Corporate Tax
Bogdanski
Spring 2017
Exam Answer Outlines
Question 1
The distribution is taxable both to Gwen and Maria. Gwen’s receipt of the preferred stock is taxable because Maria is receiving property, the promissory note, as part of the same distribution. IRC § 305(b)(2). The amount of the distribution to Gwen is the fair market value of the preferred stock, $20,000. IRC § 301(b)(1). This is also Gwen’s basis in the stock. IRC § 301(d). Given Corp’s substantial accumulated earnings and profits, the distribution is likely to be a dividend to Gwen. The stock is not section 306 stock because it was not received in a tax-free distribution. IRC § 306(c)(1). The transaction is not taxable to Corp.
Maria’s receipt of the note is also a distribution covered by IRC § 301. The amount of the distribution is the fair market value of the note, $80,000. IRC § 301(b)(1). This is also Maria’s basis in the note. IRC § 301(d). Given Corp’s substantial accumulated earnings and profits, the distribution is likely to be a dividend to Maria. Installment reporting is not available because there has been no sale or other exchange of property by Maria. The distribution is not taxable to Corp. IRC § 311(b) does not apply to distribution of the corporation’s own note.
The dividends are taxed at long-term capital gain rates. IRC § 1(h)(11).
The sale of Corp stock to Broco is covered by IRC § 304. The transaction is treated as a redemption of Broco stock, thus giving rise to a potential dividend. The analysis of whether the redemption should be treated as a sale or exchange under IRC § 302 looks to the reduction in Maria’s ownership of Corp stock. IRC § 304(b)(1). Immediately before the sale, Maria actually owns 80 percent of the vote and common stock of Corp. Immediately after the sale, Maria constructively owns 48 percent of the vote and common stock of Corp, via attribution from Broco. IRC § 318(a)(2)(C). Attribution of ownership from a corporation to its controlling shareholders is proportional. There is no attribution to Maria from Gwen or from Cecil. IRC § 318(a)(1). The reduction in Maria’s ownership of Corp voting and common stock meets the three requirements for sale treatment under IRC § 302(b)(2). Therefore, Maria may use her basis in the Corp stock to offset some of the sale proceeds she receives from Broco. The difference is a capital gain.
It is unclear whether the deemed redemption has any effect on the earnings and profits of either corporation. Assuming that it does, the amount of the reduction should be capped by IRC § 312(n)(7) at the percentage of earnings and profits corresponding to the percentage of Corp stock constructively redeemed.
Broco’s basis in the Corp stock is its cost, $350,000. No gain or loss is realized by Broco on paying this amount to Maria. There is no change in the basis of any asset held by either corporation. The stock sale is ineligible for an election under IRC § 338 because Broco is acquiring the stock from a related party. IRC § 338(h)(3)(A)(iii).
Question 2
The transactions qualify for nonrecognition under IRC § 351 because, as part of a single integrated plan, they meet the “control” and other tests of that Code section.
Jim recognizes $15,000 gain or receipt of the inventory, as “boot.” IRC § 351(b). Because the gain results from an exchange of depreciated equipment, the gain is ordinary income (depreciation recapture). Jim’s basis in the stock newly issued to him is a carryover basis from the equipment, zero. IRC § 358(a)(1). Jim’s basis in the inventory is its fair market value, $15,000. IRC § 358(a)(2). The corporation’s basis in the equipment is $15,000 – a carryover basis from Jim, plus the gain he recognizes. IRC § 362.
Risco recognizes a $3,000 gain on the transfer of the inventory to Jim. IRC § 351(f), incorporating IRC § 311(b). The gain is ordinary income.
Keisha recognizes a $30,000 gain under IRC § 357(c). Her basis in her newly acquired stock is zero. The gain is capital gain under IRC § 1231. Risco’s basis in the real estate is $180,000 – a carryover basis from Keisha, plus the gain she recognizes. IRC § 362.
Each shareholder’s holding period for the stock received includes the holding period for the asset he or she contributed. Because the transfer of inventory to Jim generates taxable income and therefore earnings and profits, the IRS could argue that the transaction constitutes or includes a dividend.
Question 3
Part A
The proposed asset sale would result in gain or loss to Tarco, which would be capital or ordinary, depending the nature of each asset sold. Predco would obtain an aggregate basis of $1,550,000 in the acquired assets. In determining how much gain or loss Tarco realizes on each asset, and Predco’s basis in each asset, the purchase price must be allocated among the various classes of assets. Under IRC § 1060, the allocation is to be performed using the “residual method,” meaning that the tangible assets are first assigned a basis equal to their respective fair market values; any leftover basis is assigned to intangibles such as goodwill. The basis of goodwill and other business intangibles must be amortized by Predco over 15 years. IRC § 197. If the parties agree to an allocation, they are bound by it, but the IRS is not. IRC § 1060.
On liquidation of Tarco, the shareholders recognize capital gain under IRC § 331. The gain may be reported on the installment method, as payments are received from Predco, assuming that the requirements of IRC § 453(h) are met. The distribution of the note accelerates the gain recognized at the corporate level, however. IRC § 336. Payments of interest are deductible by Predco and ordinary income to the recipient. Upon liquidation of Tarco, its earnings and profits disappear.
The proposed stock sale would result in capital gain to the shareholders. Installment reporting would be available. There would be no gain or loss to Tarco, no change in the basis of any Tarco asset, and no change in Tarco’s earnings and profits unless an election were made under IRC § 338. If such an election is made, the results would be essentially the same as the results in an asset-based sale, just discussed.
Because a stock deal without a section 338 election results in no immediate corporate-level tax, the price demanded by the Tarco shareholders in the proposed stock sale alternative without a section 338 election should be lower than the price they seek in an actual or constructive asset deal.
Part B
A subchapter S election would not change the tax treatment of the simple stock sale (without a section 338 election).
In an actual asset sale, or a constructive asset sale under an election pursuant to IRC § 338, a subchapter S election would not eliminate the corporate-level tax on the appreciation on Tarco’s assets. Under IRC § 1374, the “built-in” gain on the assets would remain taxable to Tarco for five years following the election.
In either type of asset sale, the pass-through income or losses recognized by the shareholders would be a mix of ordinary income/loss and capital gain/loss, depending on the nature of the assets, determined at the corporate level. Thus, pass-through gain or loss on inventory would be ordinary, as would any recapture of depreciation on equipment.
In an actual or constructive asset sale, there would be only a single level of tax on any appreciation on assets that might occur after the subchapter S election took effect.
Created by: bojack@lclark.edu
Update: 20 May 17
Expires: 31 Aug 18