Executive MBA Program – MGMT 478 by NatePotter


									                                  MGMT 227
                    CLASS SEVEN – Spring 2009
                       Corporate Taxation

CORPORATE TAXATION – Non-Liquidating Distributions

I. Taxing Cash or Property Dividends

     A. Rule: Tax SH’s for dividends up to the amount of corporate E & P
        (earnings and profits). Remainder is return of capital (it lowers basis)

     B. Computing E & P:

           1. INCLUDES:

                  Municipal Bond Interest (MBI)
                  Excludable Life Insurance
                  Federal Tax Refunds
                  Dividends Received Deduction (DRD)

           2. EXCLUDES:

                  Related party sales losses
                  Excess capital losses
                  Tax exempt related expenses (e.g. related to MBI)
                  Fines & penalties

     C. Current v. Accumulated E&P: Current is this year’s undistributed
        corporate income and accumulated is prior years’ undistributed
        income carried forward to the current year.

     D. Method for Computing:       (Freixes method…for now ignore the
        business of amending the return later and taking it all as income first
        – assume the we are always looking at the matter at the end of the

           1. Take FIRST from current E & P proportionately
           (e.g. 2 distributions then take ½ of current E&P for each

           2. Take SECOND from Accumulated E & P chronologically.

     3. FINAL STEP, depends on whether positive (+) or negative (-):

        Current E&P      Acc. E&P      Method

           +                 +         Add together - all income

           -                 -         All=return of capital; no income

           +                 -         Ignore AEP; treat CEP as income

           -                 +         Net together: if positive = income
                                         (but watch out – you must net
                                         CEP pro-rata at the date of first
                                         distribution while netting all of
                                         AEP chronologically)

E. Property Distributions: Effects are as follows…

     1. To SH’s: 3 things to know…

           a. Use FMV of property and then tax as income up to
              corporate E&P.

           b. Reduce FMV by any liability assumed by SH.

           c. Basis to SH of asset = FMV (ignore liability though)

     2. To Corporation: Must recognize a “gain” if property distributed
        when FMV>Inside Basis. CANNOT, however, recognize a
        “loss” if FMV<Inside Basis. (corporation is better off selling
        asset & giving the SH’s the money instead)

     3. The “gain” will therefore affect E&P.

     F. Constructive Dividends: Sometimes, if corporation give certain
     economic benefits to SH (e.g. discounted sale of an asset, use of
     corporate facilities, forgiveness of loans, etc.) – will be considered
     a “constructive dividend” and SH must declare income (up to E&P
     of course).


       A. Rule: Normally, Stock Dividend IS NOT income to SH, unless…

            1.   SH can elect between stock dividend or cash dividend.
            2.   Part of plan where some SH get cash & some get stock.
            3.   Preferred to common or class 1 common to class 2 common
            4.   Stock to preferred SH (some exceptions to taxation)
            5.   Convertible preferred stock (some exceptions to taxation)

       B. Stock Rights: Same rule as stock dividends.

       C. Basis of Stock: Stock Dividends lower the stock basis of all shares
          owned (see Basis section of Property Transactions)



       A. X owns 1000 shares of stock (100%) of XYZ, Inc. with a stock basis
          of $ 5,000. XYZ redeems 500 shares of stock from X (buys the
          shares back) for $ 20,000. X gets to treat the $ 2500 gain as capital
          (@ 20%). Yet X still retains 100% ownership and control of XYZ.

       B. Solution: If X retains the same voting power, then the “redemption”
          will be treated as a “dividend” and X will have ordinary income NOT
          a capital gain.


       A. Where Corporation buys back stock from SH.

       B. Rule: Only a qualified stock redemption can be treated as a capital
          gain/loss. Key factor: Whether SH’s % of ownership changes.

       C. Reasons for Stock Redemption:

         1. Retirement
         2. Death
         3. Divorce

D. What qualifies for sale or exchange treatment (as capital gain/loss)?

  1. Not Essentially Equivalent:

     a. Redemption where SH’s interest (% of ownership) is
        meaningfully reduced.

     b. Look for reductions in…

          (1) Voting


          (2) Earning Power

     c. EXAMPLES:

          (1) SH “X” reduces interest from 58% to 53% (not qualified =
              though earning power has been reduced, the voting power
              has not been meaningfully reduced).

