# Chapter C4 Corporate Nonliquidating Distributions Discussion by fionan

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Corporate Nonliquidating Distributions

Discussion Questions

C:4-1 A corporation computes current E&P on an annual basis by making adjustments to taxable
income so that the resulting amount represents the corporation's economic ability to pay dividends
out of the current year's earnings. The specific adjustments required are outlined in Table C:4-1.
Accumulated E&P is the sum of the current E&P (less distributions made out of current E&P)
balances for all previous years reduced by the sum of (1) all previous current E&P deficits and (2)
any distributions that have been made out of accumulated E&P. pp. C:4-3 and C:4-4.

C:4-2 Distributions are deemed to come first out of current E&P and then out of accumulated E&P.
Thus, if current E&P is positive, any distributions will be dividends to the extent of the current E&P
even if accumulated E&P is negative. Also, if E&P is insufficient to cover all distributions,
distributions are deemed to come pro rata out of current E&P and then in chronological order out of
accumulated E&P. pp. C:4-6 through C:4-8.

C:4-3 a.        The distribution is a \$100,000 dividend payable out of current E&P.
b.      First, \$60,000 of the distribution is a dividend from current E&P. Second, \$25,000 is
a return of capital that reduces the shareholder's stock basis to zero. Third, the remaining \$15,000 is
a capital gain. The \$50,000 accumulated E&P deficit remains.
c.      First, \$25,000 of the distribution is a return of capital that reduces the shareholder's
stock basis to zero. Second, the remaining \$75,000 is a capital gain. A \$120,000 (\$60,000 +
\$60,000) accumulated E&P deficit remains.
d.      The distribution is a \$100,000 dividend payable out of accumulated E&P. None of
the current E&P deficit reduces accumulated E&P since the distribution is made on January 1.

If the corporation makes the distribution on October 1, the answers to Parts a through c are
the same. However, in Part d, accumulated E&P as of October 1 is \$40,000 (\$100,000 beginning
balance - \$60,000 current deficit as of October 1) so that \$40,000 of the distribution is a dividend.
Allocation of the current E&P deficit to the pre-October 1 period is accomplished by multiplying
\$80,000 times 9/12ths. (Alternatively, the actual number of days could be used, in which case the
accumulated E&P deficit would be \$59,836 (\$80,000 x 273/365) in a non leap-year tax year.) Of the
remaining \$60,000, \$25,000 is a return of capital that reduces the shareholder's stock basis to zero,
and the remaining \$35,000 is a capital gain. pp. C:4-6 through C:4-8.

C:4-4 a.        The distribution amount is the FMV of all property received. If the shareholder
assumes or acquires a liability in connection with the distribution, it reduces the amount of the
distribution (but not below zero).
b.      The distribution amount is a dividend to the extent it is paid out of the current and
accumulated E&P of the corporation.

C:4-1
c.     The basis of any property received is its FMV. Any liability assumed or acquired by
the shareholder in connection with the distribution does not reduce the property's basis.
d.     The holding period for the property begins on the day after the distribution date.
pp. C:4-8 and C:4-9.

The answers would not change if they were made to a corporate shareholder because Sec. 301(c)
applies the same dividend rules to each type of shareholder. However, a corporation shareholder
may be eligible for the dividends-received deduction.

C:4-5 a.       The tax-exempt interest is added to taxable income to compute current E&P.
c.       The capital loss carryover is added to taxable income.
d.       The federal income taxes are deducted from taxable income.
e.       The U.S. production activities deduction is added to taxable income. p. C:4-4.

C:4-6 It is possible. Taxable income or loss must be adjusted to compute current E&P. If, for
depreciation, its current E&P could be \$4,000 or more. In such case, the \$2,500 distribution would
be taxed to shareholders as a dividend, and a \$1,500 accumulated E&P balance would remain. pp.
C:4-6 through C:4-8.

C:4-7 Yes. It matters if the corporation has a current E&P deficit and positive accumulated E&P.
In such case, the amount of the current E&P deficit accrued on the distribution date reduces the
accumulated E&P, and only the remainder is available for paying out dividends.
It also matters if the corporation makes more than one distribution made during the year, and
there is insufficient E&P for all distributions to be treated as dividends. In such case, current E&P is
allocated ratable to all distributions, but accumulated E&P is allocated on a FIFO basis to each
distribution. These allocations are particularly important if the corporation’s stock changes hands
during the year. pp. C:4-6 through C:4-8.

C:4-8 Yes. The corporation should sell the property to a third party and report a \$40,000 loss
(\$120,000 FMV - \$160,000 basis) and then distribute the proceeds to its shareholders. If the
corporation distributes the property to the shareholders first, the loss cannot be recognized when
determining taxable income by either the corporation or its shareholders. If the property is
distributed, the \$160,000 adjusted basis for the property reduces the distributing corporation's E&P
and therefore the taxability of future distributions. pp. C:4-9 through C:4-11.

