CLASS SEVEN – Spring 2009
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:
Municipal Bond Interest (MBI)
Excludable Life Insurance
Federal Tax Refunds
Dividends Received Deduction (DRD)
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
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
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
II. STOCK DIVIDENDS OR STOCK RIGHTS
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)
STOCK REDEMPTIONS and LIQUIDATING DISTRIBUTIONS
I. THE PROBLEM:
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.
II. STOCK REDEMPTIONS:
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:
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
b. Look for reductions in…
(2) Earning Power
(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
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
(2) If redemption qualified, then stock basis per share remains
2. Disproportionate Redemption: If two tests are met, the
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
c. Limited to the total value of the estate taxes, administrative
expenses and funeral expenses.
E. EFFECTS OF QUALIFYING REDEMPTION:
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
III. LIQUIDATING DISTRIBUTION:
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.
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
I. CORPORATE REORGANIZATIONS
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
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 &
iii. P buys T; T + S = S; now P & S survive
iv. Picture this…
c. Reverse Triangular Merger: Goal is to preserve
(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
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…
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
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
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
(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