Sample Answers to Question 3
Corporate Tax
Spring 2016
Exam No. 4010
This transaction is a typical Zenz transaciton - the
SH has redeemed some shares with the corporation and sold the others to a third
party, thus reducing her interest in the corporation. Though the transactions
occured 6 weeks apart, we know that they occured as part of one transaction
agreeed to by all three parties, and thus is probably fine (i.e. the two events
won’t be treateda s two seperate sales- rather we will look to see if the
entire transaction qualifies under 302 by examining before 3/1 and after 4/15).
THus, the sale to the third party can count as part of your reduction in your
interest.
Jill
Since at the beginning and the end of the
transaction, Jill has lost her entire interest in the corproation. Jill has
gone from being a 100% voting SH to a 0% voting shareholder. If she is
successful, Jill’s redemption will be treated as an exchange and not a 301
dividend (as it would with the ample E&P avaliable) so she can recover her
basis in the stock (currently at 100k).
There are going to be two primary hurdles for Jill
here - the frist is the family attribution from her Father. The second is going
to be whether she can waive that attribution under 302(c) due to her
relationship with Perch. There may also be some cause for concern from the
covenant being secured by the 85 shares of stock. There may also be issues with
the debenture that she is gvien from Zip in exchange for her stock.
First, her father’s shares in the corporation are
likely going to be attributed to her under 318 so that she also constructively
owns 100% of the non-voting preferred stock. Because of this rule, she
definitely runs into problems with (b)(1) and (b)(2). Under (b)(1) she still
retains a finaicial stake in the company. This is not waiveable, so she will
not get exchange treatment under (b)(1).
Under (b)(3), she may also run into problems becuase
she has not completely terminated her interest by virtue of the family
attribution rules. Though she could try to waive the attribution under 302(c),
her potential continued interest via the debenture is likely to make this fail
as well. Though she is retaining a relationship with the new parent company,
she is not doing so as a shareholder. The only potential issue could be that
she has gained a note secured with Perch stock that could be counted against
her (since Perch now wholly controls Zip), but this is probably okay. She is
also an employee of Perch, but that is also likely to be okay for the purposes
of the 302(c) waiver. Finally, she has retained a debt in Zip. She might fail
(b)(3) because of this promisorry note - as it itsn’t clear whether this is
truly debt or equity. All we know about it is that it is subordinated and the
principal is for 150k. Because of its subordianted nature, and depending on
other factors such as the debt equity ratio, whehter or not it is tied to
E&P, it might be reconstrued as equity, making her fail the test.
Though (b)(3) might not work for her becuase she can’t
waive the family attribution due to her continued interest in Zip, she likely
meets the requirements for (b)(2). The safe harbor requirements of (b)(2) state
that if you own less than 50% of the voting power of all classes entitled to
vote, the oting stock owned before and after is 80% of that owned after, and
the common stock is 80% after of the amount owned before, then you qualify.
here, she has lost all her interests in the common / voting stock of the
corporation. Though she has familiy attribution under 318 of the preferred
stock, these will not count against her for the purposes of this test (which
only applies to voting and common stock).
As a result, Jill is likely to get sale and exchange
treatment under (b)(3). Her basis in the stock is 100k. She Will use all the
100k basis in and recognize a capital gain on 900k (her total amount received
from Zip and Perch is 1 million dollars). She could use the 453 installment
method of accounting for the gain on the notes so that she is only paying the
gain as she receives the money. Or, she can elect to pay any tax on the interst
(or on anything above the FMV of the note) initially under 453(h). Which she
chooses will impact the way that the corporation calcuates basis.
Jill is going to have a basis in the notes of the FMV
of the property on the date of the distribution. Anything in addition to that
will be considered ordinary income (the interest on the notes). Both Perch and
Zip will be able to take a deduction for interest paid as a business deduction.
As far as the covenant not to compete, that might be
considered ordinary income to the extent that it seems as though it is in
exchange for services.
Kyle
This transaction likely won’t have an impact on Kyle.