C:4-9 It makes no difference whether the property is distributed first and then sold or sold first and
the proceeds distributed to the shareholder. Either way, the corporation must recognize a \$40,000
gain (\$160,000 FMV - \$120,000 basis) on the disposition/distribution of the building, and the
shareholders have a \$160,000 dividend. The shareholder's basis in the building is \$160,000. pp.
C:4-9 through C:4-11.

C:4-2
C:4-10 A constructive dividend is the manner in which the IRS or the courts might characterize an
excessive corporate payment to a shareholder to reflect the true economic benefit conferred upon the
shareholder. Such dividends are most likely to arise in the context of a closely held corporation.
Examples of constructive dividends include excessive compensation paid to a shareholder-employee or
excessive lease payments made to a shareholder-lessor. pp. C:4-11 through C:4-13.

C:4-11 Stock dividends generally are nontaxable because they do not add to the property the shareholder
already owns, nor do they reduce the property of the corporation. As a general rule, the distribution is
taxable whenever a stock dividend changes or has the potential to change the shareholder's proportionate
interest in the distributing corporation. pp. C:4-13 and C:4-14.

C:4-12 A distribution of stock rights is nontaxable unless it changes, or has the potential to change, the
shareholder's proportionate interest in the distributing corporation. The same exceptions to tax-free
treatment apply to distributions of stock rights as apply to stock dividends. A distribution of stock rights
that is nontaxable to shareholders has no effect on the distributing corporation. The shareholders must
allocate the basis of the underlying stock between the stock and the rights if the FMV of the rights is at
least 15% of the value of the underlying stock. If the FMV is less than 15% of the value of the
underlying stock, the basis allocation is elective. pp. C14-14 and C:4-15.

C:4-13 A stock redemption is the acquisition by a corporation of its own stock for consideration. Some
reasons for a redemption are listed on pages C:4-16. Some redemptions that substantially change the
shareholder's proportionate interest closely resemble a sale of stock to a third party and are treated as a
sale or exchange, while others that do not produce such a change are essentially equivalent to a dividend
and are taxed as a dividend. p. C:4-16.

C:4-14 If the redemption is treated as a sale, Andrew recognizes a \$2,000 capital gain (\$10,000 -
\$8,000). If the redemption is not treated as a sale, Andrew recognizes a \$10,000 dividend to the extent
of Field Corporation's current and accumulated E&P. In the dividend case, Andrew's \$8,000 basis in the
redeemed stock is added to his basis in his remaining stock. The 15% maximum tax rate would apply to
either the \$2,000 capital gain or the \$10,000 dividend. p. C:4-17.

C:4-15 A redemption is treated as a sale if the redemption satisfies any of the following conditions:
•     It is substantially disproportionate.
•     It is a complete termination of the shareholder's interest.
•     It is not essentially equivalent to a dividend.
•     It is a partial liquidation of the distributing corporation in redemption of part or all of a
noncorporate shareholder's stock.
•     It is made to pay death taxes. p. C:4-17.

C:4-16 Three out of the five exceptions to the Sec. 302 redemption rules (see Question C:4-15) depend
on the shareholder's stock ownership before and/or after the redemption. The attribution rules prevent
shareholders from either taking advantage of these favorable tax rules or avoiding unfavorable tax rules

C:4-3
by deeming family members or related entities to own stock that the shareholder may not own.
entities, and option attribution. pp. C:4-18 through C:4-20.

C:4-17 No. The assets will have been acquired by Ace Corporation in a taxable transaction within the
past five years and partial liquidation treatment will not be available (unless Ace is willing to retain the
assets and operate the business for at least five years prior to the partial liquidation). pp. C:4-23 through
C:4-25.

C:4-18 A Sec. 303 redemption is a redemption to pay death taxes and is treated as a sale by the estate or
by the beneficiary of the estate who inherits the stock. The estate or beneficiary's basis in the stock
redeemed is the stock's FMV on the date of death (or alternate valuation date). Because the stock is
redeemed soon after the date of death, the stock's value at the time of redemption is likely to be close the
stock's basis. Therefore, the beneficiary or estate generally has little or no gain or loss to recognize on the
redemption if it qualifies as a sale under Sec. 303. pp. C:4-25 and C:4-26.

C:4-19 A corporation must recognize gain when it distributes appreciated property in redemption of its
stock. It does not recognize any loss when it distributes property that has declined in value. Also, the
excess of FMV over the property’s E&P basis increases the distributing corporation's E&P (and taxes on
the corporation’s gain decrease E&P). As with an ordinary dividend, the amount that increases the E&P
balance may be different from the gain that increases taxable income. The E&P account also is reduced.
The amount of the reduction depends on whether the redemption is treated as a sale or exchange or as a
dividend. If the redemption is treated as a sale or exchange, the corporation must reduce its E&P by the
portion of the current and accumulated E&P balances attributable to the redeemed stock. That is, E&P is
reduced by a percentage that equals the fraction of the outstanding stock redeemed. The remainder of the
distribution reduces the capital account. If the redemption does not qualify for sale or exchange
treatment, the corporation must reduce its E&P as it does for any other nonliquidating distribution not
involving a stock redemption. p. C:4-27.

