once by discounting the price of the stock to reflect the purchaser’s future tax liability and a second time via the capital gains tax. To take the analysis a step further, consider that the earnings sitting in the corporation’s coffers waiting to be distributed have already borne the corporatelevel tax. In other words, although the corporate tax structure is based on the premise that corporate earnings will be subject to two levels of tax, in this particular instance they are effectively subject to three levels of tax.

D. The Proper Procedure: Bifurcation What the Phellis court should have done was to bifurcate the payment. Assume that Albert sold shares to Betty for $200 and that those shares’ portion of accumulated earnings was $79. The Court should have said that $79 was the price paid for the right to participate in the distribution of accumulated earnings and that the remaining $121 was the price paid for the other rights attached to the shares. In tax lingo, Betty would take a $79 basis in her right to receive accumulated earnings. When those earnings were eventually distributed as a dividend, her basis would be deducted from the amount received and would result in no taxable income: Upon Upon Receipt Sale of of Stock Dividend $79

Amount Received Adjusted the right to Basis in: participate in the distribution of preacquisition earnings

($79)

other rights attached to the shares Taxable Income

$121

($121)

$0

$0

Of course, what’s good for the goose is good for the gander. If the price paid

for the stock is bifurcated from Betty’s perspective, it also needs to be bifurcated from Albert’ perspective. Albert received $200, of which $79 is for the right to participate in the distribution of already accumulated earnings and $121 is for the other rights associated with the shares. The $79 would then be taxed as a constructive dividend instead of being taxed as capital gain. From Albert’s perspective, does the bifurcation really matter? It could matter a lot. Like Betty, Albert may be subject to different tax rates on dividends and on capital gains. If Albert is a nonresident alien or a foreign corporation, he might be subject to U.S. tax on dividends but not on capital gains. And so forth. Okay, you’re convinced. Phellis got it wrong. When shares are sold, the payment price should be bifurcated between (a) the amount paid for the right to participate in the distribution of already accumulated earnings and (b) the amount paid for the other rights associated with the shares. From the seller’s perspective, the 21 amount described in “(a)” should be treated as a constructive dividend. From the buyer’s perspective, the amount described in “(a)” should constitute her basis in the right to receive those earnings. But now you’re saying to yourself: “It’s an interesting point, but why go on about it for so long?” Well, it turns out it’s more than just an interesting point. A great deal of the law of corporate taxation—the complexity, the aberrations, the traps, and the planning opportunities—can be directly traced to Phellis. It is arguably the fundamental case of corporate taxation, the case from which all else follows. 1 257 U.S. 156 (1921). 2 Id. at 171. 3 Id. at 171. 4 Id. at 171–72.

23

CHAPTER 5

Dividends Received Deduction A. Basics The underlying concept of corporate taxation is that corporations pay tax on their income as it accrues and that shareholders then pay tax on the dividends that they receive. Each pays a relatively low rate of tax, and the overall tax burden on distributed corporate earnings for high-end taxpayers is similar (although not identical) to their marginal rate on ordinary income. But what if the shareholders are themselves corporations? Should they also be taxed on dividends that they receive? The problem here is that the corporation making the distribution already paid on that income. If its corporate shareholders pay tax on the dividend, that is a second level of tax, and the income is still in corporate solution. When that corporation distributes the already-twice-taxed earnings to its own shareholders, the income will be taxed a third time. Of course, the corporate shareholder’s shareholders might them themselves be corporations, their shareholders might be corporations. . .you see 24 where we’re going. Individuals who own stock at the top of the corporate pyramid would effectively face confiscatory rates of tax. So, the answer to the question of whether corporations should be taxed on

dividends is that they should not. There should be one corporate-level tax (the corporation that originally earned the income) and one shareholder-level tax (the individuals who ultimately receive the dividend). The intermediary corporations are nothing more than conduits and should be exempt from tax on the dividends they receive. What in fact did Congress do? Well, in some cases it effectively adopted the above analysis and freed the corporate shareholder from paying tax on the dividend. In others it did not, at least not completely. When the distributing and the receiving corporations are both members of the same “affiliated group,” the Code provides that the latter will report the dividend as gross income but will also be entitled to a dividends received deduction (DRD) of the same amount.1 The DRD will offset the gross income, leaving taxable income of zero. In most instances, this is the functional equivalent of excluding the dividend from gross income. We’ll get into the definition of “affiliated group” later on, but for the moment let’s just say that we’re talking about a situation in which, very roughly, one corporation has at least 80% direct or indirect control of the other corporations in the group. When the corporate shareholder and the distributing corporation are not in the same affiliated group, the former is still entitled to a DRD, but it will be less than the dividend received. How much less is a function of the percentage of shares owned by the receiving corporation.2 If the corporate shareholder owns less 25 than 20% of the distributing corporation, then the DRD is 50% of the dividend. If it owns 20% or more, then the DRD is 65% of the dividend.3 In both of these instances, the DRD does reduce the overall tax burden relative to a tax regime without a DRD. Nevertheless, any DRD under 100% imposes a hardto-justify additional tax burden on distributed corporate earnings.

B. Distribution of Pre-Acquisition Earnings Now things start getting interesting. How can a corporation exploit the DRD to achieve an unjustified tax benefit? Before you read on, try to figure it out yourself. It is a good test of your ability to integrate the concepts we’ve looked at so far and to put them to use to your client’s advantage. Here goes. Imagine that Potential Client Corporation has recently sold property and realized a capital gain of $100 million. It has earmarked $21 million for taxes. You approach Potential Client and tell it that you have a plan to reduce its tax bill by about $10 million. Your bona fides check out, so you get a meeting with the CEO. You tell her that you know of a certain Target

Corporation that is about to distribute a dividend of about $1 billion. Your advice to Potential Client is (a) purchase 10% of the shares in Target for $800 million, (b) collect a dividend of $100 million, and then (c) sell the shares exdividend for $700 million.4 The CEO looks at you skeptically and asks what is so brilliant about a series of transactions in which her corporation ends up in the same position from which it started. Now you explain that the $100 million loss on the sale of 26 Target will shelter the $100 million capital gain. Furthermore, as a 10% shareholder in Target, Potential Client will be entitled to a DRD of $50 million. It will therefore report taxable income of $50 million and pay tax of $10.5 million instead of the $21 million it was planning on paying. Total savings are $10.5 million (minus commissions and, of course, your fee). Thus, a series of transactions that is a wash economically can legitimately be reported for tax purposes as a loss. All that is required is a corporation with a sufficiently large realized capital gain (so that it will be able to deduct the capital loss on the sale of the Target shares), another corporation that is planning (or can be induced) to distribute a dividend, and a little bit of gumption. At this point, let’s move away from our role as tax advisors and marketers of corporate tax shelters and assume a role as neutral analyzers of the tax system. What is the root of the disparity between economic income and taxable income? Again, try to work it out yourself before continuing. The problem is computing basis. When Potential Client purchased the shares in Target, it paid $800 million for the shares. As we saw earlier with our analysis of Phellis, Potential Client should take a basis of $100 million in its right to participate in the distribution of the pre-acquisition earnings and a basis of $700 million in the other rights associated with the shares. As long as the preacquisition earnings are not distributed, Potential Client’s basis in the shares is $800 million. When Target distributes its earnings as a dividend, the $100 million received by Potential Client would, from its perspective, constitute a return of capital with no income tax consequences. Significantly, its basis in the ex-dividend shares would now be $700 million. Later on, when it sold those shares for $700 million, it would report neither a gain nor a loss for tax purposes. Presto, economic reality meets taxable income. What a thought. 27

C. Congressional Reactions Congress quickly became aware of the tax planning technique described. However, instead of viewing it as indicative of a fundamental flaw in the

corporate tax structure and working toward a proper allocation of basis, it considered it an isolated glitch. Therefore, it simply decided to make it more difficult for corporations to exploit the loophole.

1. Section 246(c) The first statutory response is § 246(c). This section provides that a corporate shareholder will not be entitled to the DRD unless it satisfies a holding period requirement with regard to the underlying stock. The minimum holding period depends on the type of stock involved. If the stock is common, then the corporation has to hold the stock at least 45 out of the 91 days commencing 45 days before the stock goes ex-dividend and ending 45 days after that date. When the stock concerned is preferred, the holding period is longer: at least 90 out of the 181 days commencing 90 days before the ex-dividend date. Failure to meet the holding requirement will disallow the DRD and the corporate shareholder will pay tax on the entire amount of the dividend. A legitimate question at this point would be: What is the connection between the inaccurate allocation of basis on the one hand and holding the stock for a minimum period of time on the other? The answer is that indeed there is no logical connection. However long the corporate shareholder holds onto its shares, the basis in those shares should be reduced following the distribution of pre-acquisition earnings. I already mentioned that Congress was not attempting to solve the underlying issue but was merely trying to make it more difficult for corporations to exploit the loophole. 28 Seeing as holding another corporation’s stock involves some risk, corporations may not be willing to hold the stock for a relatively extended period of time. By the way, that it why the holding period for preferred shares is longer than it is for common shares. Because the price of preferred stock is usually less volatile than that of common stock, Congress felt that holding the stock for 45 days would not expose the corporate shareholder to sufficient risk. What this means, of course, is that Congress did not prevent exploitation of the “loophole.” It simply made it inconvenient to do so. When corporations are willing to take the risk (and don’t forget that when analyzing the potential risks and rewards of holding shares, the ability to report an artificial loss for tax purposes could tip the scale in favor of the investment), the government is losing out.

2. Section 1059 Congress did not consider § 246(c) a completely satisfactory solution. The

problem, as Congress saw it, was that the risk the corporate shareholder is forced to undertake by holding the stock for 45 days might prove palatable when the distribution is sufficiently large relative to the price of the stock. To discourage such an attempt to take advantage of what it continues to consider a loophole, Congress enacted § 1059. This section concerns something called “extraordinary dividends.” An extraordinary dividend is a dividend which is greater than 10% of the corporate shareholder’s adjusted basis in the shares (or greater than 5% of the adjusted basis in the case of preferred shares). The idea is that when the dividend is that high, the limitation imposed by § 246(c) is insufficient and harsher measures are called for. If that were the end of the definition of extraordinary dividends, it would be extraordinarily easy to circumvent § 1059. Instead of distributing a single large dividend, the distributing 29 corporation could distribute a series of small dividends, none of which is large enough to constitute an extraordinary dividend. Therefore, the Code required the aggregation of all dividends whose ex-dividend dates occur within 85 consecutive days. Moreover, if over a period of a year, a corporate shareholder receives a series of dividends equal to or exceeding 20% of its adjusted basis in the shares (interestingly, here the threshold is the same for preferred stock and for common stock), the entire series will be considered an extraordinary dividend. However, the mere fact that a corporate shareholder receives an extraordinary dividend is not enough. The provisions of § 1059 only kick in when a corporate shareholder receives an extraordinary dividend in respect of stock, which it held for two years or less before the dividend announcement date. Note an important distinction between § 246(c) and § 1059. Section 246(c) requires a holding period of at least 45 days, which can be either before or after the date that the share goes ex-dividend. A corporation can purchase shares the day before the stock goes ex-dividend and still avoid § 246(c) by holding the stock for 45 days. In contrast, § 1059 requires a holding period of two years, all of which must be before the dividend announcement date. The corporate shareholder cannot avoid § 1059 by completing the holding period later on. Beyond the fact that the holding period is considerably longer and must be completed before the dividend announcement date, there is a much more fundamental difference between § 1059 and § 246(c). As we have seen, § 246(c) denies a DRD when the holding period is not met. In contrast, § 1059 does not affect the corporate shareholder’s right to the DRD. Instead, it provides that when the holding period is not met, the amount of the DRD (what it describes as “the nontaxed portion of the dividend”) is subtracted from the basis of the shares. The idea is to limit the capital loss on the sale 30

30 of the shares to that portion of the dividend on which the corporation actually paid tax.

D. Debt-Financed Portfolio Stock Another ostensible way to obtain an illegitimate tax benefit via the DRD is by investing borrowed funds in dividend-paying stock. Because interest paid on the loan is deductible in full, while at least 50% of the dividend income is offset by the DRD, a pretax loss could turn into a post-tax gain. For example, assume that Corporation A borrows $100,000 at 8.5% interest and invests the money in Corporation T stock. Each year, T distributes a dividend, of which A receives $7,900. Ignoring taxes, A would each year record income of $7,900, an interest expense of $8,500, and therefore an economic loss of $600. It doesn’t look like a very successful investment. However, if the interest is deductible and A is entitled to a 50% DRD, A might end up with an after-tax gain. The after-tax cost of the interest is $6,715 ($8,500 minus tax savings of $1,785). The after-tax income from the dividend is $7,070 ($7,900 minus tax of $830). Voilà: a pre-tax loss churns out an after-tax gain. Congress was aware of this little maneuver and, in order to combat it, enacted § 246A. This section denies the DRD to the extent that portfolio stock is debt financed. In our example, the stock was 100% debt financed. Therefore, § 246A would disallow the entire DRD. While the after-tax cost of the interest is still $6,715, the after-tax gain from the dividend is only $6,241 ($7,900 minus tax of $1,659). There is now an after-tax loss of $474. That seems to solve the problem. Importantly, § 246A applies only to “indebtedness directly attributable to investment in the portfolio stock.” What this means is that it is not enough that the corporation owed somebody 31 $100,000 at the time that it purchased or held the stock. Section 246A kicks in only when the indebtedness was incurred for the specific purpose of investing in the portfolio stock. A corporation may owe money, invest in the stock of another corporation, and still be entitled to the full DRD. Much more importantly, § 246A applies only to portfolio stock. It does not apply, for example, to corporations with a controlling interest in the distributing corporation. For them, financing the investment with borrowed funds, even when the indebtedness is directly attributable to the investment, does not prevent their benefiting from the DRD.

So, wait a minute. If the arbitrage really is a problem, why allow controlling shareholders to exploit it with impunity? And if it is not, then why deny the DRD for holders of debt-financed portfolio stock? I’ll leave that one for you to ponder. 1 Section 243(a)(3). 2 Section 243(a)(1). 3 Section 243(c)(1). 4 These numbers are far from fanciful. In Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (2001), rev’ing 113 TC 214 (1999), Compaq—engaging in a tax shelter technique similar to the one described in the text but slightly more complicated because it involved the purchase of shares in a foreign corporation and exploitation of the foreign tax credit—purchased Royal Dutch Shell Petroleum shares for $887 million, sold them the same day for $868 million, and later collected a dividend of $22 million (minus $3 million in Dutch withholding taxes).

33

CHAPTER 6

Sale of Shares A. Introduction When a taxpayer sells shares, the taxable gain or loss is the sales price minus the adjusted basis. That’s about as simple as things get in tax law. But is it really that simple? Let’s focus on shareholders that are themselves corporations. The problem here is that some portion of the current value of the shares may reflect accumulated earnings—earnings that have already been subject to corporatelevel tax. If a corporate shareholder pays tax on the gain from the sale of the stock, then those earnings will effectively be subject to a second corporate-level tax. Of course, the eventual distribution of those earning to the corporate shareholder’s own shareholders will entail a third level of tax. As you might expect, this snag is directly traceable to our old friend, Phellis. To see why, imagine that the Court had allowed bifurcation. When a corporation sells shares, we would allocate some of the amount realized to the right to participate in the distribution of accumulated earnings and the balance to the 34 remaining rights attached to the shares. The tax consequences would be as follows: The sale of the right to receive accrued earnings would be treated as a

constructive dividend, and the corporate shareholder would be entitled to an appropriate DRD. The amount received for the remaining rights minus the corporate shareholder’s adjusted basis in the stock would constitute capital gain. Were the sale price so bifurcated, the results would be reasonable and would accord with the underlying corporate tax structure. However, in light of Phellis, the amount paid for the shares is not bifurcated. No part of the sales price is allocated to the accumulated earnings, and the selling corporation is not entitled to a DRD. For corporate shareholders, the result of the failure to bifurcate is the imposition of an additional level of tax.

B. Bootstrap Sales 1. The Plan (Avoiding Double Taxation) Assume that a Corporation X decides to sell its shares in Corporation T and that T has accumulated earnings. How might X attempt to reduce its tax bill? Try this. Before the sale, X causes T to distribute all of its accumulated profits as a dividend. Presumably, extracting the dividend will reduce the value of the shares, but that’s okay. The total amount received (the dividend plus the ex-dividend sales price) should more or less equal what X could have received for the shares had it sold them prior to extracting the dividend. Nevertheless, there is a big difference when it comes to the tax consequences. On receipt of the dividend, X would be entitled to a 35 DRD, which would effectively shield some or all of the dividend from tax. In tax parlance, extracting a dividend prior to the sale of shares is known as a bootstrap sale, and this type of maneuver has generated quite a bit of controversy.

2. The Man (the Commissioner’s Position) The Code neither prohibits nor inhibits bootstrap sales. Nevertheless, on a number of occasions the Commissioner has argued that the substance of the transaction should be elevated above its form and that in essence the dividend is part of the “amount realized” on the sale of shares. The upshot is that X would not be entitled to a DRD on the dividend. Is this position reasonable? In other words, does it conform to the underlying structure of corporate taxation? Assuming that the earnings were accumulated after the shareholder acquired

its shares,1 then the answer to each of these questions is no. Presumably, T already paid tax on its earnings. A tax on X’s gain from the sale of the shares would constitute a second round of tax. The eventual distribution of those earning to X’s own shareholders will entail a third round of tax. Extracting a dividend prior to sale is a legitimate means of self-help to avoid a second corporate-level tax on T’s accumulated earnings.

3. The Proverbial Fan (the Cases Hit the Courts) The case law in the field of bootstrap sales is not entirely consistent. Sometimes the courts uphold the Commissioner’s position and sometimes they do not, and there is no precise formula for determining ahead of time which way they will go. The key issue that they seem to examine is whether there exists a non-business 36 motive for extracting the dividend. Other considerations include timing (how much time elapsed between the extraction of the dividend and the sale of the shares) and dependence (whether the extraction of the dividend is dependent upon the subsequent sale). The saga of bootstrap sales is typical of many aspects of corporate taxation. The unwillingness of the Supreme Court in Phellis to bifurcate the price paid for corporate shares (and Congress’ acquiescence in that decision) created a disequilibrium in the corporate tax structure: corporate shareholders who extract a dividend receive protection from a second corporate-level tax, while those who sell their shares without extracting a dividend do not. Therefore, as a form of self-help, corporations will tend to extract earnings as dividends before they sell the shares, even when they might not have done so in the absence of tax considerations. At this point, the Commissioner steps in and argues that the substance of the transaction, taken as a whole, is a sale and that it should be taxed accordingly. In response, corporations cannot simply explain that Phellis created an untenable situation in which selling shares without first extracting the earnings as a dividend would result in at least triple taxation of those earnings. Therefore, they search for some reason, beyond the obvious tax advantages, for why they extracted the earnings before they sold the shares. This little dance forces corporate shareholders to be (how can I put this delicately?) less than completely forthright with regard to their motives. There is no logical reason why the tax consequences of the distribution should turn based upon the motive for extracting the earnings, the time that elapsed between the dividend and the sale, or any other factors that typically come into play in the litigated cases. As long as the earnings were accumulated after the shareholder acquired its shares, the corporate shareholder should be entitled to a DRD.

37 How can you put all this to practical use? Simply being aware of the misallocation of basis and of the consequences of that misallocation is the first big step in the right direction. If you do that, you will be in a good position to avoid the pitfalls and maybe even to exploit some of the opportunities. 1 As we have seen, pre-acquisition earnings are a whole other kettle of fish.

39

CHAPTER 7

Individual Shareholders A. Bifurcation Because (qualified) dividends received by individuals are taxed at the same rate as (long-term) capital gains, much of what we discussed with regard to corporate shareholders is irrelevant when the shareholder is an individual. For corporate shareholders, converting dividends into capital gains or capital gains into dividends is a big deal. For individuals—much less so. Of course, this doesn’t mean that the distinction between capital gain and dividend income never has any practical ramifications. For instance, short-term capital gain is subject to the full rate of tax. Thus, if the stock was held for less than one year, the result could be the imposition of an exceedingly high overall effective tax burden. Here, the disparity between black letter law and the correct approach (i.e., bifurcation) works to the government’s advantage. As Congress is normally less sensitive to discrepancies that operate to the detriment of the taxpayer, it is perfectly content to leave this one alone. Perhaps Congress assumes that taxpayers can take care of themselves. 40 However, when the discrepancies work to the taxpayer’s benefit, Congress tends to get involved. Consider the case in which an individual purchases stock, receives a dividend, and then sells the stock (ex-dividend). Assuming that the

value of the stock dropped by the amount of the dividend, the upshot is that the taxpayer will report dividend income and a capital loss. So, bottom line, our question is this: when will a capital loss coupled with dividend income of the same amount work to the advantage of an individual taxpayer? If you know the answer, raise your hand. First, individuals can deduct up to $3,000 a year of capital losses even when they do not have any capital gain. This deduction will offset ordinary income, subject to ordinary tax rates. Second, capital losses can eliminate short-term capital gain, which is also taxed at ordinary rates. If a high-end taxpayer can use the capital loss to reduce ordinary income or short-term capital gain, she will save 40.8%, having paid only 23.8% on the receipt of the dividend. How serious are these concerns? The first is self-limiting. Because individuals can only deduct $3,000 a year of capital losses in excess of capital gains, the maximum savings for any individual from this maneuver is the difference between the ordinary tax rate and the dividend tax rate times $3,000. The greatest difference between these two rates is 20%.1 That works out to a maximum of $600 a year. Hardly earth-shattering stuff here. Your accountant will probably charge you more than that just to fill out the forms. The second is potentially more significant. An individual with substantial short-term capital gain could use the technique of purchasing stock cum dividend and selling it exdividend. By paying tax on the dividend at a reduced rate and using the capital loss to offset the capital gain, the individual could effectively reduce the 41 tax on short-term capital gain from the ordinary rate to the dividend rate.

B. Congressional Response Having identified a possible shelter for individuals, Congress was determined to prevent or inhibit taxpayers from exploiting the loophole. Of course, the most direct way to close the loophole is to strike at the heart of the problem. Have we mentioned Phellis lately? A proper allocation of basis would mean that the purchase, dividend, and subsequent sale would become a series of non-events for tax purposes. However, we know that Congress has so far refrained from overturning Phellis even to prevent much more abusive corporate tax shelters. It is certainly not going to do so just to prevent this relatively minor individual tax shelter. So, taking the corporate tax structure’s rigid adherence to Phellis as a given, what could Congress do to prevent individuals from exploiting it to convert short-term capital gain (or $3,000 annually of ordinary income) into dividends? One method might be to provide that when an individual shareholder experiences a capital loss on the sale of shares after having received a dividend

in respect of those shares, the capital loss (to the extent of the dividend) could only be used to reduce or eliminate long-term capital gain. Such a provision would focus narrowly on the problem concerned. If Congress really wanted to be nice, it might even allow the taxpayer to use the capital loss to reduce or eliminate dividend income. This would solve the problem of having to pay tax on the dividend without being able to deduct the capital loss. As you have probably surmised, Congress chose a different route. Instead of focusing on the problem and providing a narrowly 42 crafted solution, Congress—as in the case of the corporate shareholders’ DRD—imposed a holding period as a condition for the preferential tax rate. The holding period for individuals is 60 out of 121 days (beginning 60 days before the ex-dividend date) for common shares and 90 out of 181 days (beginning 90 days before the ex-dividend date) for preferred shares. As with corporations, there is no logical connection between the misallocation of basis and the holding period. The idea is that holding the shares requires the shareholder to assume a certain degree of risk, and that may deter some who would consider using the described technique to turn short-term capital gain (or $3,000 worth of ordinary income) into dividend income. Perhaps even more so than in the case of corporate shareholders, the holding period requirement for individuals seems to be a case of legislative overkill. Where an individual investor purchases stock, receives a dividend, and then sells the stock without meeting the holding period requirement, the dividend will be taxed at ordinary rates, effectively imposing a fine equal to the difference between ordinary rates and capital gains rates on the receipt of a dividend in respect of shortly-held stock. If the shareholder is indeed attempting to use the capital loss to shield short term capital gain or ordinary income, the fine might be justified. However, the additional tax burden is imposed even if the shareholder has no possibility of sheltering either short-term capital gain or ordinary income. Not only is this tax burden inequitable, it is also economically inefficient. It practically requires individual shareholders who have received dividends to hold onto their stock for at least the holding period, instead of selling when they think it appropriate to do so. Note the irony. The primary purpose of the holding period requirement was to discourage purely tax-motivated behavior. The 43 effect of the holding period requirement is to force taxpayers to plan investment strategies around their tax consequences.

1 For individuals just below the top bracket, the ordinary rate is 38.8% and the dividend rate is 18.8%.

45

CHAPTER 8

Dividends and Distributions From Capital Until now, we’ve discussed the tax consequences of receiving a dividend. What we have not yet done is explain what exactly a dividend is. It’s time.

A. Introduction For starters, the tax definition of “dividend” is not necessarily identical to the definition of “dividend” for the purposes of corporate law. In other words, what the relevant corporate law calls a dividend, tax law might not, and vice versa. Therefore, we need to focus on the definition of “dividend” in the Internal Revenue Code. According to the Code, a dividend is a subcategory of something called a “distribution,” which is any money or other property transferred from the corporation to its shareholders in respect of their shares.1 The Code goes on to tell us that a 46 distribution is a dividend if and only if it is distributed out of the “earnings and profits” of the distributing corporation.2 A distribution not out of E&P is, for tax purposes, not a dividend but rather a distribution of capital. That seems to

make sense. Now, for a technical issue. Let’s assume that a corporation has E&P. Can it decide to keep its E&P and instead distribute its capital? The answer is no. The Code makes the simplifying, irrefutable assumption that as long as a corporation has E&P, any distribution is out of that E&P.3 Only in the absence of E&P is the distribution considered a distribution of capital.