          (2) SH “Y” reduces interest from 15% to 10% (this would
              constitute a significant drop of 1/3 in voting power and
              earning power)

     d.    Effect on Stock Basis:

          (1) If redemption is not qualified (considered a “dividend”) then
              the stock basis of the redeemed stock attaches to the
              remaining stock (so basis per share of remaining stock
              goes up)

          (2) If redemption qualified, then stock basis per share remains
              the same.

  2. Disproportionate Redemption: If two tests are met, the
     redemption qualifies:

     a. After the distribution, SH owns < 80% of prior interests (%)

     b. After distribution, SH owns < 50% of voting power of company.

     c. NOTE: If 2 parties are “related parties”, we lump their interests
        together when we “count” the change in either “a” or “b” above.

  3. Complete Termination:

     a. If SH sells all shares to corporation = liquidating distribution
        and is therefore a qualified sale (capital gain/loss).

     b. But, agreement must be signed that the SH will not reacquire
        stock for 10 years (exception: through an inheritance is OK).

  4. Partial Liquidation Redemption:

     a. Redemption results where it resulted from “partial liquidation”
        of the business (e.g. the company closes one of its divisions).

     b. Requires one of the following…

        (1) Meaningful reduction in corporation’s business (like the “not
            essentially equivalent” test but applied to corporation rather
            than SH).         --OR--

        (2) Termination of an active business (e.g. division shuts down)

  5. Redemption to Pay Death Taxes:

     a. Redemption necessary to help pay SH’s estate taxes (SH died
        and estate must now pay death taxes).

     b. Requires that the value of the stock be at least 35% of total
        estate’s value.

     c. Limited to the total value of the estate taxes, administrative
        expenses and funeral expenses.


  1. Treated the same as a “liquidating distribution”

         2. Effect on Corporation:

            a. Cash: Reduces the E&P of the corporation

            b. Property: Corporation recognizes a Capital Gain on the “sale”
               of the property given to the SH, but cannot recognize a Capital

         3. Effect on the SH = Capital Gain or Loss


       A. Definition: Where Corporation dissolves and liquidates its assets
          (paying creditors and then distributing the “rest” to its SH’s).

       B. Effects on Corporation:

         1. For PROPERTY distributions, Corporation can recognize Capital
            Gain OR Loss.

         2. Exceptions:

            a. Losses dissallowed on distributions to related parties (SH owns
               >50% and the distribution is NOT pro rata [equal per share]).

            b. Built in Loss Limitation (don’t need to know for the test).

       C. Effect on SH:

         1. CASH = Capital Gain or Loss

         2. PROPERTY = Treat FMV as “cash” and it becomes a Capital
            Gain or Loss

       D. Parent-Subsidiary: If Subsidiary liquidates to Parent (80% + SH),
          then no recognition of Gains or Losses for parent or subsidiary.

                 MERGERS & ACQUISITIONS


     A. Types of Reorganization:

          1. Merger: Different types of Mergers…
                a. Straight Merger: 2 corporations merge into a single
                     (1) A + B = A
                     (2) SH’s of A & B receive shares of the “new” A
                b. Triangular Merger:
                     (1) Parent Corporation buys Target Corporation.
                     (2) Target Corporation SH’s get shares of Parent
                         (so tax free0
                     (3) Target Corporation is merged into Subsidiary of
                         Parent Corporation
                     (4) Result:
                           i. Target’s assets & liabilities now part of
                              subsidiary, but Target SH’s now own
                              shares in the Parent Corporation.
                           ii. Target has now “disappeared”. Parent &
                               Subsidiary “survive”.
                          iii. P buys T; T + S = S; now P & S survive
                          iv. Picture this…
                                   P                    T
                                                    merges into

                c. Reverse Triangular Merger: Goal is to preserve
                   Target’s existence…
                     (1) Parent forms a Subsidiary and transfers shares
                         of the Parent to the Subsidiary in exchange for

               Subsidiary’s stock (a partial Stock Exchange
               therefore occurs…see later discussion).
            (2) Subsidiary is merged into Target Corporation,
                with Parent Corporation getting Target’s shares
                and Target’s SH’s getting shares in Parent
            (3) Result:
                  i. Parent now has controlling interest in
                     Target Corporation but Target’s SH’s also
                     own stock in the Parent.
                  ii. Subsidiary has now “disappeared”. Parent
                      and Target remain.
                 iii. P creates S; S + T = T; P and T survive.
                 iv. Picture this…

                          .                          T
                                        merges    into


