Sample Answers to Question 1
Corporate Tax
Spring 2015

Exam No. 1608

Goodco distribution of preferred to Maddie and Sean

305(a) provides that stock distributions are not includible in gross income unless an exception in 305(b) applies. Since the problem provides that Goodco's distribution of preferred stock to M and S was a nontaxable stock dividend, none of 305(b) exceptions applied.

Tax Consequences to Maddie (M) and Sean (S)

If a stock distribution is not taxable, the SH's basis in the stock held prior to the distribution is allocated between the old and new stock in proportion to the relative FMV of each on the date of the distribution.

Tax Consequences to GoodCo (G)

In a nontaxable stock dividend, the corporation recognizes no gain or loss, 311(a)(1), and the corporation may not reduce it's E&P, 312(d)(1)(B).

Complete Liquidation

In a complete liquidation, a corp distributes all of its asset (or the proceeds of their sale), subject to any liabilities, to its shareholders (SH) in exchange for all of their stock. The corp then dissolves under state law. A corp liquidates for tax purposes when it ceases to be a going concern and its activities are merely for the purpose of winding up its affairs, paying its debts, and distributing any remaining balance to tits SHs. Legal dissolution under state law is not required for a liquidation to be complete. In such a liquidation, the corporate account, E&P, and other tax attributes die with the corporation.

Consequences to M & S

Amounts distributed to a SH in complete liquidation are treated as a full payment in exchange for the SH's stock. 331(a). The difference between the amount realized and the SH's adjusted basis in the stock is treated as capital gain or loss in the usual case where the stock is a capital asset. Here there is no indication that M or S is a dealer in stock, so any gain that they recognize is likely capital. Here, since G Corp distributed property to M and S, their basis of the property received is the FMV of the property on the date of distribution, without reduction for any liabilities to which the property was subject. 334(a).

The total amount realized to M & S is the FMV of the assets they received from the liquidating corporation, less the liabilities that they assumed .

M's amount realized 2,000,000 (the FMV of the property) less the 1,500,000 of Goodco liabilities that she assumed ($500K total). Thus, she recognizes $400K (500K realized - 100K basis) capital gain on the sale of her stock.

S's amount realized is also 2 million less the 1.5 million of Goodco liabilities that he assumed, so he also recognizes 400k capital gain on the liquidation.

SHs are liable for the corporation's debt as transferees. Maddie and Sean will each take a capital loss on their payment in satisfaction of the corporate debt. Arrowsmith. Notice, if the SH's were not around to pay the debt the board of directors would be personally liable.

A corporation recognizes gain or loss when it distributes property in complete liquidation as if it had sold the property to the distributee for it's FMV. Gain or loss is determined separately for each asset. Thus, Goodco will recognize:

• 400 capital gain on the real estate

• 500 gain on the machinery (this property is likely subject to the depreciation recapture provisions of 1245, the character of the loss will probably be ordinary)

• 300 loss on the inventory

• and it will break even on the accounts receivable.

Notice, 336(d) limits the recognition of loss by the distributing corporation certain distributions to related persons, when property is acquired for tax avoidance purposes, or in distributions in 3332 liquidations of a subsidiary. None of these apply here, because neither of the SHs are "related" to the corp (they each own 50%--but not "more than" 50% of the value of the corp's outstanding stock), and the distribution is prorata.

Asset Deal

Here Goodco is the Target corporation. In an asset sale like we have here, Goodco recognizes gain or loss on the sale of its assets under general tax principles, so T is required to report gain or loss on each asset sold. That calculation is determined above. The character of the gain or loss depends on the character of the asset and prior tax treatment (e.g. depreciation deductions).

Bigco takes a stepped up 1012 cost basis in the assets that it purchases. Bigco's cost includes the price paid for the assets, plus any liabilities transferred to it. A sale of assets of a going business for a lump sum is treated for tax purposes as a sale of each individual asset of the business, so the purchase price must be calculated individually for each asset. 1060 (total consideration is allocated using the residual method). Note, if the parties had contractually allocated the consideration, that allocation would be binding. In any case, both parties must fill out a form alerting the IRS about how the assets will be allocated.

Here the total consideration will be 1,000,000 cash plus the 3 million in liabilities. Because this is the exact FMV of the assets, that consideration will be allocated according to each asset's FMV. If the corporation had intangibles like good will and going concern value, those intangibles would have to be amortized over a 15 year period.

Exam No. 1759

Initial Distribution of Preferred Stock to Sean and Maddie:

The tax-free distribution of preferred stock to Sean and Maddie consists of Section 306 stock. This is a scenario like Chamberlin in that we have shareholders ("SHs") who own all stock in corporation getting distribution of preferred stock. Specifically, the stock received is Section 306 stock because it fits 306cA in that it was a tax-free distribution of preferred stock. A distribution of preferred stock is only Section 306 stock to the extent that the corporation had E & P at the time, but Goodco had a "substantial" amount which very likely exceeded the total $50k distribution. The Section 306 status taints the stock and my impact tax-treatment down the road. When the distribution was made some of the basis that Sean and Maddie held in their common stock would have shifted over to the new preferred stock. On the facts it is unclear how much that would have been.