B. Distribution of Capital We are already familiar with the tax consequences of receiving a dividend. What happens when a shareholder receives a distribution of capital (i.e., when the corporation has no E&P)? In such a case, shareholders reduce the adjusted basis in their shares by the amount of the distribution received.4 Once basis has been exhausted, any further distribution will constitute capital gain.5

C. Earnings and Profits—Definition “Earnings and profits” is clearly an important term, so we open up the Internal Revenue Code to look for the definition. We read section after section, and we’re getting a little hot and bothered and frustrated, because we know that the definition is in there somewhere, but we just can’t seem to find it. Save your energy. Despite the fact that it is pivotal in determining the tax consequences of corporate distributions, the term “earnings and profits” is not defined in the Code. The closest the Code gets is 47 § 312, which describes the effects of certain events on the corporation’s E&P. However, that is not a definition. Specifically, it does not tell us what the starting point is. Where, then, do we begin? The answer is that there really is no answer. The computation of E&P is more an issue of an intuitive understanding of what constitutes dividend-paying capacity than it is a strict application of formal rules. For example, when a corporation performs a service and gets paid for it, its E&P is increased by the amount that it receives minus the cost of providing the service. Where does the Code say that? It doesn’t. It’s just obvious. When a corporation pays federal income tax, this clearly reduces its dividend-paying capacity and therefore its E&P. Where does the Code say that? Again, it doesn’t. So, in working out E&P, simply focus on what the corporation can distribute without dipping into its capital. If you do that, you will at least be headed in the right direction. Such being the case, where does § 312, with its “earnings and profits shall be increased” and “earnings and profits shall be decreased,” come into play? Truth

be told, § 312 is best viewed as a partial checklist, telling you that when you are computing E&P, make sure to take these things into account. In most cases, you probably would have been able to figure it out on your own.

D. Current and Accumulated E&P Dividends can be distributed either out of the current year’s E&P or out of the E&P accumulated since the corporation was formed.6 When the corporation has both, it must distribute out of current E&P first and only then out of accumulated E&P (if you’re wondering why that is important, keep reading).7 48

E. Current E & P The first source for distributing dividends is the current year’s E&P.

1. The “Nimble Dividend” The fact that current E&P is distributed before we look at accumulated E&P means that it is available for distribution regardless of anything that happened before the current tax year. Even if the corporation has an accumulated deficit in E&P (i.e., if its accumulated E&P is negative), it can still distribute a dividend out of current E&P.8 This is an example of what is commonly referred to as a “nimble dividend.” The reason it is called nimble is that, just like Jack jumping over the candlestick, a corporation desiring to make such a distribution has to be quick. Once the clock strikes midnight on the last day of the tax year, the current E&P of that year gets swallowed up into accumulated E&P and is no longer separately distributable. Thus, the timing of a distribution could have far-reaching consequences. A distribution on December 31 might be a dividend, while the same distribution a few hours later, on January 1, might be a distribution of capital.

2. “The Rule of Imaginary Time” An important feature of current E&P is that, as far as its distribution is concerned, the Code views the entire tax year as a single instant. In other words, the dates on which events occur 49 during the tax year are insignificant. Taking our cue from the world of

cosmology, we might call this “the rule of imaginary time.”9 The rule of imaginary time has two important consequences. The first is that current E&P is not calculated on a running basis, but for the entire year,10 and is available for distribution from the beginning of the year. Thus: (a) Corporations can distribute their current E&P for the entire year in January, before the earnings even accrue. (b) If a corporation experiences positive E&P in the first half of the year and negative E&P of the same amount in the second half of the year, a mid-year distribution will not be out of current E&P because there is no current E&P to distribute. The second consequence of the rule of imaginary time is that when allocating current E&P to a series of distributions during the year, there is no order of precedence. If there is not enough current E&P to go around, current E&P is allocated pro rata to all the distributions.11

F. Accumulated E&P Once the current year’s E&P is distributed, the next source for distributions is accumulated E&P. Here, the order in which events occur does matter. In keeping with our cosmological terminology, we might say that accumulated E&P follows “the rule of real time.” 50 Furthermore, and just to complicate things, accumulated E&P can include some or all of the current year’s E&P.

1. No Current E&P Start with the simplest case. Assume that current E&P is exactly zero. Absent current E&P, we turn to accumulated E&P. Here, due to the rule of real time, the order in which the distributions occur is significant. Accumulated E&P is distributed on a first come, first served basis.12 Therefore, if the first distribution of the year is greater than accumulated E&P, the first distribution will exhaust E&P, and all subsequent distributions will be out of capital. If the first distribution of the year is less than the accumulated E&P, the remainder will be available for the second distribution, and so forth.

2. Positive Current E&P When there are both current and accumulated E&P, things get a bit more

complicated. Remember, we first distribute current E&P using the rule of imaginary time. Thus, the entire year’s E&P will be prorated among all of the distributions throughout the year. The next thing we do is to distribute accumulated E&P using the rule of real time. Consequently, each distribution, from the first to the last, will use up part of the accumulated E&P on a firstcome, first-served basis. Of course, since part of each distribution is out of current E&P, only the remaining amount of each distribution will be out of accumulated E&P. Once the accumulated E&P is exhausted, any subsequent distributions, to the extent that they are not out of current E&P, will be deemed distributions out of capital. 51

3. Negative Current E & P The trickiest situation of all is where there is a deficit in current E&P and, as of the end of the previous year, a positive amount of accumulated E&P. Of course, the issue here is not the distribution of current E&P (there is no current E&P to distribute), but rather the effect of the current year’s deficit on accumulated E&P. The accumulated E&P available for distribution at any particular date during the year will be the accumulated E&P as of the end of the previous year, plus or minus the E&P that accumulated during the current year as of that date. Note that although we are considering E&P of the current year, it is subject to the rule of real time because we are computing accumulated, not current, E&P (I told you this one was tricky). Technical point: since corporations ordinarily calculate their E&P annually, how can we know the E&P has accumulated during any intra-year period? The solution provided by the regulations is if we don’t know for sure, then we simply prorate the current year’s deficit.13

G. Effects of Distributions on E&P When a corporation distributes a dividend, the amount of the dividend will reduce the corporation’s E&P. That much is obvious: whatever E&P the corporation distributes is no longer available for future distribution. What happens when the distributing corporation has no available E&P (i.e., the E&P account is zero or negative)? Your immediate reaction might be that the distribution will drive the E&P account into, or further into, negative territory. However, a little 52

bit of focus will prove that this is not the case. Recall that in the absence of E&P, distributions are not dividends but rather distributions of capital. As the distribution is not out of E&P, it cannot reduce E&P. This reasoning is codified in § 312(a) of the Code, which provides that: [O]n the distribution of property by a corporation with respect to its stock, the earnings and profits of the corporation (to the extent thereof) shall be decreased by. . .the amount of money. . .so distributed. Notice the parenthetical expression “to the extent thereof.” This means that a distribution can never reduce E&P to below zero. The only way that E&P can be reduced below zero is for the corporation to experience an actual economic loss greater than its existing E&P. 1 Section 301(a). 2 Section 316(a). 3 Section 316(a). 4 Section 301(c)(2). 5 Section 301(c)(3)(A). 6 The Code also has a special rule for earnings that were accumulated before March 1, 1913, but let’s ignore that one. 7 Section 316(a). 8 Reg. 1.316–1(e) (example 1). 9 This is not a term of art, but simply a phrase that I think well describes the legislative approach to current E&P. For a description of imaginary time in cosmology, see e.g., STEPHEN HAWKING, A BRIEF HISTORY OF TIME: FROM THE BIG BANG TO BLACK HOLES 134–139 (1988). 10 Section 316(a)(2). 11 Treas. Reg. 1.316–2(b). 12 Reg. 1.316–2(b). 13 Treas. Reg. 1.316–2(b).

53

CHAPTER 9

Distribution of Property A. Introduction In addition to distributing cash, corporations can also distribute property to their shareholders (actually, seeing as property, by definition, includes cash, it is more accurate to say that in addition to distributing cash, corporations can distribute other types of property to their shareholders). The distribution of noncash property introduces an addition level of complexity.

B. General Utilities and Its Aftermath To understand the present state of the law, we need a brief history lesson. Back in 1935, the Supreme Court decided the case of General Utilities.1 The case concerned a corporation that had distributed appreciated property (i.e., property containing unrealized gain) to its shareholders. From the perspective of the shareholders, the tax consequences were clear: the fair market value (FMV) of the property constituted a dividend. The question 54 that arose concerned the tax consequences of the distribution to the corporation. The Commissioner maintained that the distribution was a realization of the

appreciation and that the corporation should pay tax on that appreciation. He raised three arguments in support of his contention. His first argument was that by declaring a dividend the corporation became indebted to its shareholders for the market value of the property at that time. Transferring the property satisfied that debt. Therefore, as with any other case in which a taxpayer uses appreciated property to satisfy a debt, the transfer constituted a sale of the property and the amount realized on the sale was the face value of the debt. The second argument was that prior to the distribution, the corporation had already negotiated the sale of the property to a third party and that subsequent to the distribution, the shareholders sold the property to that third party under the terms negotiated by the corporation. The Commissioner argued that, in effect, the corporation was the one that sold the property and that the shareholders merely served as a conduit to pass the property from the corporation to the third party. The third argument was the most important. The Commissioner argued that the very act of distributing property to shareholders constitutes a realization event. The Court rejected the Commissioner’s position. With regard to the first argument, the Court agreed that had the corporation declared a dividend of a certain amount and then used the property to satisfy the debt so created, the distribution would have constituted a taxable sale. Nevertheless, the Court made the highly technical distinction between (a) declaring a dividend of a certain amount and then distributing the property in lieu of that amount and (b) declaring a dividend of the property itself. Because the corporation had not declared a dividend of a certain amount, but merely declared that it would transfer the property to its 55 shareholders, there was no debt to satisfy other than the obligation of transferring the property to the shareholders. With regard to the Commissioner’s second argument, the Court refused to consider it on the procedural ground that the Commissioner had failed to raise it in the lower courts. The Commissioner’s third argument, that the very act of distributing the property constitutes a realization event, was the most significant. However, it seems to have been lost somewhere in the shuffle. The Court did not really deal with that issue. The General Utilities ruling, relying as it did on technical and procedural grounds and ignoring the Commissioner’s most thematic argument, became the spawning ground for subsequent litigation. Sometimes the Commissioner won. Generally, he lost. Nevertheless, General Utilities came to stand for the proposition that, provided the corporation avoided various technical pitfalls along the way, the distribution of property from a corporation to its shareholders is not a realization event. In 1954, Congress codified General Utilities in what is now § 311(a)(2) of the Code. In 1986, Congress legislated a partial repeal of General Utilities. Section

311(b) now provides that when a corporation distributes appreciated property to its shareholders, gain shall be recognized as if the corporation had sold the property to its shareholders at FMV. So why is this only a partial repeal? Because § 311(b) only applies to gain property (i.e., property whose FMV is greater than its adjusted basis). It does not apply to loss property. Here, the General Utilities principle, as codified in § 311(a)(2), continues to apply. In other words, on the distribution of property to its shareholders, the corporation will recognize gain, but it will not recognize loss. 56

C. Distribution of Property Encumbered by a Debt Let’s spice thing up a bit. Assume that the property is encumbered by a debt. How does this affect things?

1. From the Perspective of the Corporation As far as the corporation is concerned, the tax consequences of the distribution are delineated in § 311(b)(2) and § 336(b), which codify the famous cases of Crane and Tufts.2 Together, these sections provide that for the purpose of computing gain or loss at the corporate level, the amount realized is the FMV of the property or the liability, whichever is greater.

2. From the Perspective of the Shareholders When a corporation distributes encumbered property to its shareholders, the amount of the distribution is the FMV of the property minus the debt. In other words, the amount of the distribution is equal to the equity in the property. If the debt exceeds FMV, the amount of the distribution is zero (sorry, the Code is not willing to recognize a “negative” distribution). With regard to basis, the shareholders ignore the debt and take a basis equal to the property’s FMV.3

D. Effect of Property Distributions on Earnings and Profits Let’s now turn to the question of how a distribution of property affects the distributing corporation’s E&P. We’ll first consider 57 property containing unrealized gain and then property containing an

unrealized loss.

1. FMV Exceeds Adjusted Basis When corporate property appreciates in value, the appreciation enhances the corporation’s dividend-paying capacity (because is it now wealthier than it was before). However, due to the realization principle, unrealized appreciation is not reflected in the corporation’s E&P account. As we know, distribution of appreciated property constitutes a realization event. Consequently, when appreciated property is distributed, E&P should be increased by the hitherto unrealized appreciation. On the other hand, like a cash distribution, the distribution of non-cash property should reduce E&P by the value of the property. This analysis is codified in § 312(b), which provides that E&P be (a) increased by the amount by which the FMV of the property exceeds its adjusted basis and then (b) reduced (“to the extent thereof”) by the FMV of the property so distributed.

2. Adjusted Basis Exceeds FMV What happens when a corporation distributes loss property? To be consistent with our analysis of appreciated property, we would need to (a) reduce E&P by the hitherto unrealized loss and then (b) reduce E&P “to the extent thereof” by the FMV of the property. However, when it comes to loss property, the Code does not follow this model. Instead it adopts a shortcut. The idea is that the adjusted basis equals the current FMV plus the unrealized loss (work it out: if the loss is the adjusted basis minus the FMV, then the FMV plus the loss equals the adjusted basis). Therefore, instead of 58 reducing E&P first by the unrealized loss and again by the FMV, it tells us to reduce E&P by the adjusted basis of the property.4 But are the two methods actually equivalent? Not always. The problem is the application of the “to the extent thereof” qualification. If there is sufficient E&P, then there is no problem, because as long as “to the extent thereof” does not kick in, the two formulas are mathematically identical. However, if there is not enough E&P to go around, then the two methods diverge. In the first, “to the extent thereof” applies only to the distribution, not to the loss. In the second, it applies to both. As an example, consider a case in which there is no E&P. Under the first method, we reduce E&P (into or further into negative territory) by the amount of the loss. Under the second method (the one adopted by the Code), we

would not reduce E&P at all. Which method do you think makes more sense?

3. Encumbered Property We have already seen that when the distributed property is encumbered by a debt, this affects both the realized gain at the corporate level and the amount of the distribution at the shareholder level. It is reasonable to assume that it will also affect the amount by which we increase or decrease E&P. The only question is: what adjustments need to be made? Fortunately, § 312(c)(1) comes to the rescue: In making adjustments to the earnings and profits of a corporation. . .proper adjustment shall be made for. . .the amount of any liability to which the property distributed is subject. In case that isn’t clear, let me help you out. Recall that when a corporation distributes property, we reduce E&P by the FMV (in 59 the case of gain property) or by the adjusted basis (in the case of loss property).5 What section 312(c)(1) is trying to tell us is to reduce the amount by which we reduce E&P by the debt to which the property is subject. In other words, in the case of gain property reduce E&P by FMV minus the debt, and in the case loss property reduce E&P by the adjusted basis minus the debt (in both instances “to the extent thereof”). 1 General Utilities and Operating Co. v. Helvering, 296 U.S. 200 (1935). 2 Crane v. Commissioner, 331 U.S. 1 (1947); Commissioner v. Tufts, 461 U.S. 300 (1983). 3 Section 301(d). 4 Section 312(a)(3). 5 In the case of gain property, we also increase E&P by the FMV of the property, but that step isn’t relevant here.

61

CHAPTER 10

Disguised Distributions A. Not Every Transfer Is a Distribution Section 301 describes the rules that apply to “a distribution of property. . .made by a corporation to a shareholder with respect to its stock.” This implies that there is another type of distribution: distributions made by a corporation to a shareholder not in respect to its stock. When they want to make this distinction clear, corporate tax people sometimes refer to “§ 301 distributions” to distinguish them from other types of distributions (those not “with respect to its stock”). Other times, they are not so pedantic and use the word “distribution” when they really mean “§ 301 distribution.” It all depends on context. So, when is a distribution not a distribution? In other words: When is the transfer of property from a corporation to its shareholders not a § 301 distribution? Well, if a shareholder sells property or provides a service to the corporation and in return receives FMV, then the payment will not be a distribution “in respect to its stock.” It will be classified for tax purposes as it would in a similar transaction between unrelated parties. 62 But how do we know whether the transfer of property from a corporation to its shareholders is a § 301 distribution? Is it enough for the corporation and the

shareholder to state clearly, “this is a distribution with respect to stock” or “this is payment for services” in order to settle the issue? No, the classification does not depend upon any formal declaration by the corporation; nor does it depend upon the terms of any written or oral agreement between the corporation and its shareholders. It depends upon the facts and circumstances.

B. Why the Designation Matters One important reason why the designation matters is deductibility. While salaries, rents, royalties, interest, and the like are ordinarily deductible, dividends are not. This would seem to constitute a strong incentive for corporations to try and characterize the payment as something other than a dividend. Nevertheless, deductibility is only part of the story. We also need to take into account the effect of the designation on the shareholder. Due to the DRD (in the case of corporate shareholders) or the low long-term capital gain rate (in the case of individual shareholders), shareholders will often pay less tax on a dividend than on payments received for services. If the distribution is out of capital, shareholders may incur no immediate tax liability. So, we need to run the numbers for each set of circumstances to determine the overall tax burden. In some instances, there may be an advantage to classifying the payment as something other than a § 301 distribution. In other instances, classification as a § 301 distribution may be advantageous. In still others, it will not make that much of a difference. 63

C. Classifying the Payment So, how do we know when a transfer is a payment for property or services and when it is a § 301 distribution? The basic rule is very easy to state: when the payment exceeds the FMV of the property or services received, then the excess is a § 301 distribution. For example, if a shareholder leases to a corporation property with a fair market rent of $100,000 and the contract provides that the corporation will pay $150,000 for the use of the property, then only $100,000 of the payment will properly be classified as rent. The remaining $50,000 is a distribution. However, the spanner in the works is determining the FMV of the property or services provided. The more difficult it is to value the property or services the more difficult it is to characterize the payment. Perhaps the most common disputes concern shareholders who are also employees. The corporation pays what seems to be a large amount of money and calls it a salary. Should we accept the proffered characterization or should we view part of the payment as a disguised dividend? The key question is how much the services provided by the shareholder/employee are worth on the open market. That is not always easy to

figure out. Over, the years, courts have proposed test upon agonizing test to decide what is a reasonable salary for this purpose.1 Whether, at the end of the day, they make the analysis any easier is questionable. 1 See, e.g., Exacto Springs Corporation v. Commissioner, 196 F.3d 833 (7th Cir. 1999) (describing some of the multi-factor tests and proposing in their stead an “independent investor test”).

65

CHAPTER 11

Stock Distributions A. Introduction As an alternative to distributing money or other property, a corporation may issue to its shareholders additional shares. These are commonly called “stock dividends,” “stock distributions,” or “bonus shares.” Several fundamental questions arise with regard to the tax consequences of stock dividends. The first and most important is whether the stock constitutes a § 301 distribution in the hands of the shareholders. If it does, then the follow-up question concerns quantification: what is the amount of the distribution? Whether or not the stock constitutes a § 301 distribution, we need to address the issue of basis: what is the shareholder’s basis in the bonus shares, and how does the receipt of the bonus shares affect the basis of the shareholder’s original stock? Finally—and only because there is a specific statutory provision that deals with it—we need to explore how to characterize, for tax purposes, the amount realized on the eventual sale of the bonus shares. 66

B. Case Law To understand the present state of the law, we need to go back to the very

early days of the individual income tax, when constitutional issues were important in framing the parameters of the income tax.

1. Eisner v. Macomber In 1916, Standard Oil of California declared a stock dividend of 50%, meaning that for each two shares of common stock owned, shareholders were entitled to receive, at no cost, one additional share. As the taxpayer in Eisner v. Macomber owned 2,200 shares of Standard Oil stock, she received a stock dividend of 1,100 shares.1 The Revenue Act of 1916 (a precursor to the Internal Revenue Code) explicitly provided that the market value of stock dividends shall be considered gross income. In order to avoid paying tax on the value of the stock dividend she received, Macomber contended that the provision was unconstitutional. To make sure that we are all on the same page, here is a brief constitutional segue. Article I of the Constitution requires that “direct taxes” be apportioned among the states according to population. In the waning years of the nineteenth century, the Supreme Court ruled that the individual income tax, insofar as it imposed tax on income from property, was a direct tax not apportioned according to population and was therefore unconstitutional.2 Fast-forward eighteen years. In 1913, the Sixteenth Amendment to the Constitution was ratified. This amendment permitted Congress to impose tax on “incomes, from whatever source derived” without the requirement that the tax be apportioned according to population. Whew. 67 As noted, the 1916 Revenue Act explicitly imposed tax on stock dividends. The thrust of Macomber’s argument was that a stock dividend is not “income” in the constitutional sense of the term and that a tax on stock dividends—being a direct tax, not imposed on income, and not apportioned among the states by population—is unconstitutional. The Court agreed. The key question here is this: what is the difference between cash dividends and stock dividends? The claim that after receiving a stock dividend the shareholder is no better off than before (presumably the value of the bonus shares plus the value of the original stock after the distribution is equal to the value of the original stock before the distribution) is not a sufficient answer, because the same is true of cash distributions. Presumably, the value of the exdividend shares plus the cash is approximately equal to the value of the shares prior to the distribution. The Court reasoned that shareholders experience an accession to wealth when the corporation accrues income. However, in conformance with the

realization principle, tax is not imposed at that time. Cash dividends constitute a realization of that gain and, as such, are taxable. The receipt of stock dividends is not a realization event, as nothing is received out of the corporation’s assets. In a vigorous dissent, Justice Brandeis argued that a stock dividend is the equivalent of a cash dividend followed by a reinvestment of the distributed funds. The Court rejected this analogy. When a corporation distributes cash, shareholders have a choice whether or not to reinvest the money received. When a corporation distributes shares, shareholders have no choice in the matter. 68

2. “Common on Preferred” Macomber seemed to settle the issue: stock dividends are not income. However, this case involved a distribution of common shares to common shareholders (“common on common”). Would the same line of reasoning apply in other circumstances? In Koshland, the Court held that common shares issued to preferred shareholders (“common on preferred”) constitute gross income.3 It distinguished Macomber by pointing out that the distribution of common on common does not affect the shareholder’s substantive rights in the corporation. The same rights are simply spread out among a larger number of shares. In contradistinction, the distribution of common on preferred changes the shareholder’s substantive rights. Therefore, the receipt of common on preferred is a realization event.

3. “Preferred on Preferred” The receipt by preferred shareholders of additional preferred shares also affects the shareholder’s rights vis-à-vis the corporation and the other shareholders. As their rights have changed, the Koshland rule would apply and here too the shares would constitute a § 301 distribution.

4. “Preferred on Common” What would happen if the corporation distributed preferred shares to its common shareholders? Does this change the substantive rights of the common shareholders? Think about it a bit before you go on. The answer here is that is depends. If there are no preferred shares outstanding and the common shareholders receive a pro rata 69 distribution of preferred shares, then their rights vis-à-vis the corporation and

each other will not have changed. Under Macomber, the common shares would not constitute a § 301 distribution. On the other hand, if there are already preferred shareholders, then the receipt of preferred shares will allow the common shareholders to compete with the original preferred shareholders for the first dollars of any future distribution. This would entail a substantive change in their rights.4

5. Summing Up the Case Law After declaring that a stock dividend is not taxable, and furthermore that Congress is constitutionally barred from taxing stock dividends, the Court carved out exception after exception to the rule. “Common on preferred” is taxable. “Preferred on preferred” is taxable. Even “preferred on common” is sometimes taxable. Eventually the rule became the exception and the exception became the rule. Stock dividends are § 301 distributions unless they leave unchanged the substantive rights of the shareholder in the corporation.

C. Section 305 Today Macomber and its progeny are codified in § 305, and the structure of the statutory provision reflects the development of the case law. Section 305(a) states the “general rule” that gross income does not include stock in the corporation making the distribution. Section 305(b) then provides a list of circumstances in which stock dividends are nevertheless treated as § 301 distributions. In almost all instances, § 305(b) follows the older case law. However, § 305 does have its own quirks, and there are instances (not many) in which a stock dividend will not constitute a 70 § 301 distribution even though it changes the rights of the shareholders. In fact, I would suggest that you go over § 305(b) and see if you can construct a stock dividend that changes the shareholders’ substantive rights but that nevertheless is governed by § 305(a). (Really, go ahead and do it. Not only will the exercise help you better understand how § 305 works, it will also sharpen your statutory reading prowess.) While you’re at it, notice § 305(b)(1). This section tells us that that if any of the shareholders had an option to receive cash or other property, then the stock dividend will be a § 301 distribution for all the shareholders. With regard to the shareholder with the option, § 305(b)(1) seems to accord with the Court’s reasoning in Macomber. Recall that Justice Brandeis, in dissent, argued that a distribution of stock is the equivalent of a cash distribution followed by a reinvestment. The Court rejected this analogy by pointing out that,

in the case of a stock dividend, the shareholders have no choice but to receive the stock. Where a shareholder has the option of receiving cash, the stock dividend seems analogous to receiving cash and then reinvesting that cash in the corporation. But why should an unexercised option affect the tax liability of the other shareholders? Here, too, the Brandeis dissent and the Court’s response seem to require this result. Assume that one shareholder exercises an option to receive cash and the others receive shares. Presumably the proportionate share of the other shareholders in the corporation will increase, and the shares they receive will constitute a § 301 distribution. The option holder then uses the money to purchase new shares in the corporation. The issuance of new shares for cash will not affect the other shareholders. 71 So, if we accept as premises that (a) any change in the shareholder’s substantive rights constitutes a § 301 distribution and (b) that a stock dividend in which a shareholder is given an option to receive cash is equivalent to a cash distribution followed by a reinvestment of the funds received, then § 305(b)(1) does seem to follow.