The preferred stock he holds is 306 Stock. Though Zip did cancel 15 shares so
that there are only 85 shrares outstanding, it doesnt have much of an impact on
his investement or ownership/financial stake in the company. Even if it did, it
is one isolated event and not part of a recurring distrbution or redemptoin to
the corporation that might increase his interests over the years. So, he like
won’t have to pay any taxes (if he did, it would be treated as a dividend).
Perch and Zip
This Zenz transaction is considered a stock deal -
the purchasing corp (Perch) has purchased Zip (the target corps) stock so that
they are now a subsidiary of P. P is going to take a cost basis in the stock
(here that is 850k - the cost of the note and the cash). However, the basis in
some of the stock will depend on the method of accounting that Jill chooses to
use. In other words, if she decides to use the intallment method, the basis in
the stock goes up as she reports the income on the note. If she pays the tax up
front, then the compnay will report all the basis immediately (the full 850k).
Zip will not recognize a gain or a loss on the redemption
of stock from Jill.
Perch can liquidate Zip if it wants under 332 and
337. If Perch wanted to, they could make anelection to treat this as an Asset
deal. However, given that this is typically the less desireable of the two for
tax reasons, it is unilkely taht they would do this unless Zip was an S-corp.
Exam No. 4073
A first cocnern of this transaction is whether J will
be allowed to use her stock basis in her March 1 redemption of stock. The two
primary concerns are that J redeems the stocks far in advance of selling the
remainder of her stock and that J’s father owns some stock in the company.
The first issue, that the redemption is far before
the selling of the remainder of the stock, should be okay. Because the two
transactions are part of a unified plan for J to completely remove her voting
interest in the company, the two transactions should be treated as occurring
simulataneously. Under the Zenz ruling and the related following Rev.Rul. this
should be allowed for purposes of IRC 302(b)(3) as well as (b)(2).
From here J could try either IRC 302(b)(3) or (b)(2).
If she were to try to use (b)(3), a complete redemption or termination of
interest though she would run in to some serious problems. The first is that
her father owns some preferred stock and through IRC 318 attribution, J would
also be considered to own this stock. Note however, that this stock might not
actually be stock, but could be a debt. The main signal that this may be a debt
is that the stock is convertible to debt, additionally, that there seems to be
a fairly set pay schedule is indicative of a debt. These are pretty big red flags,
but when considereing the situation as a whole, it is more likely that these
would be just preferred stock. There is no indication that the amount of
dividends is tied in any way to a market rate and the intent seems to be that
whatever profits Zip makes, a portion will go to the father. So assuming that
this is stock, J will not have completely liquidated her interest in Zip and
would not meet the requirements for (b)(3). However, J could make an election
that would prevent the application of attribution from her father under IRC
302(c)(2). There do not seem to be any backward looking issues as to the
applicability of the “waiver,” but there are some concerns about forward
looking. Perch sometimes uses Jill as a consultant. This would likely trip up the
election to not apply attribution and the IRS would have a major issue with
this if it ever found out. Ultimately, 302(b)(3) would not be the ideal way to
go for J and Perch.
Better than (b)(3) J could try for a redemption under
(b)(2) which is a “substantially disproportionate redemption.” Under this
section, J must meet three tests. Keep in mind that in calculating these tests
I am assuming that the unified plan is in place and accordingly by the end of
the transaction J will not directly hold any shares, i.e. she will have
redeemed 15 and sold 85 simultaneously. The first test is a 50% test in which J
will need to hold less than 50% of the total voting stock in Zip. This test
will be met as J will hold 0% of the voting stock, since the attributed stock
from her father is nonvoting. Additionally, J will have to reduce her own total
voting power such that whatever voting power she has left will be less than 80%
of what she had initially. Again, this is met, even with attribution, because J
is going from 100% voting power to 0%. Finally, J will need to own less than
80% of the common stock compared to before the transaction. This is met because
even with attribution, J will hold 0% of the voting stock after the transaction
is complete. Finally, because there will be no need to use a waiver of
attribution (which is not even allowed under (b)(2)) J’s participation in Zip
will not cause any issues.
Note that J could probably qualify under (b)(1) if
she needed because there is a “meaningful reduction in shareholder’s
proportionate interest” since she goes from a totally controlling position to
owning nothing directly and only having attribution as to nonvoting preferred
stock.
