Tax II Outline
Tax Free Incorporation
Three Basic Requirements for §351 qualification:
– To qualify under §351 for non recognition of gain or loss:
1. One or more persons (including individuals, corporations, partnerships and other entities) must transfer “property” to the corporation;
2. The transfer must be solely in exchange for stock of the corporation; and
3. The transferor or transferors, as a group, must be in “control” of the corporation “immediately after the exchange.”
· Control (§368(c)) = the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation
· Basis (§358(a)(1)) = the basis of the stock (“nonrecognition property”) received in a §351 exchange shall be the same as the basis of the property transferred by the shareholder to the corporation
· §362: the basis of the property will transfer with the property when given under a §351 transaction
– Must all be part of one integrated plan; however, transfer need NOT be simultaneous
– Services don’t count – must be for property
– Property cannot be de minimus compared to stock received
Boot:
§351(b) – If a transaction would otherwise have qualified under §351(a) but for other property, gain realized need only be recognized to the extent of boot received
· NO LOSS recognized with boot under §351(b)
· Avoid double recognition with boot by increasing basis in stock by an amount equal to gain recognized on transfer
Installment Boot: gain not recognized until all payments received for transaction
· Corp immediately increases basis in nonrecognition property received (stock corp received)
· Corp must wait until shareholder recognizes gain to take basis increase in assets acquired
FORMULA for basis in stock or “non-recognition property” = Basis in transferred property – FMV of other property and amount of cash received + gain recognized on transfer
Liabilities:
§357(a) – assumption of liability by a transferee C in §351 exchange will neither constitute boot nor prevent the exchange from qualifying under §351.
– Debt relief not treated as boot, recognition postponed for gain attributable to transferred liabilities
· §358(d) – treats debt relief as money received
· ^^Reduces basis in stock received^^
Exceptions to §357(a):
§357(b) Tax Avoidance Exception – assumption of a liability treated as boot if taxpayer’s “principal purpose” in transferring liability was federal income tax avoidance or it was not a bona fide business purpose
– Essentially a factual determination made after “taking into consideration the nature of the liability and the circumstances in the light of which the arrangement for the assumption or acquisition was made.”
– If improper purpose exists at all, all relieved liabilities treated as boot, not just the bad ones.
§357(c) Negative Basis Exception – if the sum of liabilities assumed by C exceed the aggregate adjusted bases of properties transferred by a particular transferor, excess considered gain from the sale or exchange of property.
– Basis in property transferred – assumed liability = gain recognized, if it would make a negative basis
– Exception to §357(c): if TP is relieved of debt that would be deductible if paid directly by TP, TP doesn’t recognize gain if debt discharged by transfer because any potential income would be offset by a corresponding deduction upon payment anyway.
· If A is relieved of debt by transfer to C, but would have avoided gain by a deduction anyway if A paid herself, there is no gain recognized,
§357(d) Determination of Amount of Liability Assumed
– Recourse Liability (§357(d)(1)(a): recourse liability or any portion thereof treated as having been assumed if, as determined by all facts and circumstances, the transferee has agreed to, and is expected to, satisfy such liability, whether or not the transferor has been relieved of such liability
– Nonrecourse liability(§357(d)(1)(b): treated as having been assumed by the transferee of any asset subject to such liability
– §357(d)(2)(A,B): nonrecourse liability reduced by lesser of (a) amount of such liability which an owner of other assets not transferred to transferee and also subject to such liability has agreed with transferee to, and is expected to, satisfy, and (b) the fair market value of such other assets
Receivables:
– Constitute property under the meaning of §351 (Hempt Brothers, Inc. v. United States)
Nonliquidating Distributions
Cash:
§301(c)(1): distributions that are dividends within the meaning of §316 must be included in gross income
– Corporate shareholders may deduct 70, 80 even 100 percent of these to avoid multiple taxation
– Dividends received by noncorporate shareholders usually taxed at preferential capital gains rates (15%)
§316(a): a dividend is any distribution of property made by a corporation to its shareholders out of (1)n earnings and profits accumulated after February 28, 1913 (accumulated earnings and profits) or (2) earnings and profits of the current taxable year (current earnings and profits)
-Two irrebuttable presumptions: every distribution is deemed to be made out of earnings and profits to the extent that they exist and is deemed to be made from the most recently accumulated earnings and profits
– Distribution out of earnings and profits is a taxable dividend even is C has a historical deficit
Qualified Dividends
– Effective for eligible dividends received from 01/01/2003 until 12/31/2010
– Maximum rate for qualified dividend income is 15% for who ordinary income would otherwise be at higher rates
– 5% for lower income TP’s whose income would be taxed in the 10%-15% marginal brackets
– Dividend must be from a C meeting certain criteria: (see I.R.C. §1(h)(11)(B)(ii))
· Holding period: TP must hold stock for which dividend was paid for more than 60 days in the 121-day period beginning 60 days before the stock’s ex-dividend date
· Ex-dividend date = first date on which a share with respect to which a dividend has been declared is sold without the buyer being entitled to the dividend
– §1(h)(11)(B)(ii):
1. Any dividend from a C which for the taxable year of the corporation in which the distribution is made, or the preceding taxable year, is a corporation exempt under §501 or 521,
2. Any amount allowed as a deduction under §591 (relating to deductions for dividends paid by mutual savings banks, etc., and
3. Any dividend described
– Shareholder’s basis in distributed property = FMV as of the date of distribution
Distributions of a Corporation’s Own Obligations
– General gain recognition rule does not apply to a C’s distributions of its own debt obligations
– At SH level, both amount of dist. and dist.ee SH’s basis = FMV of obligation
Redemptions and Partial Liquidations
Introduction:
– SHS generally recognize a capital gain or loss on the sale of some or all of their stock
· However, enactment of §302 changed the treatment of redemptions and partial liquidations so that majority owners could not avoid tax by selling stock back to a C that they control
§302(a): a redemption will be treated as an exchange if it satisfies one of four statutory tests in §302(b)
– “Exchange” status means SH will recognize capital gain or loss to the extent of the difference between amount of dist. and SH’s basis in redeemed stock
– Redemption falling out side of §302(b) is treated under §302(d) as a “dist. to which §301 applies”
– §302(b)(1-3) examine whether there has been a sufficient reduction in SH’s ownership interest in C to justify treating redemption as an exchange
– §302(b)(4) shifts focus to C level and provides exchange treatment for any dist. that qualifies as a “partial liquidation” under §302(e) because it involves a genuine contraction of the dist.ing C’s business
Basic Consequences:
– If redemption treated as sale, basis of redeemed stock taken into account in determining SH’s gain or loss
– If redemption treated as dividend, SH’s basis in redeemed stock doesn’t disappear, but may be added to basis of SH’s retained stock
· If SH has no remaining stock after redemption, basis of redeemed stock may be added to basis of stock held by family members or entities whose stock was attributed to redeemed SH under §318
Tax Consequences to Dist. Corporation:
– Where redemption or dividend at SH level, tax consequences to dist. C of dist of property in a redemption governed by §311
– Dist. C recognizes gain on dist. of appreciated property
– Dist. C does not recognize loss on dist. of property that declined in value
SH Advantage:
– 15% maximum tax rate on qualified dividends changed stakes for ind. SH’s
– Major advantage to treating redemption as exchange is SH’s ability to recover basis of redeemed stock in determining gain or loss
Constructive Ownership of Stock:
– In determining stock ownership for purposes of §302(b) tests for exchange treatment, ind. TP or entity is considered as owning sotck owned by certain family members and related entities under §318