D. Quantification The bull in the china shop is the issue of quantification. In other words, if the stock dividend does constitute a distribution for tax purposes, what is the amount of that distribution? Both the case law and the regulations are clear: the amount of the distribution is the FMV of the shares received.5 Ostensibly, that seems to make sense. After all, with regard to any other property distributed by the corporation to its shareholders, the amount of the distribution is the FMV of the property. Should the valuation rule be different just because the property happens to be shares in the distributing corporation? Yes, it should, and the reason is that there is a fundamental difference between shares in the corporation and any other property. Recall that where a stock dividend does not alter the shareholder’s substantive rights, the stock received is not a § 301 distribution at all. In other words, although the stock received clearly has economic value, the amount of the distribution for tax purposes is zero. Where there is a slight change in the shareholder’s rights, it would seem proper to focus on the value of that change rather than the FMV of the stock received. Nevertheless, the case law and the regulations disagree and stick to their

view that the § 301 distribution is equal to the full FMV of the stock received. Does this make sense? Hardly. Section 305 72 represents a serious trap for the unwary. A tiny miscalculation could have far-reaching tax consequences.

E. Basis Allocation of basis after a stock dividend is a relatively straightforward affair and is a function of the tax treatment of the distribution itself. If the stock dividend is treated as a § 301 distribution, then the bonus shares take a basis equal to their FMV.6 If the stock dividend is not a § 301 distribution, then it is viewed, in effect, as a “split” of the original stock. Accordingly, the original stock’s basis is allocated to the original stock and to the bonus shares in proportion to their FMVs.7

F. Stock Dividends as a Tax Planning Tool The fact that shareholders can, in some instances, receive a stock dividend that is not a § 301 distribution opens up some interesting tax planning opportunities. Assume that a corporation has only common shares outstanding and a significant amount of E&P. The corporation’s individual shareholders are interested in withdrawing money from the corporation. One method would be to have the corporation distribute cash. The problem here, from the perspective of the shareholders, is that any funds they withdraw will be taxed as a dividend. An alternative method would be to create a new class of redeemable preferred stock and to distribute shares of this new class of stock to the existing shareholders on a pro rata basis. Such a distribution will be governed by § 305(a), and the only tax consequence is that part of each shareholder’s basis in her existing common shares will be allocated to the new preferred shares. The 73 second step would be for those shareholders who are interested in doing so to sell their new preferred shares. This transaction would most likely produce capital gain. It may be anticipated that sometime in the future, the purchaser of the shares—often referred to as the “facilitator”—will redeem the shares and collect cash from the corporation:

The result of the stock dividend, sale, and redemption is similar to that of a cash distribution. In each case, the shareholders continue to hold all of the stock in the corporation and some of the corporation’s money is now in the hands of the shareholders. The major advantage of using the stock dividend, sale, and redemption technique rather than the more straightforward cash distribution is that the amount received, up to the basis in the preferred stock, will be received tax-free (another is that classifying the income as capital gain may allow the deduction of otherwise suspended capital losses). Of course, the advantage of deducting basis is merely one of timing. The remaining shares now have a truncated basis, so that when the shareholders sell their shares in the future, they will report a greater capital gain than they would have otherwise. However, timing is (almost) everything; and while I would normally hesitate to encourage procrastination, if you can put off paying taxes it is usually a good idea to do so. 74

G. Section 306: Tainting the Stock Congress was not enthused by this end run around taxable distributions. What can it do to counter such a maneuver? One way would be to attack the first step in the process by viewing the receipt of preferred shares by common shareholders as a taxable distribution. This Congress was reluctant to do, perhaps not least because the Supreme Court once ruled such a tax unconstitutional. Furthermore, although we could cast doubt on the continuing validity of Macomber as binding constitutional precedent, as a policy matter it does make sense. Justice Brandeis’ dissent notwithstanding, a § 305(a) stock distribution is effectively just a splitting up of the rights associated with the shareholder’s common stock and spreading those rights among a larger number of shares. Taxing the stock distribution would be a clear case of legislative overkill. Therefore, Congress did not impose tax on the distribution of the preferred stock. Instead, it enacted § 306, which marks (or “taints”) the stock, in whole or in part, as potentially hazardous material. In technical terms, when a corporation

issues preferred stock to its common shareholders in a § 305(a) distribution, § 306 examines what would have happened had the corporation instead distributed cash equal to the FMV of the preferred shares. When the stock is eventually sold, a portion of the amount realized, equal to the amount of that hypothetical cash distribution would have been classified as a dividend, is considered ordinary income. So, in the extreme (although unexceptional) case in which there is sufficient E&P to go around, the preferred shares will be tainted in their entirety. Any amount received on their sale (up to their FMV at the time they were issued) is considered ordinary income. 75

H. Section 306: What’s Really Going On? Although not intuitively obvious, § 306 is another example of how the Supreme Court’s decision in Phellis creates unnecessary complexity and inequity in the corporate tax structure. The real issue underlying § 306 is how to account for retained corporate earnings when shares are sold; and that, of course, leads us directly back to Phellis. We know that when stock in a corporation with accumulated profits is sold, part of the price paid for the stock should be allocated to the right to participate in the distribution of those profits, and the seller should be taxed on that portion as if it were a constructive dividend. In other words (as far as that portion is concerned), no deduction would be allowed for basis,8 corporate shareholders would be entitled to a DRD, individual shareholders would pay tax at the rate applicable to dividends, and so forth. The Phellis Court rejected that construction and, ever since, taxpayers have been taking advantage of the misallocation. Before 2003, one of the simplest ways for individual shareholders to do so was to sell shares containing retained earnings instead of extracting earnings as a dividend. That portion of the amount realized representing the retained earnings would be taxed at capital gains rates instead of the rates applicable to ordinary income. Apparently, Congress was willing to accept that particular mode of tax planning. However, it drew the line when shareholders attempt to sell only the accumulated earnings and retain their other rights in the corporation. Although from a tax policy perspective there is no intrinsic difference between selling the right to accumulated earnings as part of the sale of other rights and selling the right to accumulated earnings on its own, Congress, as usual, was satisfied with making it difficult for taxpayers to exploit the 76 loophole instead of trying to close it. Having to sell some of the other rights

in the corporation (future earnings, voting, and so forth) might prove a practical impediment. Selling the retained earnings on their own is too easy. For that reason, Congress found the distribution of preferred shares and their subsequent sale so objectionable. The share distribution in effect separates the accumulated earnings (represented by the new preferred shares) from the other rights in the corporation (represented by the old common shares). Selling the preferred shares to a third party allows the shareholder to retain all the other rights and sell only the accumulated earnings. Therefore, Congress decided that the sale of preferred shares would produce ordinary income. The bottom line, as usual, is that as long as shareholders do not intentionally try to sell accumulated earnings while retaining their other rights in the corporation, Congress is not overly concerned with the underlying Phellis glitch in the tax system. 1 252 U.S. 189 (1920). 2 Pollock v. Farmer’s Loan & Trust Co., 157 U.S. 429 (1895). 3 Koshland v. Helvering, 298 U.S. 441 (1936). 4 Strassburger v. Commissioner, 318 U.S. 604 (1943). 5 Treas. Reg. 1.305–1(b)(1). 6 Section 301(d). 7 Section 307. 8 Unless the earnings accumulated before the seller acquired the shares.

77

CHAPTER 12

Redemptions A. Introduction A redemption is the purchase by a corporation of its own stock. After the redemption, the corporation will have fewer assets (some were used to purchase the shares) and there will be fewer of its shares outstanding (some were redeemed). From a tax perspective, the key question that arises with regard to redemptions is whether to treat the amount received from the corporation as proceeds from the sale of an asset or as a distribution. On the one hand, the shareholder parts with some shares, which looks like a sale. On the other hand, the shareholder receives some of the corporation’s assets, which looks like a distribution. So, is it “really” a distribution or is it “really” a sale? The real answer is that it’s partially a distribution and partially a sale. But the Code can’t handle that. It has to be either one or the other. Therefore, if in the eyes of the Code the redemption is more of a sale than a distribution, the entire amount will be treated as a sale; if it is more of a distribution than a sale, the entire amount will be treated as a distribution. 78

B. Why Does It Matter?

We’ll get to the question of when the Code classifies a redemption as a distribution and when it classifies it as a sale. But before we do, let’s first consider the tax consequences of each outcome.

1. Basics Nothing too exciting here. If the redemption is treated as a sale of stock, then the capital gain is the difference between the amount received and the shareholder’s basis in that stock.1 If it is treated as a distribution, then the amount received will be a dividend to the extent of the distributing corporation’s E&P, then reduce the basis of the shareholder’s remaining stock, and finally constitute capital gain.

2. Section 1059(e)(1)(A) The spanner in the works is § 1059(e)(1)(A), which provides that in almost every case in which stock is redeemed from a corporate shareholder, any amount treated as a dividend shall be treated as an extraordinary dividend. . .without regard to [the amount of the dividend or] the period the taxpayer held such stock. Recall that when a corporate shareholder receives an extraordinary dividend, the basis in its shares is reduced by “the nontaxed portion of such dividends,” which is equal to the amount of the DRD. If the nontaxed portion of the dividend exceeds the basis, the difference is immediately taxed as capital gain. 79 The policy behind § 1059(e)(1)(A) is not clear. When we talked about extraordinary dividends, we saw that the conceptual foundation is that when a shareholder receives a relatively large dividend within the first two years after acquiring the stock, there is an irrefutable assumption that the distribution is of pre-acquisition earnings. In order to prevent corporate shareholders from exploiting the misallocation of basis inherent in Phellis, Congress provided that basis will be reduced by the nontaxed portion of the dividend. There does not appear to be any reason to assume that a distribution is out of pre-acquisition earnings, just because the distribution is accompanied by a redemption of some or all of the shareholder’s stock. When the Code determines that a redemption is close enough to a distribution to be treated as one, corporate shareholders who participate in the redemption should seemingly be treated the same as corporate shareholders who receive a distribution that is not accompanied by a redemption of some of their shares.

3. Earnings and Profits

The effect of the redemption on the corporation’s E&P is a function of how the redemption is classified on the shareholder level. When the redemption is classified as a distribution, the procedure is fairly simple. As with any other distribution, the amount of the distribution will reduce E&P (to the extent thereof). The fact that a certain number of the corporation’s outstanding shares were retired in the process is irrelevant. When the redemption is classified as a sale or exchange, things get a bit more complicated. Section 312(n)(7) provides that (take a deep breath): 80 If a corporation distributes amounts in a redemption [which is treated as a sale or exchange], the part of such distribution which is properly chargeable to earnings and profits shall be an amount which is not in excess of the ratable share of the earnings and profits of such corporation. . .attributable to the stock so redeemed. If you are so inclined, you can translate this sentence into a more standard mathematical formulation,2 carry it around in your back pocket, and then look at it whenever necessary. However, to understand the provision we need to take a step back and try to work out just what it is that the Code is really trying to do. For purposes of the corporation’s E&P account, the Code effectively views the redemption as a segmentation of the corporation (call it C) into two new corporations (call them C1 and C2), followed by the liquidation of one of them. During the first phase, the Code allocates a proportionate share of C’s E&P to C1 and C2. During the second phase, C1 distributes all its assets to its shareholders and disappears. We are left with C2, which has some of C’s assets and liabilities and a proportionate share of its E&P. Moving back to the real world, C2 is none other than post-redemption C. Having redeemed x% of its shares, C retains (100−x)% of its E&P. Now reread § 312(n)(7): it says to reduce the corporation’s E&P by an amount equal to its pre-redemption E&P times the proportionate share of its outstanding shares that it redeemed. 81

4. Which Treatment Is Better? Having reviewed the relevant statutory provisions, we can now ask the question that is of paramount concern to your client. Which is better: sales treatment or distribution treatment?

Actually, it’s kind of a trick question, because there is no universally correct answer. It depends upon the particular circumstances: the amount of the distribution, the corporation’s available E&P, the shareholder’s basis in the shares redeemed and in the entirety of his shareholding, whether or not the shareholder has any otherwise suspended capital losses, and whether the shareholder is an individual or a corporation. In some situations, distribution treatment is preferable. In others, taxpayers will prefer sales treatment. Nevertheless, § 302, which contains the rules for determining whether a redemption will be classified as a distribution or as a sale, is structured so as to imply that shareholders always prefer sales treatment. The vast majority of the provisions in § 302 serve to restrict the possibility of sales treatment and to impose various burdens on shareholders who desire sales treatment. The reason for this is that prior to 2003, dividends in the hands of individuals were subject to tax at full ordinary rates. Accordingly, the Code sought to restrict sales treatment and to prevent individual shareholders from converting dividends into capital gain. Section 302 has not been updated to reflect the fact that today dividends are taxed at the same preferential rates as capital gain. From this perspective, the structure of § 302 is anachronistic. Most of the cases that discuss § 302 are concerned with pre-2003 individual shareholders, so generally taxpayers in those cases are arguing for sales treatment while the Commissioner is arguing for distribution treatment. Texts, even those published after 2003, tend to assume that shareholders always want sales or exchange 82 treatment. Keep in mind that the battlefield surrounding § 302 is no longer what it used to be, and that in many cases, shareholders will actually prefer dividend treatment.

C. Attribution Rules Section 302 contains a list of statutory rules for distinguishing between sales treatment and distribution treatment. Most of them involve comparing the shareholder’s pre-redemption and post-redemption holdings. The underlying idea is that, when the redemption results in a significant enough reduction in the shareholder’s interests in the corporation, it will be accorded sales treatment. When the redemption does not reduce the shareholder’s interests or when the reduction is not too significant, it will be treated as a distribution. However, for the purpose of calculating the shareholder’s (either preredemption or post-redemption) holdings, it is not enough to consider only the shares actually owned by the shareholder. The Code views as constructively owned by the shareholder shares that are owned by persons related to the

shareholder. Therefore, before we discuss the substantive rules we first need to examine the attribution rules, i.e., the rules that determine whose shares are constructively owned by whom.

1. Statutory Framework The primary vehicle for attributing stock ownership is § 318. This section contains a number of provisions, each of which tells us that stock actually owned by X is constructively owned by Y (we will go into these provisions momentarily). Your perfunctory reading of § 318 may lead you to believe that we need to refer to these rules whenever it is necessary, in the field of corporate taxation, to identify and/or quantify the shares owned 83 by a particular shareholder. If so, you were misled. Go back and reread the first 19 words of § 318: For purposes of those provisions in this subchapter to which the rules in this section are expressly made applicable— In other words, § 318 is not an operative provision of the Code. It is just a template. In effect, it simply allows Congress, when drafting substantive rules that require attribution of stock from one person to another, to save some effort and, instead of drafting attribution rules for each of those other provisions, simply to reference § 318. In the absence of an explicit reference, § 318 does not apply. Furthermore, even those provisions that do reference § 318 do not always adopt it in its entirely. Often, they incorporate only parts of it or modify it, so that the attribution rules vary from section to section, even among those that expressly apply the rules of § 318. Of immediate interest to us, § 302 adopts the § 318 attribution rules along with a proviso that they will not apply in all situations. Nevertheless, for the moment we will ignore the proviso and simply examine § 318 in its plain vanilla state. Afterwards, when we discuss the specific provisions of § 302, we will see where and when the rules do not apply.

2. First Attribution Rule: Family Members Section 318(a)(1) provides that stock held by individuals is constructively owned by certain close relatives. The idea seems to be that close relatives operate according to the principle of “one for all and all for one” and that when they own shares in the same corporation they tend to coordinate their actions. Of course, this Norman Rockwell ideal is often not descriptive of reality, and family

feuds can be more acrimonious than feuds among unrelated parties. 84 Nevertheless, Congress was not interested in a case-by-case investigation of family dynamics. An individual constructively owns shares that are actually owned by that individual’s (a) spouse (except for a spouse who is legally separated), (b) children, (c) grandchildren, and (d) parents (for the purpose of (b), (c), and (d), the Code makes no distinction between an adopted child and a biological child). Note that there is no attribution to siblings.

3. Second Attribution Rule: From an Entity Section 318(a)(2) attributes stock ownership from entities to those behind the proverbial veil. In doing so, it distinguishes between partnerships, estates, and trusts on the one hand and corporations on the other. For the former, the rule is simple: stock held by the entity is attributed proportionally to the partners or beneficiaries. The rule for corporations is similar, with one proviso: stock is attributed only to shareholders who own at least 50% of the shares in the corporation (perhaps on the assumption that minority shareholders have no say in the actions of the corporation). In other words, minority shareholders do not constructively own any of the stock owned by the corporation, while majority (including 50%) shareholders constructively own the corporation’s stock in proportion to their shareholding.

4. Third Attribution Rule: To an Entity Attribution from an entity to its partners, beneficiaries or shareholders is relatively intuitive (if I own a corporation and the corporation owns a house, it is fairly clear that I indirectly own the house). Attribution to an entity from its partners, beneficiaries or shareholders is less so (if I own a corporation and I also own a house, does the corporation indirectly own my house?). Nevertheless, 85 § 318(a)(3) attributes to entities stock owned by their partners, beneficiaries, or shareholders. As far as partnerships, estates, or trusts are concerned, § 318(a)(3) attributes to them constructive ownership of the stock owned by any partner or beneficiary. The entity is the constructive owner of all the stock owned by any of its partners or beneficiaries, without regard to the stock owner’s percentage interest in the entity. The rule for corporations is similar, except that stock ownership is attributed to a corporation only if the shareholder has at least a 50%

ownership interest in the corporation.

5. Fourth Attribution Rule: Option Holders Section 318(a)(4) provides that any person with an option to acquire a share constructively owns that share. Furthermore, a person with an option to acquire an option—or an option to acquire an option to acquire an option and so forth ad infinitum—is also the constructive owner of the underlying stock.

6. Operating Rules Having specified the four attribution rules—family members, from an entity, to an entity, and option holders—§ 318 then gives us a list of “operating rules” or meta-rules: rules that explain how to use the rules. The focus of these operating rules is whether the rules can be used more than once. In other words, can stock that is attributed from A to B be further attributed from B to C? a. Basic Operating Rule The basic answer, subject to two important provisos, is that the rules can be used over and over again without limit.3 That is, if stock actually owned by A is attributed to B, and if the Code says 86 that a percentage of any stock owned by B is constructively owned by C, then C constructively owns a percentage of the stock actually owned by A. Ownership of the stock can be further attributed from C to D, from D to E, and so forth. b. First Exception: “Adam and Eve” The operating rule allowing repeated use of attribution is subject to two exceptions. The first might be referred to as the “Adam and Eve” exception. If we were allowed multiple use of family attribution, every human would constructively own the stock owned by any other human. To avoid this result, the Code provides that shares attributed under the rule of family attribution cannot be further attributed under the family attribution rule.4 Thus, there is no attribution to siblings (children of parents), children-in-law (spouses of children), or parents-in-law (parents of spouses). Note that this does not mean that family attribution necessarily ends the attribution chain. All it means is that the chain cannot contain any more family attribution. Stock that is attributed to a family member can be further attributed under § 318(a)(3) to an entity in which the family member is a beneficiary, partner, or shareholder. c. Second Exception: To and From an Entity

The second exception is aimed at preventing the attribution of stock owned by one partner, beneficiary or shareholder to another partner, beneficiary or shareholder.5 In other words, the fact that my partner, fellow-beneficiary, or fellow-shareholder owns stock does not mean that I constructively own that stock. In technical terms, the operating rule states that stock attributed under § 318(a)(3) (attribution to an entity) cannot then be attributed under § 318(a)(2) (attribution from an entity). 87

D. Classifying the Redemption We can now (finally!) turn our attention to the rules that delineate the classification of a stock redemption. Section 302 lists four instances in which a redemption will be treated as a sale of stock. The unstated but clearly implied default principle is that if none of these cases apply then the redemption will be treated as a § 301 distribution. In order of appearance in § 302, the four cases are as follows: (a) a redemption not essentially equivalent to a dividend (from the perspective of the shareholder),6 (b) a substantially disproportionate redemption,7 (c) a termination of the shareholder’s interest,8 and (d) a partial liquidation.9 For reasons that will soon be made clear, we will begin with (b), continue on to (c), go back to (a), and finally finish off with (d).

E. Substantially Disproportionate Redemptions Section 302(b)(2) provides that a redemption will be treated as a sale or exchange provided that all the following conditions are met: (a) The shareholder’s share of the voting power after the redemption is less than 80% of what it was prior to the redemption.10 88 (b) The shareholder’s share of the common stock in the corporation is less than 80% of what it was prior to the redemption.11

(c) After the redemption, the shareholder has less than 50% of the total voting power.12 Don’t forget that when calculating the shareholder’s pre-redemption and post-redemption shareholding, we need to include not only actual ownership, but also constructive ownership.

1. The 80% Requirements: Non-Voting Shares and Non-Common Shares Redemption of voting common shares is relatively straightforward. As long as the shareholder’s post-redemption voting rights and common share ownership are less than 80% of what they were previously, then the 80% test is met. If there exist more than one class of common shares, then the computation of common share ownership is by market value. What happens if the shares are either non-voting or non-common? This gets a bit tricky. a. Non-Voting Shares Assume that prior to the redemption, a shareholder has only non-voting shares (0% of the voting rights). Eighty percent of 0% is 0%. Thus, to get down to less than 80% of the previous holding, our shareholder would need to end up with less than 0%. To put it mildly, that is not easy to do. Bottom line: a redemption of non-voting shares cannot possibly meet the 80% voting power requirement.13 89 b. Non-Common Shares Ostensibly, the same reasoning would apply with regard to stock other than common stock. No redemption of non-common shares could reduce the shareholder’s ownership of common shares to below 80% of what it was. Nonetheless, with regard to voting preferred stock (admittedly a very rare beast), the Service came to a different conclusion. It ruled that the requirement of reducing one’s proportional holding of common stock by more than 20% applies only if the shareholder actually owns common stock. If the shareholder owns only voting preferred stock, then it is sufficient to reduce voting power to less than 80% of what is was and to less than 50% of total voting power.14 Note that the revenue ruling applies only to voting non-common stock. It does not apply to non-voting common stock. As already demonstrated, a shareholder who owns only non-voting common stock cannot meet the substantially disproportionate requirement, because no matter how many shares

are redeemed, voting power cannot be reduced to less than 0%.

2. The 50% Requirement The third condition for sales treatment under § 302(b)(2) is that, following the redemption, the shareholder has less than 50% of the total voting power. Thus, even if the redemption reduces the shareholder’s voting power from 99.9% to 50%, it will not meet the requirements of § 302(b)(2).

3. Series of Redemptions From what we have seen so far, shareholders who want their withdrawal of cash or other assets from the corporation to receive 90 sales treatment can achieve their goals provided they are willing to reduce significantly their relative stakes in the corporation. But Congress was concerned that shareholders might engage in a series of redemptions, each of which is substantially disproportionate but, when taken as a whole, leave shareholders in a similar position to the one in which they started. To forestall such a maneuver, § 302(b)(2)(D) provides that a redemption will not be considered substantially disproportionate if it was made pursuant to a plan the purpose or effect of which is a series of redemptions resulting in a distribution which (in the aggregate) is not substantially disproportionate with regard to the shareholder. Note that this provision applies only to a series of redemptions that are part of a plan. If they are not part of a plan, then each will be evaluated independently. But why should it matter if there was a plan? The economic consequences of a redemption that is part of a series are the same whether not the series was undertaken as part of a plan. Well, as we have seen on numerous occasions, Congress is considerably less concerned with creating a comprehensive and coherent construct that with preventing or discouraging taxpayers from intentionally exploiting the inconsistencies in the structure.

F. Complete Termination Now that you understand the concept of a substantially disproportionate redemption of stock, you might jump to the conclusion that the redemption of all the stock owned by a shareholder would necessarily be substantially disproportionate. If you did, you would be wrong. Think again and see if you can come up with two cases in which a redemption of all the stock owned by a shareholder would not be substantially disproportionate. 91

91 One such case is when the shareholder’s stock is non-voting. As we have already seen, even the redemption of all of the shareholder’s stock would not satisfy the 80% test. The second case is where the shareholder, all of whose shares were redeemed, constructively owns shares that are owned by a related party. Under § 302(b)(3), the redemption of all of a shareholder’s stock is accorded sales treatment. With regard to non-voting stock, the application of this rule is pretty clear. However, the main thrust of § 302(b)(3) is to permit sales treatment on the complete termination of a shareholder’s economic interest in a corporation, even though family members continue to own stock.