Because J will be able to be eligible for exchange
treatement under (b)(2), she will get to use her stock basis in the redemption
transaction against any income from the redemption transaction. The treatment
of each payment of the promissory note will be subject to a partial redemption
of stock basis and the rest will be income. Here, 1/10th or 10% of each payment
will be a tax free return on basis and the rest will be a capital gain. J will
report the income as each payment comes in because she is a cash method
taxpayer.
Any gain from J’s transfer of stock to Perch will be
a capital gain, assuming J is not a broker/dealer in stocks. Additionally,
because some of the payments are going to be done as installments, each payment
will be subject to a partial tax free return of basis. Again, each payment will
be 10% tax free return of basis and 90% capital gains. So the initial payment
of 450k at the exchange will be 405k in capital gain and 45k of tax free return
of basis. J reports the income as each payment comes in. Note however, that if
Zip is a public company, J will not be allowed to treat her income this way,
rather all the gain will be recognized immidiately despite the fact that she is
actually receiving it in separate payments.
The Payments of the noncompete will be ordinary
income to J when she receives them. The cash that goes to the non-compete
agreement can be amortized by Perch over the next 15 years, despite the
agreement ending after only two years.
Additionally, because this was a stock deal, in which
only stock was directly transferred, Perch if it so elected, could choose to
have it treated as an asset deal, in which all assets are treated as being sold
individually. Perch should not do this though because any gain on the highly
appreciated assets will be recognized by the corporation and a gain will ensue.
Perch would get a stepped up “cost like” basis in the assets, but it would
likely not be worth the tax now. I think JFK said don’t pay tax now and get
basis to use later.
Note that in light of this being a stock sale if there were any NOL carry forwards in Zip, then they would be slowed down signficiantly under IRC 382. But since Zip has accumulated E&P, I’m assuming there is no NOL. Also note that because the E&P is substantial, but not beyond reason, it will not be subject to the accumulated earnings tax for having too much E&P.
Family Attribution
Both J and K are treated as owning 100% of Z
due to family attribution. 302(c) and 318. K’s preferred stock are most likely
NQP, because he has the right to redeem the stock.
1. March 1
Generally,
a redemption of shares is either treated as an exchange or a dividend. It will
be treated as an exchange if one of four tests is met under 302. Because of
family attribution, 302(b)(1) and 302(b)(2) definitely will not apply.
Additionally, because Z is not partially liquidating, 302(b)(4). Lastly, this
does not qualify for 302(b)(3) because although it is part of a plan and J is
completely liquidating her shares, Z never completely liquidates so J still
owns share through K. Therefore, this transaction will be treated as a dividend
under 301. J will have capital gains up to the company’s E&P and if current
and accumulated E&P is used then her basis is used. J will have capital
gains of the FMV of the note and will continue to have capital gains until the
company pays it off. The interest payments will be ordinary income to J. The
company can deduct the interest payments under 162. The company’s E&P will
decrease as it pays off the note. There is a chance that the debt will be
reclassified as preferred stock. There are 5 factors (among many depending on
which circuit the taxpayer is in) that Courts assess in determining whether
debt is equity. Court’s looks at form, intent of the parties, debt/equity
ratio, proportionality, and subordination. If the debt is re-classified then
the entire FMV will be a dividend to S and gain to Z. There are not enough
facts to concretely determine whether a court would re-classify this debt as
equity but for purposes of this analysis, the debt will remain debt.