Liquidation of Goodco:

Goodco's tax consequences:

Per 336(a) a corporation that distributes property in a complete liquidation is treated as though it sold that property for its fair market value ("FMV"). This is an example of how appreciated property in the hands of a C corporation is a "lobster trap" in that it is easy to get appreciated property into a C corp, but impossible to get it out without realizing and recognizing a corporate level gain on that property.

Real Estate:

Goodco has basis of $1.6 million in the real estate, it is considered to have sold it at FMV of $2 million, so Goodco has a gain of $400k on the real estate when it is distributed pursuant to the complete liquidation. This would likely be capital gain.

Accounts Receivable:

Goodco's basis equals the FMV so there is no gain on distribution of the accounts receivable ("AR"). You need to consider the AR because it is "property" within the context of a corporate distribution.

Machinery:

Here basis is $500k, consider sold for FMV of $1 million so recognize gain of $500k. Likely capital gain.

Inventory:

Goodco holds the inventory with a basis of $600k, but it has FMV of $350k, which would otherwise mean a loss of $250k. Section 336 has the potential of being a bit nicer of a lobster trap in that there is the potential that the corporation may be able to recognize a loss on a distribution in complete liquidation. The loss is disallowed if it goes to a "related person" within the meaning of 267 and the distribution of the loss was no pro rata among the SHs. Here the distribution of the loss asset is not pro rata (or proportional) to the SHs as the entire loss asset is distributed to Sean. To determine if Sean is a "related person" under 267 we need to apply the constructive ownership rules of 267c. Sean is considered to own in addition stock owned by his "family," which under 267b1 includes his mom (Maddie). Thus Maddie's stock is constructively owned by Sean and Sean is considered to own 100% of stock in Goodco for purposes of this analysis. Sean is a related person under 267b3, because he is considered to own more than 50% of the value of outstanding stock.

Because Sean is a related person, the loss on the distribution of the inventory is denied to Goodco under 336.

Liabilities assumed

Goodco does not have to recognize any gain for the liabilities assumed by Maddie and Sean as part of the complete liquidation.

Tax Consequences to Maddie of Distributions Pursuant to complete liquidation:

Even though she has Section 306 stock, the transaction is completely terminating her interest in Goodco so there is no adverse effects.

Real Estate

Under 331 when a SH receives a distribution from a corporation in complete liquidation the SH is afforded sale treatment where the money and property received is considered in exchange for all of their stock. As sale treatment applies, Maddie is allowed to use her basis. Maddie realizes $2 million on receipt of the real estate. She can offset $100k of that with her basis, reducing amount to $1.9 million. By assuming $1.5 million of Goodco's liabilities, Maddie also likely is able to further offset her amount realized by $1.5 million, leaving $400k of recognized gain on receipt of the real estate. It is capital gain as this is considered sale of stock. Note, the facts do not indicate what type of liabilities were assumed; this is important to know because if the liabilities consist of an installment note further analysis would be needed. Maddie receives the real estate with a cost basis equal to its FMV of $2 million.

Tax Consequences to Sean of Distributions Pursuant to Complete Liquidation:

As with Maddie, by assuming $1.5 million of the corporation's liabilities Sean will be able to offset any potential gains by $1.5 million. He is turning in his Section 306 stock, however there are no adverse consequences as this is in complete termination of Sean's interest.

Accounts Receivable:

As Hempt Brothers v. US confirms, accounts receivable are considered property for purposes of determining their treatment in a distribution. As Hempt Brothers further confirms, in a distribution the normal assignment of income doctrine does not apply and Sean may be taxed on the receipt of income earned by Goodco. Because Goodco is an accrual method taxpayer, they will have recognized the gain from the AR as soon as it was earned, thus Goodco would hold the AR with basis equal to its FMV. Sean receives the AR with transfer basis, so he also receives the AR with basis of $650k. Sean would realize a gain of $650k from receipt of the AR.

Machinery:

Sean would realize receipt of the FMV of the machinery, or $1 million.

Inventory:

When a corporation transfers property with basis in excess of the FMV, a "basis haircut" applies which reduces the basis to the FMV. Sean will receive the inventory with a basis of $350k and will realize a gain of $350k.

Overall, Sean realizes a total gain of $1.8 million (form above noted gains), but is able to offset that by the $1.5 million in liabilities assumed. Sean's gain is thus $300k and would be capital gain as it is from sale of stock.

Sale of assets to Bigco

This is an example of an Asset deal (type 2) where the SHs of Goodco first liquidated it, distributed the assets to themselves, and then sold the assets to Bigco. This is a double-tax scenario for Sean an Maddie because there is a corporate level tax when Goodco is liquidated and a SH level tax when assets are sold to Bigco. Sean and Maddie notably also take on considerably more risk in that by liquidating Goodco and just selling the assets, they, as former SHs and distributees of Goodco, are potentially liable for any Goodco creditors that may appear (for example tort claims within the statute of limitations). Maddie, by distributing real estate to herself has included herself in the chain of title and now is exposed to potential liability for environmental clean up costs, regardless of whether she contributed to problem.