1. Avoiding Family Attribution Section 302(c)(2) provides that, subject to certain conditions, we can ignore family attribution when examining whether or not there is a complete termination. The idea behind avoiding family attribution in cases like there is to allow parents who pass the family business on to the next generation to benefit from capital gains treatment on the redemption of their shares (this was particularly significant when dividends were taxed at ordinary rates). Specifically, the Code provides that if the shareholder no longer has an interest in the corporation and commits to refrain from acquiring an interest in the corporation for ten years, then for the purpose of testing complete termination, the family attribution rules will not apply. From a conceptual perspective, there seems to be a certain degree of tension between the § 318 family attribution rules and the waiving of those rules in the face of a § 302(b)(3) complete termination. The family attribution rules proceed from the premise that close family members tend to view their assets more as belonging to the family unit than to the individual who happens to 92 possess legal title. The waiver of family attribution in the case of a complete termination, on the other hand, seems to be based on the idea that once a person cuts formal ties to a corporation, the fact that family members continue to control the corporation is of no import. In fact, here there seems to be an irrefutable proposition that the lack of formal ties signifies a lack of economic interest in the corporation. The fact that the ex-shareholder may in fact be pulling the strings behind the façade of family members is irrelevant. It should be emphasized that only family attribution can be waived under § 302(b)(3). Attribution from or to an entity and attribution to an option holder cannot be waived despite the complete termination.

2. Splitting Stock Among Family Members Ostensibly, the waiver of family attribution in the case of complete termination opens up a simple planning technique. A shareholder who desired sales treatment could transfer shares to a close family member. A subsequent redemption of all of the shares owned by either of them would constitute a complete termination and be classified for tax purposes as a sale of stock. To forestall such a maneuver, Congress legislated a “look back” rule. Section 302(c)(2)(B) provides that if, during the ten years preceding the redemption, the owner of the redeemed stock acquired it from a family member or transferred other stock to a family member, then complete termination will not sever family attribution, unless the transfer did not have as one of its principal purposes the avoidance of federal income tax. Do I need to mention that we have here one more instance of Congress being less concerned with the existence of the Phellis loophole than with the possibility that taxpayers may be arranging their affairs in order to exploit it? In our example, if the 93 shareholders can show that there was a sound business or personal reason for the transfer and that tax avoidance was not an important factor, then the redemption will be classified as a sale and capital gains treatment will apply to what is effectively a distribution of corporation earnings.

3. Prohibited Interests In order for a redemption to qualify as a complete termination, it is not enough for the corporation to redeem all of the taxpayer’s shares. The taxpayer may not have any “interest in the corporation,” nor may the taxpayer acquire any such interest for ten years after the redemption.15 If the taxpayer does acquire such an interest, then the redemption will retroactively be reclassified as a distribution. The term “interest in the corporation” is not defined. Instead, the Code gives a few examples of what is and what is not included in the term. The list includes “an interest as an officer, director, or employee” but does not include “an interest as a creditor.”16 The status of other relationships is not specified. Moreover, even with regard to officers, directors, employees, or creditors, the Code leaves a great deal of uncertainty with regard to the scope of the prohibited interest. Here are some examples: a. Creditors With regard to creditors, the regulations state that if the payments of either

principal or interest are dependent upon the 94 corporation’s earnings, then the creditor has a prohibited interest in the corporation.17 Presumably, the idea is that where the fortunes of the exshareholder rise or fall according to the success of the corporation, the exshareholder is in much the same position vis-à-vis the corporation as before the redemption. Of course, whatever the formal terms of indebtedness, all creditors—and to a greater extent unsecured creditors—are dependent to some extent upon the earnings of the debtor. If the corporation is struggling economically, it may not be able to pay the interest or even repay the principal. Nevertheless, it appears that as long as there is no formal link between payments and earnings, the interest of the creditor will not constitute “an interest in the corporation.” b. Lessors Normally, the leasing of property to the corporation does not constitute “an interest in the corporation.” In fact, a lessor usually has less of a stake in the fortunes of the corporation than does a creditor. A lessor risks the rent, which might not be collectable if the corporation experiences financial difficulties. Even if the corporation goes bankrupt, in most cases the lessor can recover the property itself. A creditor risks both interest and principal. Thus, if a creditor does not have “an interest in the corporation,” it would appear that a fortiori neither does a lessor. c. Service Providers The question of whether the compensated provision of services constitutes a prohibited interest has generated some controversy. Some courts have held that any provision of services constitutes a prohibited interest.18 Others have focused on whether the ex95 shareholder, although now formally relegated to the role of independent service provider, in fact continues to control the corporation.19

4. Prohibited Interests of Related Parties If a person whose stock ownership can be attributed to the taxpayer under § 318 acquires a prohibited interest during the ten-year blackout period, this does not, of course, prevent the redemption from being classified as a complete termination. Don’t forget: the primary purpose of § 302(b)(3) is to allow

shareholders to cut ties to the corporation while a family member continues to control it. Nevertheless, in one instance, the acquisition of a prohibited interest by such a person will disqualify the complete termination. Section 302(c)(2)(C) provides that in the case of an entity, if a “related person” acquires a prohibited interest during the ten-year blackout period, the redemption will retroactively cease to be a complete termination. For this purpose “related person” means anyone to whom ownership of stock is attributable under § 318(a)(1) (family attribution) and subsequently attributable to the entity under § 318(a)(3) (attribution to an entity). That’s a bit tough to digest, so let’s break it down. Assume that (a) Individual A and Entity C each own stock in T, (b) Individual B is a partner, beneficiary, or shareholder in C, (b) A’s ownership in the stock is attributable to B under the rules of family attribution, (c) B’s constructive ownership of the stock is attributable to C under the rules for attribution to an entity, and (d) T redeems all of C’s shares. 96

In such a case, B is a “related person”: stock ownership that was attributed to B via § 318(a)(1) was subsequently attributed to C via § 318(a)(3). Therefore, if B were to acquire a prohibited interest in T during the blackout period, the redemption of C’s shares would retroactively cease to be a complete termination.

G. Redemptions Not Essentially Equivalent to a Dividend Having looked at two technical rules (substantially disproportionate redemptions and complete terminations), we can now turn our attention to the more thematic provision, which states that a redemption is to be treated as a sale if it is “not essentially equivalent to a dividend (from the perspective of the shareholder).”20 In the leading case of U.S. v. Davis,21 the Court held that for a redemption to be not essentially equivalent to a dividend, it must result in “a meaningful

reduction of the shareholder’s proportionate interest in the corporation” and, furthermore, that in determining whether the reduction is meaningful, the § 318 attribution rules will 97 apply. Subsequent lower court cases and Revenue Rulings have clarified that in determining whether there has been a meaningful reduction, all rights attached to corporate shares must all be taken into account, but that particular attention should be paid to voting rights.22 What is a “meaningful reduction”? And how does it differ from a “substantially disproportionate” redemption? We can start out by noting that when a redemption is substantially disproportionate, it is irrelevant whether there is a meaningful reduction (because it will in any case be accorded sales treatment). Therefore, we need only focus on those cases in which the redemption is not substantially disproportionate (i.e., when it fails either the 80% or the 50% requirements). You might think that a meaningful reduction occurs when a redemption is very close to being substantially disproportionate but doesn’t quite make it. For example, if a redemption reduces common shareholding by exactly 20% (substantial reduction requires less than 80%) or voting rights to exactly 50% (substantial reduction requires less than 50%), then you might think that would be a good candidate for meaningful reduction. The problem is that if Congress thought that close is good enough, presumably it would have said so. Why not simply set the bar lower, so that all concerned will know ahead of time where they stand? The answer is that the meaningful reduction standard, much more so than the substantially disproportionate standard, focuses on the substance of the shareholder’s position vis-à-vis the corporation and the other shareholders. It takes into account not only the change in the shareholder’s interest in the corporation, but also the practical effect of the change. Here are a few examples: 98

1. Potential Coalitions Is a reduction in common share ownership from 28% to 25% meaningful? It depends. Suppose that the rest of the shares are divided equally between two other unrelated persons. Before the redemption, the shareholder had 28% of the voting power and each of the other shareholders had 36%. No single shareholder had control of the corporation, while any two acting in tandem could form a

controlling coalition. After the redemption, our shareholder would have 25% and each of the remaining shareholders would have 37.5%. The situation is substantively the same: no single shareholder can control the corporation, and any two acting together can. Suppose instead that the remaining shares are equally divided among three other unrelated persons. Before the redemption, our shareholder had 28% and each of the other shareholders had 24%. Our shareholder could have formed a governing coalition with any one of the other shareholders. After the redemption, our shareholder would have 25%, the same as each of the others. Now, our shareholder needs the cooperation of two other shareholders to control the corporation. Therefore, in the second case (three other shareholders) the reduction in the shareholder’s proportionate interest from 28% to 25% is meaningful, while in the first case (two other shareholders) it is not.23

2. Indirect Ownership When the shareholder whose shares were redeemed is a partner, beneficiary, or shareholder of an entity that also owns shares in the redeeming corporation, the attribution rules provide a formula for calculating the shareholder’s constructive ownership of those shares. When examining whether a redemption is substantially 99 disproportionate, we do not look beyond the percentage ownership as determined by the formula. In contrast, meaningful reduction requires an examination of the actual effects of the redemption on the shareholder’s interest in the corporation. It is quite possible that a redemption that does not meet the technical requirement of a substantially disproportionate redemption will nevertheless result in a meaningful reduction. For example, assume that (a) A owns 100 shares in Corporation T and has a 60% interest in Partnership P, (b) B owns 300 shares in T and has a 40% interest in P, (c) the remaining 100 shares in T are owned by P, (d) under P’s bylaws, a simple majority of partnership interest is sufficient to dictate partnership policy and in particular how it votes any shares that it owns. T redeems 140 of B’s shares.

Before the redemption, B owned (actually and constructively) 340 out of 500 shares (68%). After the redemption, B owns (actually and constructively) 200 out of 360 shares (56%). This is not enough for a substantially proportionate redemption. Nevertheless, the redemption transferred effective control of T from B to A. This would seem to constitute a meaningful reduction of B’s voting power in T. 100

3. Family Hostility The rule attributing constructive ownership to family members rests upon the assumption that families operate in concert and are concerned for each other’s welfare. In applying the family attribution rule, this assumption is irrefutable, whatever the actual intra-family dynamics. Thus, under the technical substantially disproportionate standard, evidence of family hostility is irrelevant. Should family hostility be considered when examining whether there is a meaningful reduction of the shareholder’s proportionate interest in the corporation? On the one hand, families are complicated things and determining the exact nature of intra-family relationships at a given moment is not always an easy task. On the other hand, the meaningful reduction standard is supposed to be substantive, not technical. The fact that a close relative with whom the shareholder is at loggerheads owns shares in the corporation may actually be detrimental to one’s interests. The courts have struggled with this issue and still have not come up with a good answer. Some courts ignore family hostility, while others are willing to consider it. In one case, the Tax Court took the interesting, although not entirely satisfactory, position that for the purpose of determining whether there was a reduction of the shareholder’s interest, family discord is irrelevant; but, once it is determined that there was a reduction, then for the purpose of determining whether the reduction was meaningful, family discord may be taken into account.24

H. Partial Liquidations

The three provisions that we already discussed examined the effect of the redemption from the perspective of the shareholder. We saw that if the shareholder’s proportionate stake in the 101 corporation was sufficiently reduced (each case according to its own criteria), the redemption would be treated as a sale. Partial liquidation is the odd man out for two reasons. First, it examines the redemption from the perspective of the corporation rather than from the perspective of the shareholder. Second, the partial liquidation provision only applies in the case of individuals. For corporate shareholders, unless one of the other provisions kicks in, a partial liquidation will be treated as a distribution.25

1. Partial Liquidation—Definition Section 302(e)(1) defines a partial liquidation as follows: (A) the distribution is not essentially equivalent to a dividend (determined at the corporate level rather than at the shareholder level), and (B) the distribution is pursuant to a plan and occurs within the taxable year in which the plan is adopted or within the succeeding taxable year. This is one of those unusual cases in which the definition of a term is more obtuse than the term being defined. If you heard that a certain corporation was partially liquidated, you might not know exactly what the speaker meant, but you would probably have some vague idea what was going on. After all, in a liquidation, the corporation sells its assets and distributes the proceeds to its shareholders. Therefore, you would most likely surmise that in a partial liquidation, the corporation sells some of its assets and distributes the proceeds. While not entirely accurate, that’s pretty close. On the other hand, if you heard that a certain distribution was not essentially equivalent to a dividend (determined at the 102 corporate level rather than at the shareholder level), you would probably respond with something extremely insightful such as, “Huh?” Instead of clarifying, the definition merely succeeds in obfuscating. Therefore, let’s go back to the term “partial liquidation” itself. This implies the selling off of some corporate assets and the distribution of the proceeds (or, perhaps, the distribution of some of the corporation’s assets directly to the shareholders). The problem is that this is a good description of just about any

distribution. The Code does not tell us what distinguishes a partial liquidation from an ordinary run-of-the-mill distribution (other than the amorphous “not essentially equivalent to a dividend determined at the corporate level rather than on the shareholder level”), so in order to penetrate the mind of the drafters, we need to examine the legislative history. In the Senate report, we find that a partial liquidation involves “the contraction of the corporate business.” As an example, the report cites a case in which a floor of a factory is destroyed by fire. If the corporation distributes the insurance proceeds and continues operations at a reduced scale, the distribution will constitute a partial liquidation.26 What the Senate report tells us is that it is not enough for the corporation to distribute assets. The distribution must have a significant impact on the corporation’s business activity. Thus, distributing inventory or non-business assets would not constitute a partial liquidation, nor would distributing the proceeds from the sale of fixed business assets unless the sale resulted in a significant contraction of the business. 103

2. Qualified Trade or Businesses Because it might be difficult to predict whether a given contraction of business activity is sufficient to meet the statutory definition of partial liquidation, § 302(e)(2) provides a “safe harbor.” When the terms of the safe harbor are satisfied, the redemption is automatically recognized as a partial liquidation. Let’s start with a definition. A “qualified trade or business” (QTB) is one which the corporation actively conducted for the last five years (or acquired in a non-recognition transaction, provided that the business itself was actively operated for the last five years). The safe harbor tells us that if the corporation (a) owns at least two QTBs, (b) sells one and distributes the proceeds to its shareholders, and (c) continues to operate the other, then the sale and distribution will constitute a partial liquidation. Why do you think Congress imposed the five-year minimum for qualification as a QTB? Apparently, the concern was that, without the five-year requirement a corporation with funds it wishes to distribute could purchase a business, then sell it and use the proceeds to redeem some of its shareholder’s stock. Because the redemption would be funded by the sale of a business, it would qualify as a partial liquidation. To forestall this laundering technique, Congress required a five-year history, the presumption being that a corporation will not assume the risks of running a business for five years just in order to allow its shareholders to claim the advantages of a partial liquidation.

3. Why and Wherefore At this point, you might be asking yourself one or more of the following questions about the whole concept of partial liquidations: 104 (a) Why should sales treatment or distribution treatment depend upon whether there was a contraction of the corporation’s business activity? (b) Whatever the answer to question (a), why shouldn’t the distribution of non-business assets be accorded the same treatment as the distribution of business assets? If you are asking yourself these questions, that’s already a good sign. It means that you are trying to make sense out of the corporate tax structure instead of just trying to memorize the rules. Unfortunately, there are no good answers to either of these questions. Theory dictates that the amount realized on the sale of stock should be bifurcated and that the portion representing the right to participate in accumulated earnings should be taxed as a constructive dividend. However, Phellis proscribed that possibility, so the issue really boils down to making sense out of nonsense: given that the actual sale of shares is subject to a flawed tax model, should that flawed model be extended to partial liquidations? If you have a good answer to that one, let me know. It is possible to speculate that Congress wanted to subject partial liquidations to a tax regime similar to the one applicable to full liquidations, which are usually (but, interestingly, not always) treated as the sale of stock. If so, this may again be making sense out of nonsense, because the justification for treating full liquidations as sales is just as elusive as in the case of partial liquidations. Finally, even if the tax consequences of partial liquidations did make some sort of sense, it is unclear why they should be limited to the distribution of the proceeds from the sale of a business (or a 105 substantive part of a business) and why they do not apply also in the case of the sale and distribution of significant non-business assets.

I. Redemptions Through Related Corporations Imagine that the controlling shareholders of one corporation sell some of their stock to a different corporation that is also under their control. By doing so, they can extract cash without diminishing their control of either corporation:

Because, in the before picture, A and B were siblings, this is commonly known as a “brother-sister acquisition.” Another instance in which the purchase by one corporation of shares in another corporation may be functionally equivalent to a redemption is when shares in a corporation are sold to a corporation that it controls:

106 This is commonly known as a “parent-subsidiary acquisition.” Section 304 provides that brother-sister acquisitions and parent-subsidiary acquisitions are to be treated as § 302 redemptions. In other words, we need to examine the transaction in accordance with the rules of § 302(b) in order to determine if it is to be viewed as a § 301 distribution or as a sale.

1. Step One: Control Two corporations are siblings when they are under common control. A parent is a corporation that controls another corporation (the subsidiary). Therefore, to determine whether § 304 applies to a particular fact pattern, we need to understand the concept of “control.” Section 304 defines control very broadly, more broadly than any other section of Subchapter C. (a) As opposed to the prevalent definition of control that requires 80% ownership,27 in § 304 control means ownership of at least 50% of the voting power or at least 50% of the total value of the stock.28 (b) Control under § 304 is transitive. In other words, if A controls B and

if B controls C, then A controls C.29 (c) Not only does § 304 adopt the § 318 attribution rules,30 but it considerably relaxes them. While § 318 only allows attribution from a corporation to a shareholder if the shareholder has a 50% or greater 107 stake in the corporation, § 304 reduces the threshold to 5%.31 (d) Section 304 also reduces the threshold for attribution from a shareholder to a corporation from 50% to 5%.32 However, here it adds a proviso. If the shareholder owns between 5% and 50%, then the corporation will constructively own only a proportional share of the shareholder’s stock.33

2. Step Two: Applying the § 302 Tests Assuming that, in accordance with the § 304 definition of “control,” the acquisition is indeed either brother-sister or parent-subsidiary, we then turn to the § 302 tests to see whether the acquisition is treated as a distribution or as a sale. This is not as straightforward as it might seem. First, we need to make a small adjustment to the attribution rules. Specifically, § 304(b)(1) tells us that, when attributing stock from a corporation to a shareholder or from a shareholder to a corporation, we ignore the 50% restriction. Second, because § 304 involves two corporations (one of which purchases shares in the other) instead of just one (which purchases shares in itself), we need to know which corporation to focus on when applying the § 302 tests. Terminologically, the corporation whose shares are sold (“A” in the diagrams above) is called the “issuing corporation,” while the corporation that acquires shares in the issuing corporation (“B” in the diagrams above) is called the “acquiring corporation.” Section 304(b)(1) tells us that dividend 108 equivalence under § 302 is measured by reference to the shareholder’s before-and-after stake in the issuing corporation. Third, in the case of a parent-subsidiary acquisition, computing post-sale constructive ownership of the issuing corporation is not easy due the fact that ownership interests are looped. For example, assume that after the acquisition we get the following picture:

What is Shareholder’s total (actual and constructive) ownership interest in Corporation A? You can try to work it out yourself if you want, but to save you the effort, here is the formula: (x + wy)/(1 − yz).

3. Hold On, I’m a Bit Confused “A few minutes ago, you said that instead of the 50% restriction there is a 5% restriction and that between 5% and 50%, there is a proportional attribution. Now you’re saying that we should ignore the 50% restriction altogether. What gives?” Good catch. The first set of attribution modifiers (i.e., 5% instead of 50% and proportional attribution from shareholders) along with the idea of transitive control are used when we are examining the threshold question of whether § 304 applies, that is, whether we have before us a brother-sister or parent-subsidiary acquisition. If we determine that § 304 does apply, we move to § 302 to test 109 whether the transaction is a distribution or a sale. At this stage the second attribution modifier (i.e., simply ignore the 50% restriction) comes into play.

4. Step Three: Earnings and Profits The fact that § 304 involves two corporations instead of just one raises an additional question. When the sale is treated as a distribution, which corporation’s E&P is taken into account? On the one hand, the money (or other property) is coming from the acquiring corporation. On the other hand, it is shares in the issuing corporation that are supposedly being redeemed. The answer to the question of which corporation’s E&P is taken into account is “both.” Section 304 provides that the payment will be treated as if distributed first by the acquiring corporation to the extent of its E&P, and then by the issuing corporation to the extent of its E&P.34 1 For the sake of convenience, I will refer to “basis” instead of “adjusted basis.” 2 If

p = pre-redemption E&P, s = pre-redemption shares outstanding, and r = shares redeemed, then E&P is reduced by pr/s. Post-redemption E&P will therefore be: p(1 − r/s). 3 Section 318(a)(5)(A). 4 Section 318(a)(5)(B). 5 Section 318(a)(5)(C). 6 Section 302(b)(1). 7 Section 302(b)(2). 8 Section 302(b)(3). 9 Section 302(b)(4). 10 Section 302(b)(2)(C). 11 Section 302(b)(2)(C). 12 Section 302(b)(2)(B). 13 Treas. Reg. 1.302–3(a). 14 Rev. Rul. 81–41, 1981–1 Cum. Bul. 121. 15 Section 302(c)(2)(A)(ii). From a technical perspective, shareholders who want the redemption of their shares to be classified as a complete termination must file an agreement to notify the Secretary of the Treasury if they acquire a prohibited interest within ten years. Section 302(c)(2)(A)(iii). While this is ostensibly a technical requirement, it has substantive ramifications. Shareholders who prefer distribution treatment can prevent the severing of family attribution simply by failing to file the appropriate forms. 16 Section 302(c)(2)(A)(i). 17 Treas. Reg. 1.302–4(d). 18 See, e.g., Lynch v. Commissioner, 801 F.2d 1176 (9th Cir. 1986). 19 See, e.g., Seda v. Commissioner, 82 T.C. 484 (1984); Cerone v. Commissioner, 87 T.C. 1 (1986). 20 Section 302(b)(1). 21 397 U.S. 301 (1970), rehearing denied 397 U.S. 1071 (1970). 22 See, e.g., Rev. Rul. 85–106, 1985–2 C.B. 116. 23 Rev. Rul. 76–364, 1976–2 C.B. 91. 24 Cerone v. Commissioner, 87 T.C. 1 (1986). 25 Section 302(a)(4)(A). Recall, however, that any part of the distribution that is treated as a dividend will be extraordinary. For partial liquidations (as opposed to other types of redemptions), this rule applies even if when distribution is pro rata. Section 1059(e)(1)(A)(i). 26 S. Rep. No. 1622, 83d Cong., 2d Sess. 49 (1954). 27 Section 368(c). 28 Section 304(c).

29 Section 304(c). 30 Section 304(c)(3)(A). 31 Section 304(c)(3)(B)(i). 32 Section 304(c)(3)(B)(ii)(I). 33 Section 304(c)(3)(B)(ii)(II). 34 Section 304(b)(2).

111

CHAPTER 13

Complete Liquidations Compared to what we’ve done in the last couple of chapters, this one is pretty easy. The term “liquidation” typically describes a situation in which a corporation sells (“liquidates”) all of its assets, pays off its creditors, and then distributes the remainder to its shareholders. Alternatively, the corporation might be able to satisfy its creditors without selling all of its assets. It could then simply distribute its remaining assets to its shareholders. Following liquidation, the corporation may be dissolved or its corporate shell may continue to exist. The Code has special rules that apply to the liquidation of corporations that are subsidiaries of other corporations. So, let’s first consider run-of-the-mill liquidations and then we’ll talk about liquidations of subsidiaries. 112

A. Liquidation of a Corporation That Is Not a Subsidiary 1. Tax Consequences to the Shareholders From the perspective of the shareholders, the liquidation is simply viewed as a sale of stock. Whatever is received from the corporation constitutes the “amount realized” on the sale, and the difference between the amount realized

and the shareholder’s adjusted basis in the stock is a capital gain or loss.1

2. Tax Consequences to the Corporation The distribution of property in complete liquidation is viewed as a sale of the property from the corporation to its shareholders for its FMV. Subject to one exception, the corporation recognizes any resulting gain or loss.2 What is that exception? Losses are not recognized when property is distributed to a “related party” (unless it is distributed pro rata among all the shareholders).3 In this context, the term “related party” means a shareholder who owns, either actually or constructively, over 50% of the stock in the distributing corporation.4 Here is another twist: when computing constructive ownership in this context, we don’t use the § 318 attribution rules with which we are familiar, but rather the § 267 constructive ownership rules. How about this for an interesting exercise: read § 318 and § 267(c) side-by-side and try to come up with a list of instances in which § 267(c) attributes stock ownership but § 318 does not, and vice versa (okay, maybe I’m stretching the meaning 113 of the word “interesting” a little, but it should help hone your Code-reading skills).

B. Liquidation of a Subsidiary A subsidiary is a corporation, 80% or more of whose stock is owned by another corporation (“the parent”). There may, of course, also be minority shareholders.

1. Distributions to Minority Shareholders When a subsidiary distributes property to minority shareholders, the tax consequences are similar, although not identical, to the distribution of property in ordinary liquidations. The only difference is that the liquidating subsidiary does not recognize loss on the distribution of its assets.5 It does recognize gain, and shareholders recognize gain or loss on the “sale” of their shares.

2. Distributions to the Parent Corporation When a liquidating subsidiary (“S”) distributes property to its parent corporation (“P”), neither S nor P recognize either gain or loss,6 and P takes a transferred basis in the property that it receives (i.e., the adjusted basis of the

property in the hands of S becomes the basis of the property in the hands of P).7 Okay, so S’s gain or loss in the property is preserved by means of the transferred basis: when P eventually sells the property, it will recognize that gain or loss. But what about P’s gain or loss in the shares? Where is that preserved? 114 The answer is “nowhere.” It just disappears, never to be recognized. However, before you jump to all sorts of unwarranted conclusions about inconsistencies in the Code and tax planning opportunities, please note that this one sort of makes sense. Think about it: were S to have distributed all of its earnings as an ordinary dividend, P would have been entitled to a 100% DRD. The disappearance of the P’s gain on the “sale” of its shares can be thought of as substitute for that DRD. 1 Section 331. 2 Section 336(a). 3 Section 336(d)(1)(A)(i). Actually, there is an exception to the exception to the exception (got that?). If you’re interested, take a look at § 336(d)(1)(A)(2). 4 Sections 336(d)(1)(A), 267(b)(2), and 267(b)(3). 5 Section 336(d)(3). 6 Section 332 (no gain or loss for parent) and section 337(a) (no gain or loss for subsidiary). 7 Section 334(b).