2. April 15
Because
this is part of an agreement, the entire liquidation is seen as one. This is an
stock acquisition (thankfully Z and P do not have to value each asset!). The
contract between the parties is likely going to be extensive (i.e. filled with
warranties and disclaimers). Shareholders realize and recognize gain and there
is no consequence at the corporate level. S has a basis in her Z shares of
100K. S realizes and recognizes 850K (950 - 100). This is capital gain as stock
is generally a capital asset. 1001. When principal is paid to J, J will have
capital gain. J will have ordinary income when interest is paid. P can deduct
interest payments as an ordinary expense under 162. P will take a cost basis in
Z’s stock, so 950K. Assets inside Z, including basis, will not change and when
P sells them it will have to pay tax on them. P may liquidate Z. Liquidating a
subsidiary is usually a nontaxable event. 332 and 337. P may want to do a 338
election which turns a stock purchase into a an asset deal. It creates a deemed
purchase of assets by Z. So Z could get a basis step up. This is entirely
optional but most companies do not do it. Usually only done if Z is an S corp
is an affiliated group. K retains the NQP stock in Z and can convert the stock
if he wanted to. However, it is likely that P contracted that K cannot have the
option. If Z has any losses, the carry overs get slowed way down. 382. Z’s
E&P disappears if it is liquidated.
Noncompete
J
will be taxed on the non compete as ordinary income when she receives it. She
will have 100K of ordinary income in two years. The IRS may re-characterize
this payment as part of the acquisition. S has been working for P during the
following years after the transaction would looks very suspicious. Speaking of
the $200, this is ordinary income to S when she receives it, and P can deduct
it under 162.
Exam No. 4810
The issue is whether the purchase will be considered an
exchange under §302 so that J can use her basis against the proceeds of the
buyout. A series of redemptions will qualify as an exchange if they are
pursuant to an overall plan that is substantially disproportionate in effect to
that shareholder. In this case, the result is substantially disproportionate
under 302(b)(2) because J is going from 100% voting power to 0%. However, there
is a family attribution issue under 302(c) because J is completely terminating
her ownership under 302(b)(3) and thus 318(a)(1) applies. Under 318(a)(1),
family attribution applies and her father’s interest in the preferred stock
will be attributed to her. However, this moves us back to 302(b)(2)
substantially disproportionate redemption of stock where J passes the voting
power test with flying colors. Since J is going from 100% voting power to 0%
voting power (even with family attribution) and she is going from 100% of
common stock ownership to a 0% common stock ownership (even with family
attribution), she passes both the 302(b)(2)(B) and 302(b)(2)(C) tests and she
will qualify for exchange treatment of her stock. She does not have to worry
about the waiver under 302(c)(2)(C) because the exchange is not essentially
equivalent to a dividend. Thus she can do some occasional consulting work
without worrying about running afoul of 302(c)(2)(C). Since J has no control of
the company through her father, she is not trying to get cash out of the
company while still running it.
Assuming the transaction is an exchange:
The 3/1 redemption: J can use $15K of basis against the
receipt of the $150K when she gets it to offset the gain. She’ll have $15K
tax-free return of basis and $135K of LTCG. If this wasn’t part of a complete
sale of J’s shares, the redemption of the 15 shares would be a problem because
J would still have 100% of the voting power and the promissory note looks like
more like equity than debt since it is subordinate. However as part of a plan
to sell her complete ownership, it is not going to be considered a constructive
dividend.
The 4/15 buyout: J can elect installment treatment under
453 and use her basis in proportion to the payments. e.g. use 45K of basis
against the 450K cash and the $40K remainder of basis against the $400K
installment as received with the balance being capital gains. It is concerning
that the note is secured by the 85 shares of stock. If Perch defaults on this
note and J gets the stock back, the IRS may recharacterize the transaction as a
dividend because J would be back in the same position that she was before the
transaction occurred. Perch will need to make the installment note payments
timely and treat it as actual debt. Additionally, the redemption of the 15
shares on 3/1 will definitely look like she was trying to cash out E&P
because there was no effect on her control of the business since she still had
100% of the voting power.
The $100K for the noncompete agreement will be ordinary
income to J and a deductible expense to Zip.
Kyle will continue to own the nonvoting preferred stock of
Zip and is unaffected by the transaction between Zip, Perch and J.
Perch will have basis of $1M in Zip’s common stock but the
payments to J will not be deductible except for the noncompete agreement
payment. Perch get Zip’s assets with transferred basis and Zip’s E&P
remains intact.
There are no tax consequences to Zip and there are no
basis changes in Zip’s assets. Basically Zip is now a subsidiary of Perch. Zip’s
E&P has not changed.
Created by: bojack@lclark.edu
Update: 20 May 16
Expires: 31 Aug 17