2. Consolidation: A + B = C

3. Stock Purchase – With Cash: A buys B’s stock with CASH

4. Stock Exchange – A buys B’s stock with Stock of A.

5. Asset Purchase: A buys B’s assets (but not its stock or

6. Asset Sale Reorganization: A buys B’s assets in exchange
   for A shares.

      B. Factors to Consider in Choosing
           1. Is SH’s approval Required?
                 a. Merger/Consolidation: Both corporation’s SH’s must
                 b. Purchase of Stock/Assets: Only Seller Corporation’s
                    SH’s need approve
                 c. Stock Exchange – only Seller Corporation’s SH’s need
                 d. Sale of Asset Reorganization – both Boards and SH’s
                    must approve
           2. Liabilities: They are assumed in a Merger, Consolidation,
              Stock Purchase but NOT in an asset purchase.
           3. Restrictions on Sale: If either corporation restricts stock
              sales, maybe a merger might work.
           4. Tax Issues: See discussion below
           5. Appraisal/Dissenter’s Rights:
           6. Other Issues: Bulk Sales laws, Antitrust, securities
              regulation, WARN Act (50+ employees laid off must give
              notice to employees before merger occurs), Property Tax

II.   Taxation of Mergers & Acquisitions

      A. General Review of Taxation Rules:

           1. Income Tax Rates – Individuals (10% to 35%) &
              Corporations (15% to 35%)

           2. Sale of Property (including stock):
                 a. Types of Property: Ordinary, Capital and § 1231
                 b. Ordinary – subject to ordinary rates
                 c. Capital Assets – Individuals (5 or 15%); Corporations
                    (no special rate)
                 d. § 1231 Assets – Gains are @ 5 or 15%, but may be
                    partially ordinary (due to recapture rules).

     3. Goal - To minimize or defer taxation in a reorganization.

B. Basic Corporate Taxation:

     1. Sale of Stock – Leads to Capital Gains & special 5/15% tax

     2. Sale of Assets – Leads to § 1231 Gains at 5/15% or
        ordinary gains (or 25%) on depreciation recapture.

C. Section 368 of the IRC provides the various alternatives for
   tax free mergers:

     1. 368(a) – Called a Type A Merger

           a. Applies to Mergers and Consolidations
           b. Tax Free exchange – no tax to SH’s or corporations
           c. REQUIREMENT: Must be a “continuity of interest” – in
              other words, the disappearing corporation’s SH will
              continue to have an interest (stock ownership, for
              example) in the survivor corporation.
           d. Stock and Asset basis from “disappearing” corporation
              carries over to “surviving” corporation.
           e. Any cash involved = Boot = taxable income to SH’s
              (capital gains)
           f. If Debt and Stock involved…

                 (1) Still qualifies so long as stock is “a substantial
                     part” [generally > 50%] of the deal.
                 (2) Debt Securities portion of it, however, is
                     considered boot = taxable income.
           g. Rules apply the same to Triangular Mergers.
           h. Reverse Triangular Mergers, however, requires that at
              least 80% of the acquired stock of the target must be
              acquired solely with stock (and not boot or cash).
           i. BETTER than a Stock Exchange (Type B) because
              boot/cash/debt can be partially involved and the deal
        still qualifies for non-recognition.

2. § 368(b) – Called a Type B Merger

     a. This is the classic “stock exchange”.
     b. Tax Free Exchange if the following is met:
           (1) Continuity of interest requirement (same as for
               mergers, Type A)
           (2) HOWEVER, exchange must be solely for voting
           (3) No boot/cash/debt securities/non-voting stock
               can be part of the deal or else the entire
               transaction is disqualified.
           (4) Acquiring corporation must end up with at least
               80% of the target corporation.
     c. Basis of stock/assets carries over to new SH’s &

3. § 368(c) – Called a Type C Merger

     a. Called a “Sale of Assets Reorganization”
     b. Tax Free Exchange if the following is met:
           (1) Continuity of interest
           (2) Purchaser must acquire “substantially all” of the
                    90% or more of FMV of selling
                      corporation’s net assets
                    70% of the FMV of gross (total) assets
           (3) Acquired solely for stock of acquiring corporation
               (no boot)
           (4) Assumption of liabilities is allowed as part of the
               deal (still considered “tax free”)
           (5) Boot permitted (cash/debt securities/assumption
               of liability) so long as long as 80% of assets
               purchased with stock only.
(6) DISTRIBUTION TO SH’S: The selling
    corporation must distribute all of the stock
    received and any remaining assets it has to its


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