115

CHAPTER 14

Section 351 A. Introduction Shareholders or prospective shareholders will often transfer property to a corporation in exchange for shares. This can occur when the corporation is formed or at any point thereafter. The exchange of property for shares in the transferee corporation (“T”) is, of course, a realization event. However, Congress was concerned that imposing tax at that time could impede incorporation or, more generally, the movement of assets into corporate solution. Consequently, § 351 provides that the gain or loss, although realized, will not be recognized. The only proviso is that, following the exchange, the transferors control T. “Control” here means 80% of the voting power and 80% of each class of non-voting stock. Importantly, § 351 applies only to the transfer of property, not to the provision of services. A person who provides services in exchange for shares will report the FMV of those shares as income. 116

B. Group Transfers For § 351 to apply, it is not necessary for the transferor (on his, her, or its own) to control T. If a number of persons transfer property to T in exchange for

shares, then § 351 will apply as long as the group collectively ends up with control. For example, if 10 persons transfer property and, in exchange, each receives 10% of T’s shares, then none of the transferors will recognize gain or loss. What if I am transferring property to a corporation in exchange for shares and I want § 351 to apply, but I won’t reach the 80% threshold? The fact that it is enough for the transferring group as a whole to control T seems to invite a simple planning maneuver. Take a minute and see if you can figure out how to do it. Let’s try this: have the existing shareholders transfer property of nominal value in exchange for a few shares. Following the transfer, the transferring group will collectively control the corporation. Problem solved. Not so fast. The regulations are one step ahead of you. Treas. Reg. 1.351– 1(a)(1)(ii) provides as follows: Stock. . .issued for property which is of relatively small value in comparison to the value of the stock. . .already owned. . .shall not be treated as having been issued in return for property if the primary purpose of the transfer is to qualify. . .the exchanges of property by other persons transferring property. In other words, if the current shareholders transfer property of relatively small value, they will not be considered part of the transferring group. Because on my own I do not control the corporation, § 351 will not apply. To clarify the matter further, Rev. Proc. 77–37, 1977–2 C.B. 568, § 3.07 tells us that stock received for property is not of 117 “relatively small value” if the FMV of the property is equal to or greater than ten percent of the FMV of stock already owned or received for services. So, the regulation does not completely shut the door on this planning technique. All it requires is that the existing shareholders transfer property worth 10% or more of the value of their shares. In some cases, that might be a problem but in many case it will be simple to do. By the way, there is no reason why the property cannot be cash. However, pay particular attention to the fact that this is strictly an antiavoidance regulation. It only applies if the primary purpose of the transfer is to qualify for § 351. If the transfer was not tax motivated, then the existing shareholders will count as part of the transferring group even if the property that they transfer is of relatively small value.

C. Mechanics of § 351

The purpose of § 351 is to defer recognition of gain or loss. The operative word here is “defer.” In other words, gain will be subject to tax (and losses will be deductible) at some later time. Normally, when the Code defers recognition of gains or losses, it does so by means of either a “transferred basis” or a “exchanged basis.” The classical example of a transferred basis is a gift of appreciated property. The recipient of the gift takes the donor’s basis and will eventually pay tax, not only on the appreciation that occurred while she held the property, but also on the appreciation that accrued when the donor held the property.1 The classical example of an exchanged basis is a like-kind exchange.2 The adjusted basis of the old property becomes the basis of the new 118 property, and when the taxpayer sells the new property, he pays tax, not only on the appreciation of the new property, but also on the prior appreciation of the old property.3 We might say that with a transferred basis the donee “steps into the shoes” of the donor, while with an exchanged basis the new property “steps into the shoes” of the old property. In either case, tax on the unrecognized gain is deferred to a later date. With regard to § 351 transfers, the Code employs both methods. The transferor takes an exchanged basis in the shares,4 and the corporation takes a transferred basis in in the property.5 Is the use of both an exchanged basis and a transferred basis a case of legislative overkill or is it necessary in order for the gain or loss to be forgiven instead of forgotten (that is, deferred but nevertheless preserved)? Let’s examine this a bit more carefully. Assume that the owner of the property is an individual. Were she simply to sell the property, the hitherto unrealized gain would likely have been subject to the user-friendly capital gains rates. However, if the individual transfers the property to a corporation in a § 351 exchange, then the corporation will pay tax on that gain when it sells the property and the transferor will pay tax on that gain when she sells the shares. Thus, the hidden price of deferral is an additional level of taxation. One ironic anomaly of this feature is that § 351, which was enacted as a means of preventing taxation from impeding the transfer of assets to a controlled corporation, could have the opposite effect. A doubling (or more) of the tax burden on accumulated gain might well give pause to individuals who would otherwise be interested in incorporation. 119

When the transferor is a corporation, the analysis is a little more complicated. If the transferring corporation (“X”) is entitled to a 100% DRD, then the fact that X takes an exchanged basis in the shares and T takes a transferred basis in the property is not too worrisome. When T sells the property, X can extract the aftertax gain as a tax-free dividend. The overall tax burden is the same as if X had sold the property itself. In other words, the deferral does not create an additional level of tax. On the other hand, if X is entitled to less than a 100% DRD, then the dividend that it eventually receives will not be completely tax-free. Here, the price of deferral is an additional partial (35% or 50%, depending upon the DRD) level of tax.

D. Property Containing Unrealized Loss What happens when the FMV of the property is less than its adjusted basis (let’s call this “loss property”)? Now the duplication could operate to the benefit of the taxpayer. The corporation will take the property with a high basis (i.e., with a built-in loss). The transferor will receive shares with a high basis (i.e., with a built-in loss). The same economic loss would be recognized both at the corporate level and at the shareholder level. This could prove particularly advantageous for individuals and for corporations entitled to less than a 100% DRD. Congress noticed and was concerned about the duplication of the loss. Of course, an evenhanded approach would be equally concerned about the duplication of gain. However, we already know that Congress is generally willing to ignore glitches in the tax system when they work to the detriment of taxpayers. When the glitches work to their benefit, that is a different story entirely. To prevent what it perceived of as an opportunity for abuse, Congress enacted § 362(e)(2). This section provides that when loss property is transferred to a corporation in a § 351 exchange, the 120 corporation’s basis in the property will be the FMV and not the transferor’s adjusted basis. As an alternative, § 362(e)(2)(C) provides that if both the transferring shareholder and the corporation agree, then the corporation will take a (high) transferred basis in the asset and the shareholder will take a (low) FMV basis in the asset. The idea is that the loss will survive either on the shareholder level or on the corporate level, but not both. Such being the case, here is an interesting question: what happens when a person transfers both gain property and loss property in a § 351 exchange? Does the Code require double recognition of the gain, but allow only single recognition of the loss?

Apparently, Congress was convinced that that would be both cruel and unusual. Double-counting gains and single-counting losses is okay as long as you don’t do them simultaneously. So, when a person transfers both gain property and loss property in a § 351 exchange, § 362(e)(2) applies only to the extent that the unrecognized loss exceeds the unrecognized gain.

E. Avoiding § 351 Section 351 was intended as a pro-taxpayer provision, allowing deferral of gain that would otherwise be recognized when appreciated property is exchanged for shares. However, in many cases, § 351 and the accompanying provisions act to the taxpayer’s detriment. We have already encountered several examples: (a) When the shareholder is an individual, § 351 will result in the unrecognized gain being double-taxed: once in the hands of T and again in the hands of the shareholder. (b) When the shareholder is a corporation entitled to a DRD of less than 100%, § 351 may result in the unrecognized gain being taxed once in the hands of 121 T, and then partially taxed in the hands of the corporate shareholder when the net proceeds are distributed. (c) When the FMV of the property is less than its adjusted basis in the hands of the transferor, § 351 will defer recognition of the loss. In each of these cases, the shareholder and the corporation would most likely prefer that § 351 not apply. However, § 351 is not elective. You cannot simply waive it away. It applies when it applies, so the only way to avoid § 351 is to make sure that, following the exchange, the transferors as a group do not control the corporation. In some situations, that can take some doing. Structuring the transaction so as to avoid the application of § 351 can be just as difficult as structuring it so that it conforms to the requirements of that provision.

F. Boot As already noted, § 351 was intended as a means of facilitating simple corporate restructuring by allowing the transfer of property to a controlled corporation without the transferor incurring any tax liability. Furthermore, it is arguable that the replacement of indirect ownership for direct ownership is not a “true” realization. However, when the transferor receives from the corporation both stock and something else (commonly referred to as “boot”),6 the above reasoning does not apply to the boot. The exchange of part of the property for

boot is either an ordinary cash sale (if the boot takes the form of cash) or a classical barter transaction (if the boot takes the form of some other property).7 122 Section 351(a) says that gain or loss shall not be recognized if property is transferred to a corporation “solely in exchange for stock in such corporation.” A summary reading of this provision would leave one with the impression that were the transferors to receive stock plus anything else, all of the gain or loss would be recognized. Ostensibly, one who wanted § 351 to apply would need to be extraordinarily careful not to take anything other than stock. Conversely, an easy way to avoid § 351 would be to receive something from the corporation in addition to the stock. However, § 351(b) qualifies § 351(a) and tells us that where shareholders receive stock and other property, gain will be recognized, but only to the extent of the boot received. In other words, recognized gain is the lesser of the realized gain or the FMV of the boot. Losses are still not recognized.

1. Basis The receipt of boot does not undermine the principle that unrecognized gain or loss needs to be preserved at both the shareholder and the corporate levels (subject to the proviso that the corporation cannot absorb an aggregate loss). However, actualizing that principle when boot is received is slightly more complicated. a. Basis of the Shares in the Hands of the Transferor Section 358(a)(1) gives the formula for computing the basis of the shares in the hands of the transferor. It says to (a) take the adjusted basis of the exchanged property, (b) add any gain recognized by the transferor, and (c) subtract the FMV of any boot received. This formula (adjusted basis plus recognized gain minus boot) pops up frequently in the field of corporate restructuring, so it might be a good idea to commit it to memory. To help you out, here is the reasoning behind the formula. Adding recognized gain 123 reflects the idea that only the unrecognized portion of the gain needs to be preserved. Subtracting the FMV of the boot reflects the fact that the transferor takes a FMV basis in the boot itself. b. Basis of the Property in the Hands of the Corporation For T, the only consequence of the fact that the transferor receives boot is that it may cause some or all of the transferor’s gain to be recognized. Therefore,

§ 362(a) tells us that to compute the corporation’s basis in the property, all we need to do is add the recognized gain to the transferor’s adjusted basis. What about loss property? Here we need to take two factors into consideration. The first is that there is no recognized gain. Therefore, the provision that we add recognized gain is irrelevant, so all we are left with is the transferor’s adjusted basis. The second factor is the caveat that the corporation may not import an aggregate loss. How does that play out in practice? If the transferor transfers only loss property, then the corporation will simply take in each asset a basis equal to its FMV (instead of the higher adjusted basis). If the transferor transfers both loss property and gain property, things get a bit tricky. This is because the corporation is allowed to import a loss on specific property, as long as it does not import a net loss. Therefore, we need to compute all of the losses and all of the gains and, if the losses exceed the gains, to decrease the basis of the loss property so that the net loss is exactly zero. The procedure is as follows (take a deep breath): (a) Ascertain each asset’s FMV. (b) Calculate the transferor’s adjusted basis in each asset. (c) Subtract (b) from (a) to arrive at the realized gain or loss from each asset. 124 (d) Assign to each asset a portion of the boot (the Code does not tell how this should be done, and the Service has taken the ostensibly reasonable approach of assigning the boot proportionally according to the FMV of each asset).8 (e) For each of the properties whose FMV exceeds its adjusted basis, calculate how much of the realized gain is recognized. (f) Calculate the corporation’s preliminary basis in each of the assets (i.e., the basis that the corporation would have had in the absence of § 362(e)(2)). Here you use the formula: adjusted basis plus realized gain. (g) Add up the preliminary bases of all the assets. (h) Add up the FMV of all the assets. (i) If the cumulative FMV is equal to or greater than the cumulative preliminary basis, then there is no cumulative imported loss and you can stop. The corporation takes in each asset a basis equal to its preliminary basis. (j) If the cumulative FMV is less than the cumulative preliminary basis,

then subtract the former from the latter. The difference is the net builtin loss. (k) Allocate the net built-in loss to the loss property in proportion to their respective built-in losses.9 (l) Reduce the preliminary basis of each loss property by its allotted share of the net built-in loss. (m) Exhale. 125

2. Assumption of Liabilities a. General As part of a § 351 exchange, T may assume liability for a debt (this commonly occurs when the property is mortgaged, but the debt could be unconnected to any property transferred). If so, then relief from the liability would seem to constitute boot. Nevertheless, relief from debt is different from other types of boot. When boot takes the form of cash, the transferor can use the cash to pay the tax. When boot takes the form of other property, the transferor can usually sell the property to pay the tax. When boot takes the form of relief from indebtedness, the transferor may not have the capacity to pay tax on the realized gain. Requiring the transferor to pay tax could prevent or impede a § 351 restructuring and frustrate the legislative goal. Therefore, Congress provided that the assumption of liabilities by the corporation does not ordinarily trigger recognition of gain.10 Instead, the transferor reduces the basis in her stock by the amount of any liabilities assumed by the corporation.11 Only if the amount of the liability exceeds the transferor’s adjusted basis will the transferor recognize gain (and even then, only to the extent of the excess).12 Consequently, in the case of debt assumption, we need to revise the formula for computing the basis of stock in the hands of the shareholder: (a) adjusted basis (b) plus recognized gain (c) minus the market value of any boot received (d) minus the amount of any debt assumed by the corporation, with the proviso that basis can never be negative. (Thought experiment: why not allow negative basis?) 126 b. Tax Avoidance Because boot (up to the amount of realized gain) is currently taxable while

assumption of liabilities merely reduces basis, it could prove advantageous for a transferor to convert boot into liability assumption.13 For example, instead of transferring property to the corporation in exchange for stock and cash, the transferor could borrow against the property and then transfer the encumbered property to the corporation in exchange for stock (and if it wishes, the corporation could then pay off the debt by using the cash that It would otherwise have paid the transferor). Although the two structures are similar, the transferor will recognize gain in the first but not in the second. The fact that economically equivalent transactions have different tax consequences is not something about which Congress ordinarily cares too much. What does bother Congress, as we have seen on numerous occasions, is the possibility that taxpayers might actually plan their affairs to take advantage of the more beneficial route. In other words, if you mortgage your property and then transfer the mortgaged property to a corporation, that’s fine. However, if you mortgage your property in contemplation of transferring it to a corporation, that is a problem. To counter such an egregious exploitation of a loophole, Congress provided that if the principal purpose of the taxpayer with respect to the assumption of liability was to avoid federal income tax (or any other purpose beside a bona fide business purpose), then any assumption of liability by the corporation will be considered boot.14 Caveat emptor: note that the reclassification applies not 127 only to the “tainted” liability but to all liabilities of the transferor that T assumed as part of the exchange. c. Escaping Through an IOU When the debt assumed by the corporation exceeds what would otherwise be the transferor’s basis in the shares, the difference is taxable. One way for the transferor to avoid such a perilous fate is by transferring additional property (including cash) to the corporation. As long as the total adjusted basis of all the transferred property exceeds the total debt assumed by the corporation, the transferor will not currently be subject to tax. However, what if the transferor cannot or does not wish to contribute any additional property to the corporation? Could the transferor instead write and transfer to the corporation a note to cover the difference? In two key cases, the Second and Ninth Circuits reversed the Tax Court and held that such a maneuver is effective.15 As pointed out by the Ninth Circuit, the note “represents a new and substantial increase in [the shareholder’s] investment in the corporation.”16 Furthermore, writing the note to the corporation is economically similar to the shareholder borrowing money from a third party and

then contributing the cash to the corporation. This would clearly avoid any § 357(c) gain. The corporation could then purchase the note, putting it in the same position as it would have been had the shareholder simply issued the note directly to the corporation.17 1 Section 1015(a). 2 Section 1031(a). 3 Section 1031(d). 4 Section 358(a). 5 Section 362(a). 6 The term “boot” comes from the phrase “to boot” (meaning “in addition”), as in: “The shareholder received stock and other property to boot.” 7 Interestingly, the Code does not consider the possibility that in addition to stock, the transferor might receive services from the corporation. 8 Rev. Rul. 68–55, 1968–1 Cum. Bul. 140. 9 Treas. Reg. 1–362–4(g)(5). 10 Section 357(a). 11 Section 358(d)(1). 12 Section 357(c)(1). 13 This presumes that the shareholder wants to defer recognition of gain. As we saw earlier, this will often not be the case. 14 Section 357(b)(1). 15 Lessinger v. Commissioner, 872 F.2d 519 (2nd Cir. 1989); Peracchi v. Commissioner, 143 F.3d 487 (9th Cir. 1998). 16 Peracchi at 493. 17 Id., at 493–4.

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CHAPTER 15

Corporate Divisions A. Introduction and Terminology In earlier chapters, we discussed the tax consequences of a corporation transferring cash or other property to its shareholders. Depending upon the circumstances, the transfer could be classified as a distribution, a redemption, or a liquidation. Now assume that the property distributed consists of shares or securities in a subsidiary. Although conceptually the distribution of rights in a subsidiary is similar to the distribution of any other property, both the terminology and the law are different. Let’s begin with the terminology. A corporation that transfers to shareholders its shares or securities in a subsidiary is called the “distributing corporation.” The subsidiary is called the “controlled corporation.” The transfer itself is called a “corporate division.” The terms “distributing corporation,” “controlled corporation,” and “corporate division” appear in § 355, the primary statutory provision that governs the tax consequences of corporate divisions. In addition to these statutory terms, there exist terms of 130 common usage that describe the different types of corporate divisions:

When a corporation transfers cash or other property to its shareholders, the transfer is ordinarily referred to as a distribution. However, if the property distributed consists of its shares or securities in a subsidiary, the transfer is called a spin-off. When a corporation transfers cash or other property to its shareholders and, in return, the shareholders surrender shares in the corporation, the transfer is ordinarily referred to as a redemption. If the property that is transferred consists of its shares or securities in a subsidiary, the transfer is called a split-off. When a corporation transfers all of its cash and other property to its shareholders, the transfer is ordinarily referred to as a liquidation. If the property transferred consists of its shares or securities in two or more subsidiaries, the transfer is called a split-up. A further distinctive feature of the world of corporate division involves the transfer of assets to a controlled corporation in preparation for a spin-off, a splitoff, or a split-up. Ordinarily, such a transfer would be a § 351 exchange. However, when the transfer occurs within the framework of a corporate division, it is called a “divisive D reorganization.”1 131

B. Tax Consequences of a Division (Without Boot) 1. Basic Statutory Provisions The transfer of property from a corporation to its shareholders is ordinarily a taxable event both from the perspective of the corporation and from the perspective of the shareholder. However, when the transfer is part of a simple corporate division (i.e., when no boot is distributed, and all of the statutory and non-statutory conditions are satisfied) there are almost no immediate tax consequences. The corporation does not recognize gain or loss. The shareholders do not recognize gain or loss and do not report any dividend income. As far as basis is concerned, the shareholders take an exchanged basis in the shares and securities that they receive. If, following the distribution, a shareholder no longer holds any shares in the distributing corporation (“D”), then whatever basis she had in her old D shares becomes her basis in her newly received shares in the controlled corporation (“C”). If she retains some or all of her shares in D, then whatever basis she had in her old D shares will be allocated to her C and D shares in proportion to their FMV.

2. Corporate-Level and Shareholder-Level Taxation

One might get the impression that the primary focus of § 355 is deferral and that the advantage (or disadvantage in the case of losses) that it confers is one of timing: instead of the shareholder’s gain or loss being recognized at the time of the corporate division, it is preserved by means of an exchanged basis. Indeed, § 355 does defer shareholder-level tax. However, it does much more than that. 132 First and most important, it eliminates the corporate-level tax. Following the division, the shareholder’s basis in her C shares (or in her new C shares and her retained D shares, combined) will equal her previous adjusted basis in her D shares. This preserves the shareholder-level gain or loss. Now, what about D’s unrealized gain or loss in its C shares? Where is that preserved? The answer is that it is not preserved anywhere. D’s unrecognized gain or loss in its C shares will never be recognized. In this respect, § 355 is the mirror image of § 351. In the last chapter we saw that, following a § 351 exchange, the corporation takes a transferred basis in the asset, and the shareholder takes an exchanged basis in the shares. By preserving the unrecognized gain both at the corporate level and at the shareholder level, the Code adds a corporate-level tax. In a § 355 division, the Code does the opposite: it eliminates the corporate-level tax.

3. Gregory The effect of the corporate division provisions on the overall tax burden is well exemplified in the seminal case of Gregory v. Helvering.2 Gregory owned all the shares of United Mortgage. United Mortgage owned 1,000 shares of Monitor Securities:

Gregory wanted to sell her interest in Monitor for cash. One way to accomplish this would be for United Mortgage to sell its 133 shares in Monitor and then distribute the proceeds to Gregory. The problem

is that in such a case the tax burden would have been extremely heavy. Not only would United Mortgage have had to pay tax on its hitherto unrealized gain in the Monitor shares, but also the distribution would have constituted a dividend. At the time, dividends were taxed at ordinary rates. In an effort to reduce the tax burden, Gregory caused United Mortgage to transfer its shares in Monitor to a new wholly-owned corporation called Averill and spin off its Averill shares to Gregory:

The transfer of the Monitor shares to Averill and the spin-off of the Averill shares to Gregory were tax-free under the corporate division provisions. A few days later, Gregory liquidated Averill:

At that time, under the General Utilities doctrine, the transfer of appreciated assets to shareholders did not constitute a realization event on the corporate level. Thus, Averill reported no gain on the transfer of its Monitor shares to Gregory. On the shareholder level, Gregory reported capital gain on the “sale” of her Averill shares and took a FMV basis in the Monitor shares. Her 134 subsequent sale of the Monitor stock most likely did not result in any taxable gain. In other words, instead of full tax at the corporate level and full tax at the shareholder level (two levels of tax), the sale was taxed only once at a preferential rate (one-half of a level of tax). Now, the fact that different methods of extracting earnings from a corporation carry drastically different tax burdens is hardly conducive to the establishment of a coherent tax structure. Furthermore, given these differences, tax advisors would be remiss if they did not advise their clients to structure their transactions in such a way as to lighten their overall tax burden. In the face of such challenges, what is the best way to defend the integrity of the tax structure? The straightforward method would be to determine the

appropriate total tax burden on gain earned through a corporation and then make certain that corporate profits are always subject to that burden. It does not make much sense to institute alternative routes, each bearing a different tax burden, and then to focus attention on preventing taxpayers from choosing the least arduous one. Such a policy focuses on the symptoms instead of on the underlying inconsistencies. Guess which method was chosen both by the Court and by Congress. a. Judicial Response In order to prevent Gregory from exploiting the glitches that her tax advisors uncovered, the Court held that the corporate division provisions only apply when the division is pursuant to a business purpose. Seeing as Gregory had no purpose for acting as she did other than her desire to save on taxes, the Court determined that the transaction was not a division and that the transfer of the Averill shares to Gregory was an ordinary dividend. 135 We have already encountered this theme many times, although usually in the legislative context. In the view of both Congress and the courts, the problem is not that the corporate tax structure is inconsistent and that those inconsistencies result in corporations or their shareholders bearing inordinately high or inordinately low tax burdens. The problem, as they see it, is that taxpayers or their advisors might be aware of those inconsistencies and actually alter their behavior accordingly. In other words, if the taxpayer is minding her own business (pun intended) and happens to obtain an unjustified tax benefit, that is okay. What seems to be unacceptable is the taxpayer noticing ahead of time that certain courses of action bear higher burdens than others and acting on this information. Returning to Gregory, if Gregory could have demonstrated a business purpose for what she did (for example, that United Mortgage needed capital and that spinning off Monitor was necessary in order to attract an investor) then the elimination of one-and-a-half levels of tax would apparently have been acceptable. b. Congressional Responses Gregory won in the Board of Tax Appeals. She lost in the circuit court and the Supreme Court. However, seeing how her planning maneuver had succeeded in the court of first instance and either unwilling to wait for the Supreme Court to set things right or unwilling to rely on the judiciary to counter all attempts at what it considered abusive tax planning, Congress responded immediately by removing spin-offs from the ambit of the corporate division provisions. By 1951, Congress had come to realize that not all spin-offs were “abusive”

and, furthermore, that provisions allowing tax-free split-offs and split-ups can also be exploited by aggressive tax planners. Therefore, it reinstated spin-offs and simultaneously 136 imposed significant restrictions on the use of the corporate division provisions. However, in imposing these restrictions Congress did not attempt to deal with the fundamental inconsistency in the Code caused by the fact that the corporate division provisions caused one-and-a-half levels of tax to disappear. Congress, in effect, followed the lead of the Court and attempted to prevent the elimination of those one-and-a-half levels of tax when—and only when—the primary purpose of the division was to eliminate those levels of tax. This basic legislative conception underlying § 355 remains the same today as it was in 1951. When, as determined by both objective and subjective criteria, the corporate division was undertaken to further the corporation’s business interests, the Code is willing to allow the elimination of one level of tax (there currently is no savings on the shareholder level because qualified dividends are taxed at the same rate as long-term capital gain). On the other hand, when, as determined by both objective and subjective criteria, the driving force behind the division was the desire to procure that tax benefit, the Code views the corporate division as abusive and denies the benefits.