Attribution of purchase price

When a group of assets are sold in a lump sum, the IRS still demands that each item transferred be allocated its portion of the purchase price. Here there is no indication as to whether the parties agreed to how the purchase price will be applied. Section 1060 sets out a default where the purchase price is first assigned to tangible objects by their FMV and then any remaining purchase price goes to intangible things (e.g. if there was a covenant not to compete), amortizable over 15 years by buyer. You would also need to establish how much was paid for each item in order to figure out what Bigco's basis in each will be. Bigco will take each item with a cost basis, which will be whatever amount is allocated to it.

Sean:

Sean will realize $1.5 million from the sale because Bigco has assumed his liabilities. Sean also sold the machinery, in which he had a basis of $1 million, the inventory in which he had a basis of $35k, and the AR in which he had a basis of $650k, so he had a total basis of $2 million in property sold. He realizes gain of $500k from the cash received, so his total realized gain is $2 million. Because his basis is also $2 million, overall he recognizes no gain on the sale of the assets.

Maddie:

Maddies also realizes gain of $1.5 million from Bigco assuming her liabilities. She realizes a further $500k from receipt of the cash, for a total realized gain of $2 million. She had basis of $2 million in the real estate so she is able to completely offset her gain and recognizes no gain or loss on the sale.

Payment to satisfy creditors

-Per Arrowsmith v. Commissioner, both Sean and Maddie will be able to claim a deduction of $6k, the amount each paid to satisfy the creditor's debt, in the year they make the payment. Per Arrowsmith, will look to character of original gain to characterize the deduction. The original gain was capital gain, thus the deduction here will be for capital loss.

Exam No. 1046

The federal income tax consequences are broken down by transaction as follows:

Liquidation of Goodco (G)

Since this transaction all occurs at once, it would qualify for liquidation treatment (it would be helpful if they did it pursuant to a plan if it lasted longer). Because of this, the E&P is not an issue.

Maddie (M) would realize $2 million dollars on the distribution of Real Estate (FMV $2 million) and recognize $1.9 million of it (2 million over 100,000 basis) as taxable long term gain (assuming it was held longer than 1 year by the corporation). However, since she also assumed liabilities of G the amount realized drops by $1.5 million to $.5 million. Applying her basis to this amount means that she actually ends up being taxed on long-term gain of only $400,000. She would take an FMV basis in the land at $2 million.

Sean (S) would similarly realize $2 million minus the liabilities assumed (1.5 million), or $500K. Of that only $400K would be recognized (again, presumably as long term gain) because of his basis. He takes an FMV basis in each property received.

The company is treated as having sold for FMV each of the underlying properties. In this case that results in a $400K (capital) gain on the real estate ($2M FMV over $1.6M basis); a $500K (capital) gain on the machinery ($1M FMV over $.5M basis); $0 gain on the inventory (it has a higher FMV than basis); and $0 gain on accounts receivable (FMV = basis). Thus when all the dust clears G has a $900K capital gain that it will pay ordinary tax rates on. G does not, however, get to take loss on the inventory because it distributed the loss property to a "related party." A related party is defined as someone that "directly or indirectly" owns more than 50% of the company. Both parties constructively own 100% of the company because they are related as parent and child. Further, the loss was not distributed "pro rata" to the parties (as it would need to be since BOTH are related parties), but only to one of them, in violation of § 336(d). Thus no loss is allowed to the company on the transaction.

Sale of Former Corporate Assets to Bigco (B)

M's Tax: M has a basis in her assets (land) of $2 million. She realizes $500K plus $1.5M (assumption of liabilities). Thus, she recognizes no gain on this transaction.

S's Tax: S has the same basis in his assets ($2M) and has the same consequences (no gain recognized)

B takes a cost basis allocate to each asset and recognizes no gain or loss on the transaction. One added benefit for B is that the chain of title has been broken (as it would not have been in a stock sale) such that B will not have to worry about (most) potential clouds on the title of the assets it purchased (and the potential future liabilities springing therefrom). B also does not inherit any of the E&P from G... its as if G never existed at all for B's purposes.

Judgment against G

The later judgment that M and S have to pay will be deductible by them on their personal income taxes as a Long Term Capital Loss of $6,000. They can use that amount to offset other capital gains or up to $5K of ordinary income.

Ancillary Issues

There may be § 306 stock issues that the parties will have to contend with. In this case M and S each received preferred stock in a non-taxable § 305(a) distribution at a time when the company had E&P. These conditions render the preferred stock § 306 stock and attach the stigma of potential dividend treatment on its disposition. However, it appears that M and S may avoid §306 treatment via §306(b) since they completely terminated their interest in G without a stock redemption. Alternatively, they could argue that their transaction was "not in avoidance" but for legitimate business purpose of selling of their entire old company. In the end, it is doubtful that § 306 would apply, since the behavior it is meant to prevent (bail outs of corporate earnings via preferred stock without dividend treatment) is not really the substance of what happened when M and S completely sold off the assets of the company (not the preferred stock of the company).

Created by: bojack@lclark.edu
Update:  6 Feb 16
Expires:  31 Aug 17