C. Requirements 1. Business Purpose Gregory established the principle that a corporate division must have a business purpose if it is to qualify under § 355. Today the regulations build upon that theme by declaring that § 355 will apply only to distributions that are incident to corporate readjustments required by business exigencies.3 The concept of business purpose is broad; there is no all-inclusive list of legitimate business purposes. Examples of business 137 purposes gleaned from the regulations, from published rulings, and from case law include the following: (a) complying with antitrust legislation,4 (b) allowing shareholders to devote their energies to specific businesses when some shareholders are proficient in one of the corporation’s businesses and others are proficient in another,5

(c) facilitating a merger,6 (d) issuing stock to a key employee,7 (e) focusing the corporation’s line of business to facilitate access to credit or equity,8 and (f) warding off a hostile takeover.9 a. Shareholder Purpose The business purpose required under § 355 is a corporate purpose and not a shareholder purpose. In other words, even if the shareholders had a legitimate non-tax reason for the division, it will not satisfy the business purpose requirement. Of course, this does not mean that the existence of a shareholder business purpose will necessarily disqualify a division. All it means is that, even if there is a shareholder business purpose, there also has to be a corporate business purpose. b. Transfers Following a Divisive D Reorganization As we have seen, a divisive D reorganization is the transfer of property to a controlled corporation as a preliminary step in a 138 corporation division. However, this initial transfer, even without the subsequent distribution, will sometimes suffice to accomplish the business purpose. For example, if the purpose is to protect the distributing corporation from the risk of holding one of its businesses, then simply incorporating the risky business might be enough. The regulations provide that in those instances in which the initial transfer of assets to the subsidiary suffices to accomplish the business purpose, the subsequent division will not be construed as having a business purpose and will not qualify under § 355.10 c. Alternative Arrangements The regulations do not merely break apart the steps of the division and question whether the second step is necessary after the execution of the first. They go further and state that if it is possible to achieve the business purpose by means of a nontaxable transaction that does not involve the distribution of shares in the subsidiary and if such alternative transaction is neither impractical nor unduly expensive, then the division will not be viewed as having a business purpose.11 The “alternative arrangement” regulation emphasizes what is perhaps the

central theme in the entire statutory, judicial, and regulatory scheme. The taxfree distribution of shares in the controlled corporation has the potential to eliminate the corporate-level tax. If left unfettered, this could seriously undermine the corporate tax structure. Therefore, the Treasury decided that it is only available in those instances in which the corporation has no other practical options available to accomplish its goals. In other words, the corporation needs to show that it tried its utmost to avoid benefiting from the tax advantages of a corporate division, 139 but—hey, these things happen—its back was up against the wall, and it simply had no reasonable alternative.

2. Continuity of Proprietary Interest (COPI) A second judicial concept that is today embodied in the regulations is COPI. The idea behind COPI is that non-recognition is only appropriate when the corporate division is more a change of form than of substance. If those who owned the distributing corporation prior to the division continue to own each of the corporation entities after the division, then the realization is more technical than actual. A strict COPI principle would require that the ownership interests in each post-division corporate entity be identical to the ownership interests in the predivision distributing corporation. This would ensure that the division is a mere change in form and does not alter any of the parties’ substantive rights. The actual COPI rules don’t go that far. Even if there is a substantive change in the parties’ rights, COPI will be satisfied as long as, in the aggregate, the owners of the pre-division distributing corporation own a significant interest in each of the modified corporate forms.12 With regard to how much of an interest they need to retain, the regulations are a bit enigmatic. All they say is that they need to own “an amount of stock establishing a continuity of interest in each of the modified corporate forms in which the enterprise is conducted after the separation.”13 The examples indicate that the magic number is somewhere between 20% (which according to Example 4 is not enough) and 50% (which according to Example 2 is sufficient). 140 However, divisions are not the only type of restructuring that is subject to the COPI requirements. Reorganizations must also comply with COPI. In regulations effective as of 2012—although preceded by temporary regulations that were promulgated in 2007—an example appears in which a 40% proprietary

interest is deemed sufficient to satisfy COPI in the case of a reorganization.14 Consequently, it is generally assumed that 40% is sufficient to satisfy COPI also in the case of a division.

3. Active Trade or Business (ATB) In order for a division to qualify under § 355, both D and C must be engaged in ATBs.15 The purpose of the ATB requirement seems to be that the distribution of shares in a corporation whose only assets are passive investments is more likely to be a cover for a bailout of corporate earnings. However, it is important to emphasize that ATB is a technical requirement, independent of the business purpose test. Even if the division was undertaken in pursuit of a legitimate business purpose, failure to comply with the ATB requirement will prevent application of § 355. a. Active Conduct The regulations define “trade or business” in very broad terms. A trade or business is “a specific group of activities. . .carried on. . .for the purpose of earning income or profit.”16 This would seem to include any economic activity undertaken by the corporation, including passive investments. However, owning a trade or business is not sufficient: the trade or business also needs to be actively conducted. Here, the regulations are much stricter. A corporation is considered to be 141 actively conducting a trade or business only if it performs “active and substantial management and operational functions.”17 Furthermore, the regulations clarify that the corporation must perform these functions in-house and not through independent contractors.18 b. Separate Affiliated Group The ATB requirement could prove problematic when business activity is performed through subsidiaries. Therefore, Congress provided that, for the purpose of determining whether a corporation is engaged in the active conduct of a trade or business, all members of the corporation’s “separate affiliated group” (SAG) are to be treated as a single corporation. In other words, as long as any corporation in D’s SAG has an ATB, then D will be treated as if it had an ABT (and the same goes for C). “SAG? What’s that?” Glad you asked. Section 355(b)(3) tells us that Corporation X’s SAG includes X and all those corporations in which X and other members of its SAG collectively have at least 80% control. “You’re

kidding me, right? If I don’t know what a SAG is, how can I know which corporations are members of X’s SAG? And if I don’t know which corporations are members of X’s SAG, how can I apply the definition in the first place?” Okay. The trick to following recursive definition such as this one is to chew slowly. Step one: X is obviously a member of X’s SAG. Step two: all corporations in which X has direct 80% control are members of X’s SAG. Step three: any corporation controlled by X’s SAG (as described in the previous steps) is a member of X’s SAG. Step four: repeat indefinitely. 142 c. Five-Year Requirement As already noted, the requirement that both D and C actively engage in a business or trade was intended to bolster the business purpose test. Congress presumed that when one of the corporations is not actively engaged in a trade or business, the bailout potential is too great to ignore. Having established ATB, Congress was then concerned that the distributing or the controlled corporation might attempt to satisfy that requirement by purchasing or starting a new business in contemplation of the division. To avoid such an end run, the Code provides that corporation will not be treated as engaged in an active trade or business, unless the “trade or business has been actively conducted throughout the 5-year period ending on the date of distribution.”19 Notice that the Code describes the five-year condition in the passive voice (“has been actively conducted”). There is no explicit reference to who it was who conducted the trade or business. The only caveat is that the trade or business “was not acquired” (notice again the passive voice) during that fiveyear period in a transaction in which gain or loss was recognized in whole or in part.20 In other words, if the corporation itself (or a member of its SAG) actively conducted the trade or business for five years, then the five-year requirement is satisfied. Otherwise, we need to trace the history of the trade or business for five years. Only if it was passed from one individual or entity to another through a series of non-recognition transactions will the corporation be treated as being engaged in the active conduct of a trade of business. 143 d. Trade or Business Acquired Indirectly Having provided that a trade or business acquired in a taxable transaction during the five-year period preceding the distribution will not qualify as an ATB under § 355, Congress was then concerned that taxpayers may attempt to

circumvent that restriction by purchasing, not the trade or business itself, but control of a corporation conducting such trade or business. Therefore, it imposed the same restrictions on indirect acquisition of a trade or business as on direct acquisition.21 In other words, a trade or business will not satisfy the ATB requirement if indirect control of such trade or business changed hands during the last five years in a transaction in which gain or loss was recognized. e. Division and Expansion of an Existing Trade or Business The fact that a trade or business needs a five-year history in order to qualify under § 355 raises some conceptual questions with regard to the division or expansion of business activity. When a business is divided does each part carry the history of the original business or does it start counting from scratch? When a business expands, geographically or into new fields, is the expansion part of the old business or it a new business? In general, the courts have taken a very liberal view of the division and expansion of existing businesses. For example, in Lockwood’s Estate, a corporation which had been operating in a few western states established a branch in Maine.22 Three years later, 144 the corporation incorporated its Maine operation in a wholly-owned subsidiary and spun off the subsidiary to its shareholders. The Eighth Circuit held that “the test. . .is not whether active business had been carried out in the geographic area later served by the controlled corporation but, simply, whether the distributing corporation, for five years prior to the distribution, had been actively conducting the type of business now performed by the controlled corporation without reference to the geographical area.”23 Eventually, the Service and the regulations followed suit. In fact, the Service has taken the Lockwood’s Estate principle one step further. Rev. Rul. 2003–38 concerned a corporation that had been operating a brick-and-mortar retail shoe business and began selling shoes online. Two years later, it transferred the internet business to a subsidiary and distributed all of the stock in the subsidiary to its shareholders. The Service ruled that because the corporation continued to rely on the experience, know-how, and goodwill associated with its retail stores, the website was not a new business, but rather an expansion of the existing business.24

4. Distribution of All the Stocks and Securities As part of the division, D must distribute to its shareholders all of the stocks and securities that it holds in C. In most cases, retention of any stock or

securities will disqualify the division.25 There is one exception to this rule. D may retain some stock or securities provided that it transfers stock constituting “control” of the subsidiary and establishes to the satisfaction of the Secretary that its retention of the stock or securities was not in pursuance of a plan having as one of its principal purposes the avoidance of 145 federal income tax.26 For example, if D owns 92% of C, distributes 80% to its shareholders, and retains the remaining 12%, the distribution of the shares to its shareholder could qualify under § 355.

D. Boot Earlier, when we talked about the tax consequences of a division, we relied upon the simplifying assumption that the shareholder received only stock and securities of C. The distribution of boot complicates things.

1. From the Perspective of the Shareholder a. Recognizing Gain and Loss The immediate consequences of boot from the perspective of the shareholder depend upon whether the division is a spin-off, a split-off, or a split-up. The reason for the difference is in that in the case of a spin-off, the shareholders simply receive stock and boot from D. They give up nothing in return. By contrast, in split-offs and split-ups, shareholder trade some or all of their shares in D in exchange for the stock and boot that they receive. Therefore, with spin-offs we apply § 301 in its plain vanilla state. The boot (in its entirety) is a dividend to the extent of D’s E&P, then reduces basis, then constitutes capital gain. Split-offs and split ups are trickier. We first compute realized gain, that is, the difference between the value of everything the shareholder receives and the shareholder’s adjusted basis in the shares surrendered. The recognized gain is the lesser of the realized gain or the boot. 146 b. Characterizing Gain Sticking with split-ups and split-offs, the Code goes on to discuss how to characterize the gain: whether it is to be viewed as a dividend or as gain from the sale of property. Section 356(a)(2) tells us that when an exchange:

has the effect of the distribution of a dividend. . .then there shall be treated as a dividend. . .such an amount of the gain. . .as is not in excess of [the distributee’s] share of the accumulated earnings and profits. . . . That phrase “has the effect of the distribution of a dividend” sound eerily like § 302, doesn’t it? Well, in fact, when examining whether a split-off or split-up has the effect of the distribution of a dividend, we apply the § 302 dividend equivalence tests (substantial disproportionateness, complete termination, and meaningful reduction).27 If under those tests, the redemption is treated as an exchange, then so be it: realized gain, to the extent of boot, is considered gain from the sale of an asset. On the other hand, if it does not pass the § 302 tests, then the shareholder will report a dividend equal to (please reread § 356(a)(2) before continuing) whichever of the following is the least: (a) the realized gain, (b) the amount of the boot, and (c) the shareholder’s ratable share of D’s accumulated E&P. The remainder (if any) of the recognized gain is capital gain. 147 c. Basis The shareholder’s basis in any boot received will be its FMV.28 That’s easy. What about non-boot property? Well, remember when we were discussing § 351, I mentioned that the formula “old adjusted basis plus recognized gain minus boot” would pop up repeatedly? Here we go. When a shareholder receives boot in a division, then the old adjusted basis is increased by any recognized gain and decreased by the FMV of any boot received. The readjusted adjusted basis is then pro-rated by value among the shareholder’s post-division stock and securities.

2. From the Perspective of the Corporation When D transfers boot to its shareholders in the framework of a corporate division, it recognizes gain but does not recognize loss.29

E. Divisions in the Nature of Sale Section 355 contains a couple of provision that are geared toward removing from its ambit transactions that, although they meet all the technical requirements, nevertheless resemble sales of stock more than they do divisions. They’re a bit intricate, but let’s take a look at them.

1. Section 355(d) Imagine that D and C have each been engaged in an active trade or business for at least five years. D wants to sell its shares in C to P. The question is how to structure the transaction. If P were simply to purchase the shares for cash, D would pay tax on any hitherto unrealized gain. D is looking for a way to avoid 148 or lessen its tax liability. Knowing what you do about § 355, can you come up with any suggestions? Here’s one. P could invest cash in D in exchange for newly issued shares. D would then transfer its shares in C to P in a split-off. If § 355 were to apply, D’s gain would not be recognized (either now or in the future). This kind of tax planning strategy should hardly surprise us. We know that the primary effect of § 355 is to eliminate the corporate-level tax. Like moths to a flame, tax advisors are naturally drawn to § 355 whenever corporations are exposed to tax on the sale of property. Of course, Congress has other ideas. Elimination of the corporate-level tax may (for some reason) be permissible when a corporation transfers stock and securities in a subsidiary to its existing shareholders. However, becoming a shareholder for the sole purpose of being able to receive control of the subsidiary in a tax-free corporate division is another matter entirely. Therefore, Congress decided to forestall this type of maneuver, and the relevant provision is § 355(d). This section is not an easy read, partly because it is constructed as a tower of definitions and substantive provisions. So, let’s start with the most basic definition and work our way up from there. (a) “Disqualified stock” is initially defined as stock in either the distributing corporation or the controlled corporation if such stock was purchased during the five-year period that preceded the distribution.30 In our example above, If P purchased the D stock less than five years before the split-off, then P’s stock in D would be disqualified. 149 (b) “Disqualified stock” also includes stock in the controlled corporation that was distributed in respect of disqualified stock in the distributing corporation.31

Since the stock that P received in C was issued to P in respect of its disqualified D stock, P’s C stock would also be disqualified. (c) A “disqualified distribution” is a distribution following which disqualified stock held by any one person possesses at least 50% of the voting power or at least 50% of the value of all the outstanding stock in either the distributing corporation or the controlled corporation.32 In our example, we have already seen that P’s stock in C is “disqualified stock.” If immediately after the distribution, this stock constituted at least 50% of the voting power or 50% of the value of all the stock in C, then the distribution of C stock to P would be a “disqualified distribution.” Ready for some more? (d) In the case of a disqualified distribution, any stock or securities in the controlled corporation that are distributed are considered boot from the perspective of the distributing corporation.33 In our example, the C stock received by P is boot from the perspective of D.34 150 (e) When a distributing corporation distributes appreciated boot in the framework of a corporate division, it must recognize the appreciation as income.35 Thus, D will recognize any realized gain from the “sale” of its shares in C. Bottom line: § 355(d) imposes the corporate-level tax that D was trying to avoid. Now that we understand how § 355(d) operates, let’s put on our tax advisor hats and ask how the parties to the transaction can circumvent the application of this section. It would seem that the key would be to keep any new shareholder from owning 50% or more of either the voting power or the value of C immediately after the distribution. However, this is more easily said than done. First, as with certain other sections that we have already encountered, § 355(d) does not consider only the stock directly owned by each shareholder, but attributes stock ownership to related persons. However, as you might expect, § 355(d) has its own unique set of what it calls “aggregation rules,” that are similar, but not identical, to the § 318 attribution rules. Take a peek at § 355(d) (7)(A) and § 355(d)(8) and see if you can spot the differences between them and

§ 318. Second, § 355(7)(B) provides that persons purchasing stock in either the distributing corporation or the controlled corporation pursuant to a plan shall be considering as one person. So, there is no avoiding § 355(d) by having a number of unrelated parties each purchase some of the stock. Even if none reaches the 50% threshold, as long as they do so jointly, § 355(d) will kick in. 151

2. Section 355(e) Returning to our example of D seeking a tax-efficient way to sell its shares in C to P, we will now add that D is planning to distribute the proceeds of the sale to its shareholders, who are individuals. Were it to do so, it would pay tax on the sale of its shares and its shareholders would pay tax on the receipt of the dividend. We know that the technique of D issuing shares to P for cash and then distributing its shares in C to P in a split-off is forestalled by § 355(d). Instead, imagine that D spins off its shares in C to its shareholders and that they then sell those shares to P. Were this strategy to work, D would not pay tax on the distribution of the C shares to its shareholders, and they would pay tax on the difference between the sales price and their exchanged basis in the C shares. Again, this would eliminate the corporate-level tax. The purpose of § 355(e) is to prevent such a maneuver. It provides that where the division is part of a plan, pursuant to which one or more persons acquire stock representing a 50% or greater interest in the distributing corporation or in any controlled corporation, then all stock and securities that are distributed shall constitute boot from the perspective of the distributing corporation. In our example, the division was part of a plan pursuant to which P acquired a 100% interest in C. Therefore, on the distribution of the C stock to its shareholders, D will pay tax on the hitherto unrealized appreciation of that stock. So far, so good. But in practice, how do we know whether the subsequent acquisition of stock is part of a plan? Well, sometimes we know and sometimes we don’t. To help us out in those cases in which we don’t, the regulations come along and provide us with some guiding principles. First, they describe certain facts that would seem to indicate the existence or nonexistence of a plan, 152 although they emphasize that the list is not exclusive and that all relevant fact and circumstances need to be taken into account.36 Second, they provide a list of nine safe harbors.37 Where one of these safe harbors applies, the distribution

will not be treated as part of a plan, regardless of the other facts and circumstances. In order to understand the first list—what the regulations call “plan factors” and “non-plan factors”—we need to focus on two significant events: the distribution and the acquisition. In delineating the “plan factors” and the “nonplan factors,” the regulations ask four questions: The first question is whether prior to the event that occurred first, serious preparations were already underway with regard to the event that occurred second. The second question is whether there was an identifiable, unexpected change in market or business conditions after the first event that resulted in the otherwise unexpected second event. The third question is whether the distribution was motivated in whole or in substantial part by a corporate business purpose other than to facilitate the acquisition. The fourth question is whether the distribution would have occurred at approximately the same time and in similar form regardless of the acquisition or a similar acquisition. In each case, a positive answer constitutes a plan factor or a non-plan factor, as the case may be. A negative answer usually is neither a plan nor a non-plan factor (although it may be taken into account as part of the overall facts and circumstances). Having listed the plan factors and the non-plan factors, the regulations go on to provide nine safe harbors.38 Your familiarity 153 with these safe harbors might make your client a bit more happy, but examining them would make this book a lot less short. Nevertheless, they are important in practice, particularly because tax advisors prefer, if possible, to avoid the uncertainty implicit in multi-factor tests. Therefore, should you ever encounter a proposed corporate division in which § 355(e) is a potential impediment, you would most likely want to review the list of safe harbors to see if the facts of your particular case fit, or can be made to fit, into one of them. 1 Section 368(a)(1)(D). 2 293 U.S. 464 (1935). 3 Treas. Reg. 1.355–2(b). 4 Treas. Reg. 1.355–2(b)(5) (example 1). 5 Treas. Reg. 1.355–2(b)(5) (example 2).

6 Commissioner v. Morris Trust, 367 F.2d 794 (4th Cir. 1966). 7 Rev. Rul. 88–34, 1988–1 C.B. 115. 8 Rev. Rul. 77–22, 1977–1 C.B. 91; Rev. Rul. 85–122, 1985–2 C.B. 118. 9 Priv. Ltr. Rul. 8819075 (May 13, 1988). 10 Treas. Reg. 1.355–2(b)(5) (example 3). 11 Treas. Reg. 1.355–2(b)(3). 12 Treas. Reg. 1.355–2(c)(1). 13 Treas. Reg. 1.355–2(c)(1). 14 Treas. Reg. 1.368–1(e)(2)(v) (example 1). 15 Section 355(b)(1)(A). 16 Treas. Reg. 1.355–3(b)(2)(ii). 17 Treas. Reg. 1.355–3(b)(2)(iii). 18 Treas. Reg. 1.355–3(b)(2)(iii). 19 Section 355(b)(2)(B). 20 Section 355(b)(2)(C). 21 Have you noticed that the business purpose test is an attempt to guarantee that the division is not simply a disguised distribution, that the active trade or business test is an attempt to strengthen the business purpose test, that the five-year restriction on direct acquisition is an attempt to prevent an endrun around the active trade or business test, and that the five-year restriction on indirect acquisition is an attempt to prevent maneuvering around the five-year restriction on direct acquisition? While we’re at it, did you notice that the business purpose test really doesn’t make any sense in the first place? 22 Lockwood’s Estate v. Commissioner, 350 F.2d 712 (8th Cir. 1965). 23 Id. at 717. 24 2003–1 Cum. Bul. 811. 25 Section 355(a)(1)(D)(i). 26 Section 355(a)(1)(D)(ii). 27 Commissioner v. Clark, 489 U.S. 726 (1989). 28 Section 358(a)(2). 29 Section 355(c)(2). 30 Sections 355(d)(3)(A) and 355(d)(3)(B)(i). 31 Section 355(d)(3)(B)(ii). 32 Section 355(d)(2). 33 Section 355(d)(1). 34 Note that the stock is not boot from the perspective of Corporation P. 35 Section 355(c)(2).

36 Treas. Reg. 1.355–7(b)(3) and (4). 37 Treas. Reg. 1.355–7(d). 38 Treas. Reg. 1.355–7(d).

155

CHAPTER 16

Reorganizations A. Overview The idea behind the reorganization provisions is to prevent taxes from becoming an impediment to corporate restructuring. Therefore, the Code provides that, subject to a number of conditions, gain that is realized in a reorganization will not be recognized. Beyond the statutory requirements, the courts have also imposed a number of what are often termed “common law” requirements. These non-statutory requirements are fleshed out in the regulations. One of the statutory requirements is that the shareholder or the corporation receives “solely stock or securities” in exchange for whatever it is that is giving up.1 However, it will probably not surprise you to learn that the receipt of cash or other property will not necessarily spell doom for the reorganization. Often the reorganization will qualify despite the boot, but gain will be recognized to the extent of boot received. To keep things 156 manageable, though, I’ll ignore boot for the moment. We’ll get back to it toward the end of the chapter.

B. Non-Statutory (“Common Law”) Requirements

Because the non-statutory requirements are common to all types of reorganizations, we’ll talk about them first.

1. Continuity of Proprietary Interest (COPI) In the context of reorganizations, COPI means that a substantial portion of what the Target Corporation (“T”) shareholders receive in exchange for their T shares must take the form of an equity interest in the Acquiring Corporation (“P”). That much is clear. What is not so clear is exactly how much of the consideration needs to be an equity interest in P. The best that the regulations do is to provide an example in which the proportion of equity interest is 40% and to conclude that that satisfies COPI.2 In another example, the regulations provide that 28.57% does not satisfy COPI.3 This means that for those planning corporate reorganizations, 40% is safe. Less than that might also be okay, but the lower you go, the more of a risk you’re taking.

2. Continuity of Business Enterprise (COBE) The Commissioner was long of the opinion that qualification as a reorganization requires P to continue operating T’s business enterprise. The courts tended to be more lax and usually considered COBE as satisfied if P used T’s assets in its own business or even if it sold T’s assets and used the proceeds in its own business. 157 Today, the regulations strike a middle path between the positions taken by the Commissioner and the courts. They require either that P continue a significant portion of T’s business activity or that it use a significant portion of T’s assets in its own business. On the other hand, selling the assets and using the proceeds in P’s business or holding onto the assets as passive investments will not pass muster. What is a “significant” portion? Today, it is generally accepted that about one-third is the threshold of P continuing T’s businesses or using T’s business assets in its own business.

3. Business Purpose In the previous chapter, we encountered the principle that a corporate division will not qualify under § 355 unless it had a business purpose. Although developed from a case involving a corporate division, this doctrine is in principle applicable also to the reorganization provisions of the Code. In other words, a transaction that does not have a business purpose will not constitute a “reorganization” as that term is used in § 368. Nevertheless, in practice, business purpose is much less significant for

reorganizations than it is for divisions. A possible reason is that, while a division can eliminate a level of tax, the best that a reorganization can do is defer taxation. In other words, it is considerably less likely that corporations will undertake a reorganization simply to achieve tax benefits, and, if they do, the benefits will likely be much more moderate.

C. Reorganizations, From A to G Let’s now turn to the Code itself. Section § 368(a)(1) lists seven different type of reorganizations. Because they are described in subparagraphs (A) through (G), they are called, not surprisingly, “A reorganizations,” “B reorganizations,” and so forth. Furthermore, some of these have more than one form: an ordinary two-party 158 reorganization, a two-party reorganization followed by a drop-down, or a triangular reorganization. We’ll start by discussing two-party A, B, and C reorganizations. We will then move to drop-downs and triangular reorganizations. After that, we will go back and complete the list by describing D (well, one kind of D anyway), E, F, and G reorganizations.

D. “A” Reorganizations 1. Definition An A reorganization is “a statutory merger or consolidation” in accordance with the law of the jurisdiction to which the corporation is subject. That’s all. Despite the seemingly straightforward language of § 368(a)(1)(A), a restructuring that is characterized as a merger or a consolidation by the law of the relevant jurisdiction will not necessarily qualify as an A reorganization. Nonstatutory requirements—such as COPI, COBE, and business purpose—must still be satisfied. In fact, the very dearth of statutory requirements for A reorganizations makes the non-statutory requirements all the more significant. For this reason, most of the cases and rulings that discuss COPI and COBE have involved A reorganizations.

2. Divisive Mergers Beyond the ordinary non-statutory requirements applicable in principle to all types of reorganizations, there exists a non-statutory restriction unique to A reorganizations, namely that a merger must be acquisitive and not divisive in nature. For example, assume that the law of the jurisdiction to which T and P are

subject allows T to transfer some of its assets and liabilities to P and to retain the rest. Although this is a “statutory merger” in the sense that a statute of 159 the appropriate jurisdiction describes it as a merger, it is not a “statutory merger” as the Code fathoms that term. To qualify as a § 368 statutory merger, all of T’s assets and liabilities must be transferred to P, and T must cease existing as an independent legal entity.4

3. Tax Consequences of an “A” Reorganization The merger of T into P constitutes a realization event both for T and for its shareholders. From T’s perspective, it sold its assets to P. The consideration that it received was P’s assumption of T’s liabilities and P’s issuing stock to T’s shareholders. In the parlance of the Code, this is the “amount realized.” Therefore, T’s realized gain on the sale is the difference between (a) the amount of liabilities assumed plus the FMV of the stock issued and (b) T’s adjusted basis in its assets. T’s gain is often referred to as “inside gain.” From the perspective of T’s shareholders, they surrendered their stock in T and in return received stock in P. The difference between (a) the FMV of the stock received and (b) their adjusted basis in the stock surrendered constitutes realized gain. This is often referred to as “outside gain.” When the merger qualifies as an A reorganization, the realized gain is not recognized at the time of the merger. Instead, tax on both the inside gain and the outside gain are deferred until a later date. The inside gain is preserved by means of P taking T’s basis in the property that it receives. The outside gain is preserved by means of T’s shareholders taking an exchanged basis in their new shares (i.e., the adjusted basis of their old T shares becomes the basis of their new P shares). 160

E. “B” Reorganizations 1. Definition B reorganizations involve the acquisition by P of shares in T. The primary requirements to qualify as a B reorganization are: (a) following the purchase P owns at least 80% of T, and (b) the only consideration received by those T shareholders who sold their stock within the framework of the reorganization is voting stock in P.

As opposed to an A reorganization, in a B reorganization, T continues to exist as a legal entity and retains all of its assets and liabilities. In fact, one of the primary attractions of a B reorganization is that it is often easier to transfer shares in T than it is to merge T into P and transfer to P all of T’s assets and liabilities. Some of the reasons are as follows: (a) Transferring assets and liabilities may involve a good deal more paperwork. (b) There may be assets that by law or contract cannot be transferred. (c) P may be wary of exposure to contingent or unforeseen liabilities. (d) In the case of a merger, minority shareholders may have the right to object or to have their shares redeemed instead of becoming minority shareholders in a different corporation. When shares in T are sold or exchanged, minority shareholders remain minority shareholders in the same corporation and have relatively few remedies available if they do not approve of the reorganization. 161

2. “Solely for. . .Voting Stock” Section 368(a)(1)(B) defines a B reorganization as the acquisition by one corporation, in exchange solely for all or part of its voting stock. . . of stock in another corporation. . . This is not the first time that we’ve encountered a statutory provision that conditions non-recognition treatment on the receipt only of stock. However, in those other cases, we saw that the presence of boot did not disqualify the entire exchange; it merely resulted in gain being recognized up to the amount of the boot. It is perhaps surprising to learn that, subject to a very limited number of exceptions, § 368(a)(1)(B) allows no such leeway. The presence of almost any consideration other than P voting shares will doom a B reorganization. There’s an expression that captures this notion: “No boot in a B.” If you ever want to impress a corporate tax lawyer, find an opportune moment to trot that one out.

3. Creeping “B” Reorganizations When P, in one fell swoop, acquires at least 80% of the shares in T in exchange for voting shares, the acquisition clearly qualifies as a B reorganization. But what happens if P acquires 80% of the outstanding T shares in a series of transactions? What happens if P acquires 80% of T for its own voting stock and also acquires additional shares in T for which it pays cash? The fundamental rule in such cases is that all acquisitions by P of T stock, in pursuance of its plan to acquire control of T, must sink or swim together.

Thus, if in pursuance of its plan P acquires 80% or more of the stock in T in exchange for its own voting stock and additional shares for cash, the acquisition will fail to qualify as a B reorganization, because some of the stock was paid for with something other than its own voting stock. On the other hand, if P 162 bought some T stock for cash and then decided to acquire control of T, then as long as the new shares were acquired solely for its own voting shares, the reorganization would qualify.5 Colloquially, stock held by P before it began taking steps to acquire control of T is referred to as “old and cold.” Even more colloquially, stock acquired by P as part of its plan to take control of T is referred to as “young and hot.” Thus, as long as all young and hot stock is paid for with P voting stock, the “solely for. . .voting stock” requirement will be satisfied.

4. Tax Consequences of “B” Reorganizations Structurally, B organizations are similar to § 351 exchanges. In each case there is a transfer of property to a corporation in exchange for shares in that corporation. It is not surprising to discover that their tax consequences are also similar: T’s shareholders take an exchanged basis in their P shares, and P takes a transferred basis in its T shares. In other words, the adjusted basis that the shareholders had in their T shares becomes both their basis in their new P shares and P’s basis in its newly acquired T shares. And in case you were wondering, then yes, just like § 351 exchanges, B reorganizations often involve an additional level of tax as the price of deferral.

F. “C” Reorganizations 1. Definition In a C reorganization, P acquires substantially all of T’s properties in exchange for its own voting stock.6 T must then 163 liquidate, transferring to its shareholders the P stock that it received along with its remaining assets, if any.7 This is a little more complicated than either A or B reorganizations, so let’s diagram it:

The effect of a C reorganization is similar to that of an A reorganization: P ends up with all of T’s assets, and T’s former shareholders end up with shares in P. Nevertheless, the requirements for a C reorganization are different from those of an A reorganization. The primary statutory requirements for qualification as a C reorganization are (a) that P acquires “substantially all” of T’s properties, (b) “solely for all or a part of its voting stock,” and (c) that following the exchange, T is liquidated. Let’s take a look at these requirements one by one.

2. “Substantially All” Neither the Code nor the regulations tell us how to determine when the assets acquired by P constitute “substantially all of the properties” of T. For advance ruling purposes, the Service has established a bright line rule of 70% of the FMV of T’s gross assets and 90% of the FMV of T’s net assets (assets minus liabilities).8 Nevertheless, while not eligible for an advance ruling, acquisitions 164 of less than that amount may also qualify. As noted in a revenue ruling:9 The answer will depend upon the facts and circumstances in each case rather than upon any particular percentage. Among the elements of importance that are to be considered in arriving at the conclusion are the nature of the properties retained, the purpose of the retention, and the amount thereof. In other words, the value of the properties transferred to P is only one element that should be considered in examining the “substantially all” requirement. For example, if T retains some non-business assets simply for the purpose of satisfying its debts, there might be greater flexibility than if it retained business assets for the purpose of distributing them to its shareholders.

3. “Solely for. . .Voting Stock” Were the “solely. . .for voting stock” requirement taken at face value (as it is, for example, in B reorganizations), qualification as a C reorganization would often be unachievable. Fortunately for those attempting to engineer a C

reorganization, the Code and the courts have permitted a certain degree of latitude. a. Assumption of Liabilities Avoiding boot in an asset acquisition (C reorganization) is much more difficult than in a stock acquisition (B reorganization). The reason is that in an asset acquisition, P will often need to assume some or all of T’s liabilities. Because assumption of T’s liabilities constitutes consideration that is not voting stock in P, C reorganizations would be all but impossible without legislative dispensation. Therefore, Congress provided that “in determining 165 whether the exchange is solely for stock, the assumption by the acquiring corporation of the liability of the other shall be disregarded.”10 b. Other Boot In a further lightening of the “solely for. . .voting stock” restriction, § 368(a) (2)(B) provides that P may use cash or other boot to pay for T’s assets, on condition that voting stock is used as compensation for at least 80% of the FMV of all of T’s assets. However, there is a catch. In this context, assumption of liabilities is not disregarded but rather is treated as a cash payment. One unfortunate consequence is that if T’s liabilities are greater than 20% of the FMV of its assets, no extra boot (beyond assumption of liabilities) is permitted.

4. Liquidation of the Target Corporation Following the exchange of its assets, T must liquidate and distribute its assets (consisting primarily of its shares in P) to its shareholders.11 As already noted, the result of the asset acquisition and subsequent liquidation of T is similar to that of a statutory merger: P ends up with T’s assets and T’s shareholders end up with shares in P. The Code authorizes the Secretary to waive the requirement to liquidate T (subject to whatever conditions the Secretary may prescribe).12 For example, one might request a waiver if T has non-transferable property or there is value to the T corporate charter. Should the Secretary agree to permit the reorganization without T’s actual liquidation, it will be viewed for tax purposes as if T had distributed all of its assets to its shareholders in complete 166 liquidation and they had then contributed those assets to the capital of a new corporation.13

5. Tax Consequences of a Type “C” Reorganization The tax consequences of a C reorganization are similar to those of an A reorganization: On the sale of its assets to P, T’s gain or loss is not recognized. P takes a transferred basis in the assets it receives from T (thus preserving the “inside gain”). On T’s liquidation, T does not recognize any gain on the distribution to its shareholders of its newly acquired P stock, and T’s shareholders do not recognize any gain on the exchange of their T shares for the P voting stock. Instead, T’s shareholders take a basis in their new P stock that is equal to their adjusted basis in the old T stock (thus preserving the “outside gain”).

G. Triangular Reorganizations and Drop-Downs Until now, we have only considered two-party reorganizations: P acquires either T’s assets or T’s stock and pays with its own stock. However, there are times when three (or more) corporations are involved in the reorganization (in fact, these are most reorganizations are structured in the real world). Now things start to get spicy. Assume, for instance, that in a statutory merger, the parties want T to merge, not into P, but into a subsidiary of P. In other words, they would like for the subsidiary (“S”) to hold T’s assets, 167 and for T’s former shareholders to receive stock in P (here, “P” stands for S’s parent):

There are two basic methods to move from the “before” picture to the “after” picture. The first is for P to absorb T’s assets and liabilities in exchange for its own stock and then to transfer those assets and liabilities to S in a § 351 exchange. This is known as a “drop-down.” The second is for S to absorb T’s assets and liabilities directly and in return for P to issue shares to T’s former

shareholders. This is known as a “triangular reorganization” (or, in this specific case, a “triangular merger”). Either way, T’s shareholders end up with shares in P, and T’s assets and liabilities end up in S. The problem with either of these two methods is that, without specific concessions in the Code or the regulations, they would fail to satisfy the requirements for a reorganization. In our example, a drop-down would violate COBE, as P is neither continuing T’s business nor using T’s business assets. A triangular merger would violate COPI, as T’s shareholders receive no direct proprietary stake in S. Moving on to B and C reorganizations, a triangular reorganization would violate the statutory requirement that the acquiring corporation use its own voting stock to acquire T’s stock or assets. Drop-downs would again face the COBE problem. 168 Eventually, Congress was convinced that it is often necessary or desirable to structure a reorganization in such a way that the target’s shareholders receive stock or securities in the parent of the corporation that received the assets. Accordingly, and subject to number of provisos, it permitted both drop-downs and triangular reorganizations. Furthermore, with regard to triangular mergers, Congress specifically provided that the restructuring may take the form of either a forward triangular merger (an example of which was described above) or a reverse triangular merger (which will be explained shortly).

1. Drop-Downs We’ll start with drop-downs. Section 368(a)(2)(C) provides as follows: A transaction otherwise qualifying [as a reorganization] shall not be disqualified by reason of the fact that part or all of the assets or stock which were acquired in the transaction are transferred to a corporation controlled by the corporation acquiring such assets or stock. Thus, if P were to drop down to a subsidiary some or all of the assets that it receives, the transaction could still qualify as a reorganization. Drop-downs can also be more complicated. For example, P could divide the shares or the assets among several subsidiaries. Furthermore, the corporations to which P drops down the shares or assets might not be direct subsidiaries of P. The regulations permit such drop-downs provided that all the corporations receiving assets or stock are members of P’s “qualifying group” (a “qualified group” is pretty much the same as the “separate affiliated group” that we came across when we talked about corporate divisions Remember the recursive definition? A 169

corporation is a member of the group if and only if members of the group have at least 80% control of the corporation).14

2. Triangular Reorganizations: General In a triangular reorganization, S receives T’s assets or T’s stock directly from T or from T’s shareholders; in exchange, P issues stock to T or to T’s shareholders. From the perspective of property law and corporate law, triangular reorganizations are often less complicated than drop-downs. This simplicity is a great part of their appeal. However, from the perspective of tax law, the rules governing triangular reorganizations are more restrictive. Case in point: while in a drop-down it is sufficient that P exercise either direct or indirect control over S, in a triangular reorganization P must be S’s direct parent. We will start off will triangular Bs and Cs. We will then discuss the two types of triangular A reorganizations: forward triangular mergers and reverse triangular mergers.

3. Triangular B Reorganizations a. Qualifying as a Triangular B Reorganization The requirements for qualifying as a triangular B reorganization are similar to those for qualifying as a two-party B reorganization. The only difference is that it is the parent of the acquiring corporation that issues stock to T’s shareholders:15 170

b. Tax Consequences of a Triangular B Reorganization A triangular B reorganization is functionally similar to an ordinary two-party B reorganization followed by a drop-down. Perhaps not surprisingly, the tax

consequences are also similar. In other words, if you want to determine the tax consequences of a triangular B reorganization, simply pretend that it had been structured instead as a two-party B reorganization followed by a drop-down.16 In the imaginary two-party B reorganization, T’s shareholders do not recognize gain or loss on the exchange of their T shares for P voting stock. Instead, their adjusted basis in their old T shares becomes the basis of both (a) the new P shares in the hands of the shareholders and (b) the old T shares in the hands of P. The subsequent imaginary drop-down is a § 351 exchange. Neither P nor S recognizes gain or loss. Instead, S takes a transferred basis in the P stock equal to P’s transferred basis. Simultaneously, P’s basis in its S stock is increased by the same amount. 171

4. Triangular C Reorganizations a. Qualifying as a Triangular C Reorganization In a triangular C reorganization, T transfers its assets to S in exchange for P voting stock. Following the exchange, T is liquidated:

As we have seen, in two-party C reorganizations there is a certain degree of flexibility of the “solely for. . .voting stock” requirement: P may assume T’s liabilities and T’s shareholders may receive a limited amount of boot (20% of the value of T’s assets minus liabilities assumed). The rules for triangular C reorganizations are similar, with the proviso that, although P is issuing the stock, S is the one that must assume the liabilities.17 With regard to the additional boot that T’s shareholders may receive, presumably that could come from either P or S. b. Tax Consequences of a Triangular C Reorganization As with a triangular B reorganization, a triangular C reorganization is taxed as if it were a two-party reorganization followed by a drop-down of the assets to

a subsidiary:18 172 In the first stage of the imaginary two-party reorganization, T does not recognize gain on the transfer of its assets to P. P takes a transferred basis in those assets. In the second stage of the imaginary two-party reorganization, T liquidates. T’s shareholders take an exchanged basis in their new P shares. In the imaginary drop-down, S takes a transferred basis in the assets that it receives from P (which, don’t forget, took a transferred basis from T), and P adds the basis that it had in those assets (less any liabilities assumed in the reorganization) to its basis in the S shares.

5. Forward Triangular Mergers a. Qualifying as a Forward Triangular Merger In a forward triangular merger T merges into S and, in return, T’s shareholders receive shares in P.19

In a two-party merger, there are no statutory restrictions regarding the structure of the consideration received by T’s shareholders. The only limitation is the non-statutory COPI, which requires that a substantial portion (40% to be on the safe side) of 173 the consideration take the form of equity interests in the acquiring corporation. The other 60% can be anything. It may include shares in other corporations (including, presumably, shares in the parent of the acquiring corporation). Therefore, you might expect that in the case of a forward triangular merger, as long as 40% or so of the consideration takes the form of an equity interest in P, the other 60% could include stock in S.

If that is what you expected, guess again. The Code provides that a forward triangular merger is possible only if “no stock of the acquiring corporation is used in the transaction.”20 In other words, while 60% of the consideration may take the form of anything from army boots to zoot suits, it may not include a single share of S stock. A further restriction on the forward triangular merger is the requirement that S acquire “substantially all of the properties” of T. We encountered this expression when we examined C reorganizations. It is reasonable to assume that the meaning of the expression in the context of forward triangular mergers is the same at in the context of C reorgs. b. Tax Consequences of a Forward Triangular Merger At this point, it will hardly surprise you to learn that a forward triangular merger is taxed as if it were a two-party merger of T into P, followed by a dropdown of T’s assets from P to S.21 Thus, on the imaginary merger of T into P, P takes a transferred basis in the property that it receives from T, and T’s shareholders take an exchanged basis in their new P shares. On the imaginary drop-down, S takes a transferred basis in the property, and P adds its basis in the property to its basis in its S shares. This is known in tax parlance as the overand-down method. 174

6. Reverse Triangular Merger a. Qualifying as a Reverse Triangular Merger Conceptually, the reverse triangular merger is probably the most complicated of the various reorganizations. In form, it is a type of A reorganization (or perhaps a C reorganization); in substance, it is a type of B reorganization (or perhaps a § 351 exchange). What makes it unusual—what gives it its status as a “reverse” triangular merger—is that the corporation that is nominally the acquiring corporation is actually the target corporation. The nominal target actually survives this type of merger intact. In a reverse triangular merger, S merges into T. T’s shareholders transfer stock representing a controlling interest in T to P in exchange for P voting stock:22

From a technical perspective, not only has T survived and retained the property that it held at the outset, but it is has also absorbed S’s property.23 However, let’s look at what is really going on. All of T’s assets are now owned by P’s subsidiary, all of the assets that used to belong to P’s subsidiary still belong to P’s subsidiary, and T’s former shareholders now have shares in P. In 175 effect, T has simply replaced S in the corporate hierarchy. Pretty cool when you think about it. With regard to the consideration that T’s shareholders receive for their shares, reverse triangular mergers are more restrictive than the forward variant. There, all you need is to satisfy COPI and to refrain from using any of S’s stock. Here, stock constituting at least 80% control of T must be exchanged for P voting stock. b. Tax Consequences of a Reverse Triangular Merger With regard to all other triangular reorganizations, we saw that their tax consequences are determined as if P had acquired T’s assets or T’s shares in a two-party reorganization and then dropped the assets or the stock down to S.24 This fiction does not work with reverse triangular mergers because T is both the target and the surviving entity. Clearly, P cannot be viewed as acquiring shares in T and then dropping those shares down to T. If it were, we would end up with the anomaly of T owning all of the shares in itself. This would not be of any help in determining P’s basis in its T shares. To overcome that problem, the regulations impose a second-stage fiction. They provide that P’s basis in its T stock is equal to the basis it would have had in its S stock had the reorganization been structured as a forward triangular merger instead of as a reverse triangular merger.25 This is a second-stage fiction because P’s basis in its S stock in the case of a forward triangular merger is itself determined by a fiction: it is the basis it would have had in its S stock had T merged into P and had P then dropped T’s assets down to S. When the smoke clears, T’s former shareholders take an exchanged basis in their new P shares, T takes a transferred basis in the assets it absorbed from S,

and P’s basis in its newly acquired T 176 shares is equal to its adjusted basis in its old S shares plus the adjusted basis that T had in its assets less any liabilities of T prior to the reorganization.

H. Other Reorganizations Having examined A, B, and C reorganizations in some detail, we can now describe the remaining types of reorganizations more briefly, as they are considerably less intricate.

1. Acquisitive “D” Reorganizations There are two kinds of D reorganizations: divisive and acquisitive. A divisive D reorganization is a drop-down initiated as a prelude to a division. We talked about those when we discussed corporate divisions. In this chapter we will describe acquisitive D reorganizations. In an acquisitive D reorganization,26 T transfers all or substantially all of its assets to P in exchange for stock and securities.27 At this point, T and T’s shareholders must jointly own at least 50% of the stock in P.28 T must then liquidate and distribute all of its assets (including, of course, its shares and securities in P) to its shareholders.29 177

This type of acquisitive D reorganization is structurally similar to a C reorganization, and in certain circumstances it can prove an attractive alternative. The primary advantages of an acquisitive D over a C is that consideration for the transferred assets can be any stocks or securities in P and not just P voting stock. The primary disadvantage is that, following the transfer, T and T’s shareholders need to own at least 50% of the stock in P.

2. Type “E” Reorganizations

Shareholders own various and sundry rights vis-à-vis the corporation. Any reshuffling of those rights among the parties concerned is likely to trigger a realization of at least part of their built-in gain. In order to allow such readjustments to take place without fear of adverse tax consequences, Congress provided nonrecognition treatment for recapitalizations, referred to in the Code as E reorganizations.30 The non-statutory requirements are relatively insignificant in the case of E reorganizations. As E reorganizations involve a single corporation, the COBE, COPI and non-divisiveness requirements are obviously irrelevant.31 Business purpose is germane in principle and could be problematic if examined strictly from the perspective of the corporation: often it is the shareholders, not the corporation, who are interested in the recapitalization. However, the courts have 178 tended to be fairly lenient in this respect and are usually willing to assume that the happier the shareholders are, the more smoothly the corporation will run.

3. Type “F” Reorganizations An F reorganization involves “a mere change in identity, form, or place of organization of one corporation, however affected.”32 The classical example of an F reorganization is the reorganization of a corporation in a different jurisdiction. While the new corporation is a different legal person than was the old corporation, in substance it is a continuation of its predecessor.

4. Type “G” Reorganizations A G reorganization involves the transfer of substantially all of a corporation’s assets to another corporation within the framework of a bankruptcy proceeding, in return for stock or securities in the acquiring corporation (in the case of a two-party G reorganization) or its parent (in the case of a triangular G reorganization).33 In order for the transaction to qualify as a G reorganization, the transferring (i.e., the bankrupt) corporation must distribute to its shareholders or security holders any stock or securities that it receives.34 The fact that the transfers occur within the framework of a bankruptcy could make it difficult to satisfy some of the conditions ordinarily required for qualification as a reorganization. For example, shareholders of the bankrupt corporation may not receive any proprietary interest in the acquiring corporation or its parent (potentially violating COPI), and the bankrupt corporation may have to retain significant assets to pay off some of its creditors 179

179 (potentially violating the requirement that it transfer “substantially all” of its assets to the acquiring corporation). Accordingly, the legislative history indicates that COPI and the “substantially all” requirement are to be interpreted leniently in the case of a G reorganization. Short-term creditors are counted toward satisfying COPI; and the “substantially all” requirement is not violated merely because the bankrupt corporation used some of its assets to make payment to creditors.35

I. Tax Consequences of Boot When no boot is received by T or by T’s former shareholders, the reorganization (regardless which type) is tax-free: recognition of any gain or loss is deferred by means of a transferred or an exchanged basis. Let’s now examine what happens when boot is involved. We will need to consider the effect of boot on T’s shareholders, on T, and on P. Of course, we will continue to assume that the transaction qualifies as a reorganization.

1. From the Perspective of T’s Shareholders a. Recognition of Gain As you probably expected, T’s shareholders must recognize realized gain to the extent of the boot received.36 In other words, recognized gain is the lesser of realized gain and the FMV of the boot. Losses realized in a reorganization are not recognized. b. Characterization of Gain With regard to characterization of the gain, § 356(a)(2) provides as follows: 180 If an exchange. . . has the effect of the distribution of a dividend. . . then there shall be treated as a dividend to each distributee such an amount of the [recognized] gain. . . as is not in excess of his ratable share of the undistributed [accumulated] earnings and profits of the corporation. . . The remainder. . . shall be treated as gain from the exchange of property. We encountered a similar provision in the context of corporate divisions. Here, too, the phrase “has the effect of the distribution of a dividend” means that we need to apply the principles embedded in § 302. When, under the § 302 tests, the exchange would have been treated as a distribution then the shareholder will report a dividend equal to the realized gain, the amount of the boot, or the

shareholder’s ratable share of accumulated E&P, whichever is least. Any gain not classified as a dividend will be treated as gain from the sale of property. c. Effect of Boot on Basis In computing the basis that T’s shareholders take in their new P stock, we need to take into consideration that some of the gain may have be recognized and that the boot itself has basis. The formula is one with which we are already familiar: the new basis equals (a) the old adjusted basis (b) plus the recognized gain (c) minus the FMV of any boot received.37

2. From the Perspective of T In a B reorganization (either two-party or triangular), T remains in existence and retains all of its assets. Therefore, in B reorganizations, there are ordinarily no tax consequences to T. In all others, there are not one but two potential realization events. The first is the disposition of its assets in the reorganization itself. 181 The second is the disposition of its assets during its subsequent actual or constructive liquidation. a. Exchange of Property in the Reorganization You might expect that T would recognize any realized gain to the extent of the FMV of the boot received. If you did, you would be only partially correct. Section 361(b)(1) requires T to recognize realized gain to the extent of any boot received (here comes the all-important proviso) if and only if the target corporation fails to distribute the boot to shareholders or to creditors as part of the plan of reorganization. We have already seen that in any A or C reorganization, T will be liquidated, either actually or constructively. As a result, T will rarely if ever recognize gain despite the receipt of boot. Note that T will not recognize gain even if it used some of the boot to pay off its debts prior to liquidation. Section 361(b)(1) provides for recognition of gain only if the boot is not distributed to T’s shareholders or creditors. Only if it were to sell the boot after receiving it and before liquidation would T recognize gain. Of course, no reasonable tax advisor would allow T to do such a thing, so from a practical perspective the issue is moot. Nonetheless, it is worth asking why the Code would require recognition of gain under such circumstances. This is not merely a timing issue. It is an additional tax: a fine, if you will, for failing to pay close attention to the finer points of tax law. b. Disposition of Property Following the Exchange As part of the plan of reorganization, T will usually dispose of its assets by

transferring them either to its creditors or to its shareholders. These assets include T’s “retained property” (i.e., assets that T held prior to the reorganization and that were not 182 transferred to P or S) and the assets that it received within the framework of the reorganization. Thus, at this stage of the game, there are three types of assets that T might hold: (a) what the Code calls “qualified property” (i.e., stock, options, and debt received from P), (b) boot (i.e., anything received from P other than qualified property), and (c) retained property.38 The rules for determining the tax consequences on the distribution of each category of property are different. (a) Qualified Property The disposition of qualified property by T is a realization event. Nonetheless, § 361(c)(1) provides that the realized gain will not be recognized if T distributes the property to its shareholders or to its creditors. However, if T were to sell the qualified property, then the gain would be recognized. Of course, no reasonable tax advisor would counsel the sale of qualified property by T. As are many others, this provision is no more than a nuisance for the well advised and a trap for the unwary. (b) Boot The disposition of boot by T, whether by sale or by distribution to its shareholders, is a recognition event. Nevertheless, it is not likely to involve any actual tax liability, because T takes a FMV basis in any boot that it receives in the reorganization.39 (c) Retained Property The disposal of retained property—by sale, by transfer to creditors, or by distribution to shareholders—is a 183 realization event. Any gain or loss in the property will be recognized.

3. From the Perspective of P There are no special provisions concerning the tax consequences of boot from the perspective of P. Therefore, P will recognize gain or loss on the sale or exchange of its property during the reorganization. 1 Sections 354(a)(1) and 361(a).

2 Treas. Reg. 1.368–1(e)(2)(v) (example 1). 3 Treas. Reg. 1.368–1(e)(2)(v) (example 11). 4 Treas. Reg. 1.368–2(b)(1)(ii). 5 Although note that Treas, Reg. 1.368–2(c) requires that such a series of transactions must take place “over a relatively short period of time such as 12 months.” 6 Section 368(a)(1)(C). 7 Section 368(a)(2)(G)(i). 8 Rev. Proc. 77–37, 1977–2 Cum. Bul. 568. 9 Rev. Rul. 57–518, 1957–2 Cum. Bul. 253. 10 Section 368(a)(1)(C). 11 Section 368(a)(2)(G)(i). 12 Section 368(a)(2)(G)(ii). 13 Rev. Proc. 89–50, 1989–2 Cum. Bul. 631. 14 Treas. Reg. 1.368–1(d)(4) 15 Section 368(a)(1)(B). 16 Treas. Reg. 1.358–6(c)(3). 17 Rev. Rul. 70–107, 1970–1 Cum. Bul. 78. 18 Treas. Reg. 1.358–6(c)(1)(i). 19 Section 368(a)(2)(D). 20 Section 368(a)(2)(D)(i). 21 Treas. Reg. 1.358–6(c)(1)(i). 22 Section 368(a)(2)(E). 23 Thus, for example, if for any reason the reverse triangular merger does not qualify as a reorganization, T will not recognize gain or loss. 24 See Chapters 17.F.4.b, 17.F.5.b, and 17.F.6.b, supra. 25 Treas. Reg. 1.358–6(c)(2)(i)(A). 26 Section 368(a)(1)(D). 27 Section 354(b)(1)(A). 28 Section 368(a)(2)(H)(i). 29 Sections 354(b)(1)(B) and 368(a)(1)(D). 30 Section 368(a)(1)(E). 31 Treas. Reg. 1.368–1(b). 32 Section 368(a)(1)(F). 33 Sections 368(a)(1)(G) and 354(b)(1)(A).

34 Section 354(b)(1)(B). 35 S. Rep. No. 1035, 96th Cong., 2d Sess. 49 (1980). 36 Section 356(a)(1). 37 Section 358(a)(1). 38 Note that (c) is not applicable to mergers. 39 Sections 358(a)(2) and 362(b).

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CHAPTER 17

Carryover of Tax Attributes A. Introduction Despite the fact that income tax is imposed on an annual basis, rarely does a corporation begin the year with a clean slate. For example, net operating losses (NOLs) can be carried forward, E&P accumulated in one year may be distributed in another year, and so forth. In tax parlance, these are described as “tax attributes.” Ordinarily, tax attributes are non-transferrable. Consequently, when a corporation’s legal life comes to an end, its tax attributes ordinarily die with it. Section 381 contains an important exception to this rule. It provides that in two specific cases, the tax attributes of a defunct corporation will be taken over by another corporation: the liquidation of a subsidiary,1 and the cessation of a corporation’s legal life within the framework of a reorganization.2 186 Before we continue, a couple methodological notes: (a) Section 381 describes a liquidated subsidiary as “the distributor corporation” and a corporation that ceases to exist within the context of a reorganization as “the transferor corporation.” For the sake of convenience, I will refer to the distributor or the transferor

corporation simply as “T.” (b) This chapter is not the whole story. The use of inherited tax attributes by the acquiring corporation may be circumscribed by § 382 and § 383, which delineate the fate of tax attributes following a change in ownership. We’ll discuss those in the next chapter.

B. Tax Attributes Section 381(c) lists twenty-two tax attributes that may be transferred from one corporation to another. Paragraphs (1), (2), and (3) refer, respectively, to NOLs, E&P, and capital loss carryovers. Paragraphs (4) through (26) essentially refer to various tax accounting issues. It is certainly not necessary to memorize the list, but you should at least skim over it so that you get some idea of the type of tax attributes included. One important reason that you might not want to exert too much energy familiarizing yourself with the list is that it is not a complete compendium of all transferrable tax attributes. It is more like a set of examples from which you can extrapolate other transferrable tax attributes. For example, foreign tax credits are inheritable even though § 381 makes no mention of them.3 187

C. Which Corporation Inherits the Tax Attributes? In the simplest type of reorganization or liquidation, where all of T’s assets are distributed or transferred to a single corporation which is scheduled to retain those assets for its own use, then that corporation is clearly the “acquiring corporation” that receives T’s tax attributes. However, we know that both liquidations and reorganizations can be more complicated than that. In a liquidation, there may be minority shareholders. Reorganizations may be triangular or followed by drop-downs. In these scenarios, which is the acquiring corporation for the purpose of § 381? Can there be more than one acquiring corporation? The regulations provide a simple answer to those questions: only one corporation can inherit T’s tax attributes, and that corporation is the one that directly receives T’s assets.4 This is the case even if it ultimately retains none of those assets itself. Thus, if T merges into P and P subsequently drops the assets down to S, it is P (not S) that will inherit T’s tax attributes. Well, perhaps not so simple. There is one sort-of exception: E&P following the liquidation of a subsidiary with minority shareholders. Here, the regulations in effect allocate the subsidiary’s E&P among its shareholders pro rata. True, the minority shareholders cannot actually inherit any of the E&P (remember only

one corporation can inherit tax attributes), so their portion simply disappears. The parent will inherit only its own proportionate share (80% to 100%) of the subsidiary’s E&P. 188

D. Blending the Tax Attributes of the Target and Acquiring Corporations The next step is to determine how the inherited tax attributes will blend with the acquiring corporation’s own tax attributes. In many cases, the blending process is straightforward. For example, if the acquiring corporation has accumulated E&P and it inherits accumulated E&P, if it has an E&P deficit and it inherits an E&P deficit, or if it has an NOL and it inherits an NOL, it would simply carry forward the sum of its own tax attribute and that which it inherited. Things get a bit more complicated when the plus or minus sign attached to the tax attributes of the two corporations is different. Specifically, we need to consider situations in which (a) the acquiring corporation has positive E&P and T has a deficit in its E&P account, (b) the acquiring corporation has a deficit in its E&P account and T has positive E&P, and (c) T has an NOL and the acquiring corporation had taxable income in the current year.

1. Earnings and Profits a. In General With regard to E&P, § 381(c)(2)(B) prohibits the blending of one corporation’s previous positive E&P with the other corporation’s previous E&P deficit. They must be carried forward by the acquiring corporation as two separate items. In subsequent tax years, any positive E&P accumulated after the liquidation or reorganization will offset the previous E&P deficit. Any deficit in E&P accrued after the liquidation or reorganization will offset the previously accumulated positive E&P. 189 For example, if T merges into P and, as of the date of the merger, one corporation had accumulated E&P of $100 while the other had an E&P deficit of $80, then instead of blending the two (and ending up with accumulated E&P of

$20), P will carry them forward separately. The carried-forward deficit will reduce future positive E&P, while any deficit accrued in the future will reduce the carried-forward positive E&P. Note that when the acquiring corporation is carrying both positive and negative E&P, it may distribute dividends out the positive and ignore the fact that it is also carrying an E&P deficit. The negative E&P will continue to be carried forward to offset future positive E&P. b. Year of Liquidation or Reorganization The prohibition against blending positive and negative accumulated E&P applies not only to future tax years, but also to the tax year in which the liquidation or reorganization takes place. T’s tax year ends on the date of the liquidation or the reorganization (except in the case of an F reorganization).5 However, the liquidation or reorganization may occur in the middle of the acquiring corporation’s tax year. In such a case, it is impermissible to blend T’s accumulated E&P (whether positive or negative) with the “differently signed” E&P that accumulated during the first part of the acquiring corporation’s year (i.e., until the liquidation or the reorganization).6 Positive or negative E&P that accumulate in the second part of the year are considered post-liquidation or postreorganization E&P. 190

2. Net Operating Losses The fact that T’s tax year ends on the date of the liquidation or the reorganization is significant also for NOLs. The acquiring corporation can use the inherited NOLs to offset its taxable income only from the second part of the year, not from the first part.7 In practice, this means that if the acquiring corporation has current taxable income, then that taxable income will be allocated pro-rata between the first part of the year and the second part of the year. The inherited NOL will be deductible only to the extent of the taxable income allocated to the second part of the year. Any remainder will be carried forward to subsequent tax years. 1 Section 381(a)(1). 2 Section 381(a)(2). 3 Rev. Rul. 80–144, 1980–1 Cum. Bul. 80. 4 Treas. Reg. 1.381(a)–1(b)(2)(i). 5 Section 381(b)(1). 6 Section 381(c)(2)(B).

7 Section 381(c)(1)(B).

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Restrictions on Use of Tax Attributes A. Introduction 1. Corporate Identity and Trafficking in Tax Attributes One of the fundamental characteristics of a corporation is that it retains its legal identity despite any change in the makeup of its shareholders. Were we to take this principle at face value, a corporation that reports an NOL in one year and taxable income in a subsequent year would be permitted to the deduct the NOL, even if its shareholders at the time that the loss was incurred no longer held any shares at the time that the corporation was attempting to take the deduction. Such a rule opens up the possibility of “trafficking” in losses. Sensibly or not, Congress tends to look askance at such a prospect. Consequently, it established an elaborate set of rules that eliminate or restrict the use of certain tax attributes following an ownership change. Let’s take a look at them. 192

B. Section 382: Net Operating Losses Of the many tax attributes that a corporation may possess, NOLs are perhaps the most significant, and the statutory scheme restricting their use is by far the

most detailed.

1. Ownership Change Section 382 restricts the use of NOLs following an “ownership change,” so let’s start by defining that term. An ownership change occurs when the percentage of stock owned by any group of shareholders increases by more than fifty percentage points over a three-year “testing period.”1 In other words, if there exists any group of shareholders whose combined shareholding at time t2 is more than fifty percentage points greater it was at time t1 (where t2 − t1 is less than three years), then there has been an ownership change. So far so good, but what if T is a publicly-traded corporation? After three years of daily trading, there may indeed be a subset of shareholders whose stake in the corporation has increased by over fifty percentage points. Should this also constitute an ownership change, which would trigger a restriction on the corporation’s ability to deduct its carryover NOLs? Congress did not think so. Therefore, when investigating whether there has been an ownership change, the Code considers separately only shareholders who owned at least 5% of the stock at some point during the course of the testing period. All other shareholders are lumped together and are considered to be a single shareholder.2 193 And yes, just in case you were wondering, § 382(l)(3) adopts a modified version of the § 318 attribution rules.

2. Consequences of an Ownership Change Once it is determined that there has been an ownership change, § 382 imposes two primary restrictions on the deductibility of NOLs. The stricter of the two eliminates the NOL outright. The more lenient allows the corporation to deduct the NOL, but spreads out the deduction over a number of years. a. Eliminating the NOL: Continuity of Business Enterprise Section 382(c) provides that, following an ownership change, the “new loss corporation” (NLC) will lose its right to deduct the NOL unless it continues the business enterprise of the “old loss corporation” (OLC) for at least two years following the date of the ownership change. We need to define a few new terms. The OLC is the corporation that generated the NOL.3 The NLC is the corporation that ended up with the NOL

after the ownership change.4 Note that the OLC and the NLC are often the same corporation. Only if the NOL was transferred from one corporation to another under § 381 will the NLC and the OLC be different corporations. Another term that we need to define is “continue the business enterprise.” As we saw in our discussion of reorganizations, COBE requires that P continue T’s business activity or uses the target’s assets in its own business. The same idea applies here. The major difference is that § 382 requires the NLC to continue the business enterprise of the OLC for at least two years, while the reorganization regulations impose no such requirement. Thus, it is possible for a transaction to satisfy COBE for the purpose of 194 qualifying as a reorganization, for the NOL to pass from one corporation to another under § 381, and for § 382 then to eliminate the NOL because of a failure to satisfy COBE. b. Section 382 Limitation: Deferring Deduction of the NOL Assuming that the COBE requirement is satisfied and that the NLC is entitled to deduct the OLC’s NOL, the “§ 382 limitation” kicks in and restricts the amount of the NOL that may be deducted each year.5 The idea behind the § 382 limitation is that Congress did not want the NLC to be able to deduct the NOL more quickly than the pace at which the OLC would have been able to deduct it. Because of the time value of money, the present value of an NOL to a taxpayer who expects to deduct it over a short period of time is greater than the present value of the same NOL to a taxpayer who expects to deduct it over a longer period of time. Therefore, if the NLC could freely deduct the NOL, the Code would encourage the purchase or merger of loss corporations solely because the NLC can deduct the losses more quickly. Of course, determining how much of the NOL the OLC would have been able to deduct (i.e., what would the OLC’s taxable income have been) were it not for the ownership change is not a simple task. One possibility that comes to mind is to rely on the OLC’s taxable income during the years preceding the ownership change. However, besides for the standard disclaimer that past performance is not indicative of future results, the OLC is, by definition, carrying forward an NOL, meaning there is a good chance that its taxable income in recent years was either very low or negative. 195 Therefore, Congress sought an objective formula, unrelated to any corporation’s actual performance, by which to predict what the old loss

corporation would have been able to deduct. The formula that it chose was the value of the OLC times “the long-term tax-exempt rate.”6 Here is another term that we have to define. The long-term tax-exempt rate is the interest rate on long-term U.S. government debt, adjusted to reflect the difference between taxable and tax-exempt securities.7 In effect, it is the interest on a hypothetical U.S. government long-term tax-free bond. The Code presumes that, were it not for the ownership change, the amount that the old loss corporation would have earned is equal to the value of the corporation times this rate. For example, if the OLC was worth $80,000,000 and the long-term taxexempt rate is 3%, then each year following the ownership change the NLC will be entitled to deduct no more than $2,400,000 of the NOL. c. Section 382 Limitation: Anti-Stuffing Rules Having established a formula for limiting the NLC’s annual NOL deduction, Congress then began to consider how taxpayers might attempt to circumvent the limitation and how it might go about impeding such circumvention. The only part of the formula (the value of the OLC times the long-term tax-exempt rate) over which taxpayers have any degree of control is the value of the OLC.8 Therefore, Congress was concerned that shareholders might try to inflate the value of their corporation prior to the ownership change. The obvious way to do this is to transfer assets to the corporation. Another method would be to prevent the corporation from distributing its assets, even though the corporation does not need 196 them for its business activity. Should these techniques succeed, the NLC would be entitled to deduct the NOL sooner; and because a deduction today is worth more than a deduction tomorrow, the shareholders would presumably receive more for their shares (beyond the value of the additional assets). To forestall these techniques, § 382 contains a number of “anti-stuffing” rules. The first provides that capital contributions whose principal purpose is to increase the § 382 limitation will be disregarded.9 Moreover, any capital contributions received during the two years preceding the ownership change are irrefutably presumed to such a purpose.10 The second anti-stuffing rule is aimed at OLCs that own substantial nonbusiness assets that could easily be distributed to shareholders without adversely affecting the corporation’s business (“substantial” here means at least one-third of the value of all its assets). In effect, the Code considers a virtual world in which the corporation had distributed to its shareholders all its non-business assets along with a commensurate share of its indebtedness. The § 382 limitation

is then calculated based on the value of the OLC in such a virtual world. When the OLC owns shares in another corporation, then there is an added twist in applying the second anti-stuffing rule. If the OLC is a minority shareholder in the other corporation, then, in most cases, the shares will simply be non-business assets. However, if the OLC owns 50% or more of the shares, then the corporate veil is lifted and the OLC is viewed as owning a proportionate share of the other corporation’s assets.11 197 d. Section 382 Limitation: Built-In Gains and Losses Consider these two hypothetical situations. In each case, assume that the merger constitutes an ownership change from the perspective of T and that sale of the asset produces ordinary gain or loss: (a) Built-In Loss T owns an asset with a built-in loss. It merges into P. Following the merger, P sells the asset and realizes the loss. Based on what we’ve seen until now, P can freely deduct the loss. (b) Built-In Gain T is carrying an NOL and has an asset with a built-in gain. It merges into P, and P inherits T’s NOL. Based on what we have seen so far, deduction of the NOL by P will be subject to the § 382 limitation. Therefore, were P to sell the asset, it might have to pay tax on some of the realized gain. The real question that arises in situations such as these is how much credence to give the realization doctrine. Strict adherence to the realization doctrine would dictate that the loss (in the first example) or the gain (in the second) belongs to P. Abandoning the realization doctrine would require us to adjust T’s NOL by adding its unrealized losses (in the first example) and subtracting its unrealized gains (in the second). What did Congress do? It neither abandoned the realization doctrine nor adhered to it strictly. In § 382(h), it provided that built-in gains and losses will effectively be treated as belonging to the OLC if they are realized within five years of the ownership change. After five years, the fact that the built-in gain or loss accrued while the asset was owned by the OLC is ignored, and the gain or loss is 198 treated as belonging entirely to the NLC. Obviously, § 382(h) applies only to

the gain or loss that was built-in at the time of the ownership change. Further depreciation of loss property or further appreciation of gain property belongs entirely to the NLC. The treatment of unrealized gains and losses gets a bit trickier when the OLC has some assets with built-in gains and others with built-in losses. In such a case, gains or losses in the minority group (i.e., gains if there is a “net built-in loss” or losses if there is a “net built-in gain”) do not count. In other words: if there is a net built-in gain, then realized losses are not subject to the § 382 limitation; if there is a net built-in loss, then realized gains do not increase the § 382 limitation. Section 382(h) does of course apply to gains or losses in the majority group. However, the total amount of gain or loss to which § 382(h) will apply cannot exceed the net built-in gain or the net built-in loss. Once that threshold has been passed, future realizations of gain or loss will not invoke § 382(h).

C. Section 383 If you managed to understand § 382, then § 383 should not present a problem. The idea behind § 383 is that the § 382 limitation applies not only to NOLs but also (a) to net built-in capital losses that are realized within five years of the ownership change and (b) to certain credits of the OLC. The § 383 template is as follows. If, in a given year, the NLC exhausts its entire § 382 limitation, it cannot deduct any of the OLC’s net built-in capital losses and cannot use any of its carryover credits. If it has not exhausted its § 382 limitation, it may use the remainder (i.e., the difference between its § 382 limitation and the NOL that it actually deducted) for capital losses and credits. 199

1. Net Built-In Capital Losses As far as net built-in capital losses are concerned, the procedure is straightforward. Every unused dollar of the § 382 limitation permits the deduction of one dollar of built-in capital loss.

2. Credits In principle, the application of § 383 to credits is similar to its application to net built-in capital losses: the NLC can only benefit from the credit to the extent of the unused portion of the § 382 limitation. However, application of the principle to credits is a little more complicated because losses are stated in terms of income, while credits are stated in terms of tax. Therefore, before the § 382 limitation is applied to credits, it needs to be converted from units of income into units of tax. The regulations provide that the NLC, alongside its computation of its

taxable income, needs to determine what its taxable income would have been had it deducted losses in the full amount of its § 382 limitation. The difference between the two is the § 383 limitation for the use of credits carried over from the old loss corporation (“the § 383 credit limitation”).12

D. Section 269 As we have seen, § 382 and § 383 contain an array of restrictions whose goal is to dissuade corporations and their shareholders from trafficking in beneficial tax attributes. One feature common to both of these sections is their reliance on objective criteria as indicia that perhaps something not quite above board is occurring. 200 Section 269 takes a different tack for combating tax-attribute trafficking by focusing on subjective criteria. True, it is not devoid of objective criteria. It applies only when a person or persons acquire control of a corporation (meaning that a person or persons who had less than 50% control of the corporation before the transaction has at least 50% control afterwards) or when a corporation acquires an asset with a transferred basis.13 However, the focus of § 269 is subjective. It provides that if the primary purpose of the acquisition is the avoidance of federal income tax by securing the benefit of a favorable tax attribute, then the Secretary may disallow the use of the attribute. The primary purpose of the transaction, like any other subjective factor, can be discerned only by a careful examination of all the facts and circumstances.

E. Section 384 The final anti-trafficking measure that we will consider is § 384. As opposed to § 382, § 383, and § 269, the focus of § 384 is not trafficking in beneficial tax attributes but rather trafficking in gains. The idea is as follows. Imagine that P is carrying an NOL that it cannot deduct because it is not producing sufficient taxable income. T, whose only property is an asset with a large built-in gain, merges into P, and T’s shareholders receive 40% of the stock in P. Had the merger constituted an ownership change from the perspective of P, the deduction of the NOL would have been subject to the § 382 limitation. However, under the facts of the example, the merger is not an ownership change from the perspective of P. Apparently, P can freely use its NOL to offset the gain on the sale. In effect, P’s pre-merger NOL is offsetting T’s pre-merger gain. 201

Section 384 was enacted to combat this type of tax planning maneuver. It applies to A, C, and D reorganizations involving a corporation with property containing net unrealized built-in gain (“a gain corporation”). If, during the five years following such a reorganization, the acquiring corporation realizes any portion of that gain, the gain may not be offset by any other corporation’s preacquisition loss. In our example, T is a “gain corporation.” Therefore, were P to sell the asset within five years, none of the gain could be offset by its pre-reorganization NOL. 1 Section 382(g)(1). 2 Section 382(g)(4)(A). 3 Section 382(k)(2). 4 Section 382(k)(3). 5 Section 382(a). 6 Section 382(b)(1). 7 Section 382(f). 8 There is not much that a taxpayer can do to change the long-term tax-exempt rate. 9 Section 382(l)(1)(A). 10 Section 382(l)(1)(B). 11 Section 382(l)(4)(E). 12 Treas. Reg. 1.383–1(c)(6). 13 Section 269(a).

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Final Words As you may have noticed, corporate taxation is a strongly rule-based field of study. There are rules. There are exceptions to the rules. There are exceptions to the exceptions to the rules. There are meta-rules that tell us when to use which rule. There are exceptions to the meta-rules. So, where does all that leave you? How do you approach this morass of detail? Should you view corporate taxation as a compendium of random provisions and simply try to memorize the rulebook? You could, but unless your memory is better than most, that could prove rather difficult. As an alternative, I would suggest that you try to see patterns. Consider how the whole system works (or could work or should work) and how the various provisions fit into that pattern. When they do—great. When they deviate from the model, make a mental note of that and try to figure out why they do so. Understanding why a particular provision deviates from the norm is also a good way to remember it. One other thing. In a law school course, we tend to discuss subjects in succession. Focus on one, learn it, review it, make sure 204 you understand it, then move on to the next. In practice (and on exams!), it doesn’t work that way. Usually, you are given a set of facts and you have to figure out which subjects are relevant. Sometimes it’s fairly obvious; other

times, not so much. Also, in practice (and on exams), you may have a fairly wide degree of latitude with regard to the facts. What if we do it this way? What if we tweak it that way? How do we get the result we want? You need to see the whole picture. So, when you are studying a subject—sure: learn it, review it, make sure you understand it. Then ask yourself: how does it relate to subjects that we covered in previous chapters? I think it’s a fairly safe bet that most law students and most lawyers do not find corporate taxation particularly fascinating. Bewildering, perplexing, confusing, obtuse—yes. But not interesting enough to attempt to master. That’s fine. But if you are one of those who do, welcome aboard! You may find that it can be a lot of fun.