C:4-20 A preferred stock bailout is to a plan devised by shareholders to use preferred stock to withdraw
earnings from a corporation as a capital gain rather than as a dividend. The specific steps of the plan are
described on page C:4-28. Section 306 prevents the scheme from working by denying capital gain
treatment to certain sales or exchanges and redemptions. It operates by causing certain preferred stock
held by a distributee to be tainted. When the tainted (or Sec. 306) stock is sold or redeemed, part or all
of the gain or income recognized is treated as a dividend or a “deemed” dividend rather than capital gain.
Prior to the 2003 Act, dividends and ordinary income were taxed at higher rates than were capital gains.
Therefore, Sec. 306 was extremely disadvantageous. Under current law, dividends and capital gains are
both taxed at a maximum rate of 15%. Therefore, Sec. 306 has lost much of its sting. Nevertheless, Sec.
306 is still in effect. pp. C:4-27 through C:4-30.

C:4-21 Section 304 requires that a sale of stock of one controlled corporation (Plum Corporation) to a
second controlled corporation (Cherry Corporation) be treated as a contribution to the capital of the
purchasing corporation and a stock redemption of part of the purchasing corporation's stock. If the
redemption is substantially disproportionate or meets any of the other exceptions of Secs. 302(b) or 303

C:4-4
that permit exchange treatment, it is treated as a sale by Bill. Otherwise it is treated as a dividend
distribution to Bill. In this case, Bill owns 100% of the Plum stock before the redemption and 96% after
the redemption (80 shares directly + [80% x 20 shares] indirectly through Cherry). Therefore, the sale
fails to qualify under any of the sale or exchange exceptions and is treated as a dividend. pp. C:4-30
through C:4-33.

C:4-22 A determination that part of the compensation paid an owner-employee is unreasonable in
amount means that the corporation loses its tax deduction for that portion of the payment. Generally, the
unreasonable compensation is taxed as a dividend to the owner-employee. After the 2003 Act, the
detrimental effect of a dividend is diminished at the shareholders level because of the 15% maximum tax
rate. The corporation still loses the deduction for the reclassified amount, however. The double taxation
associated with dividend treatment can be avoided by having the owner-employee enter into a hedge
agreement to repay any salary amounts determined to be unreasonable in amount. The shareholder is
taxed on the salary payment in the year in which he or she receives the compensation, and the
shareholder claims a deduction in the year he or she repays the excess amount to the corporation. pp.
C:4-11 through C:4-13, C:4-33, and C:4-34.

C:4-23 A bootstrap acquisition is an arrangement whereby a seller sells part of his stock to a purchaser
and has the corporation redeem the remainder of his stock. The advantage of this arrangement is that the
purchaser needs less cash to make the purchase. The consequence to the seller is the same as though he
had sold all his stock to the purchaser because the redemption qualifies for sale treatment as long as the
sale and redemption are all part of an integrated plan to terminate the seller's entire interest. pp. C:4-34
and C:4-35.

Issue Identification Questions

C:4-24 •       Because the two cash distributions exceed E&P, what portion of each distribution comes
out E&P?
•       What portion of each shareholder's distribution is a return of capital?
•     What portion of the return of capital distribution(s) reduces the basis of the
shareholder's stock?
•     What portion of each shareholder's return of capital distribution is a capital gain?
•     Is the capital gain recognized long-term or short-term?

The issue is to what extent Marsha's distribution is a dividend. Dye Corporation has \$12,000 of
current and accumulated E&P, so only \$12,000 can be a dividend to either Barbara or Marsha. Current
E&P is allocated ratably to Barbara and Marsha (\$4,000 each), and accumulated E&P is allocated on a
first-in, first-out basis so the remaining \$4,000 of E&P is allocated to Marsha. Therefore, Marsha has an
\$8,000 dividend and a \$2,000 return of capital. Barbara has a \$4,000 dividend and a \$6,000 return of
capital. Any amount received by Marsha or Barbara after recovering their stock basis is a capital gain.
The return of capital distribution reduces the basis of Marsha's stock investment and will cause a
corresponding increase (decrease) in the capital gain (capital loss) reported on her sale of the Dye stock
to Barbara. pp. C:4-3 through C:4-8.

C:4-5
C:4-25 •       What reasons might cause the sale price to be \$125,000 below the apparent prevailing
market price?
•       What gain or loss does Spring Harbor recognize on the sale?
•       What is Spring Harbor’s E&P balance?
•       Do the related party sale rules apply to the sale?
•       If the \$125,000 shortfall is treated as a dividend,
•       At what rate is the dividend taxed?
•       What gain or loss does Spring Harbor recognize on the distribution?
•       What is the shareholder's gross income?
•       What is the shareholder's basis in the land?
•       What is the shareholder's holding period for the land?
•       What is the distributing corporation's gain or loss on the distribution?
•       What effect does the distribution have on the distributing corporation's E&P?

One issue is whether Spring Harbor can recognize a \$25,000 loss on the sale of the land to
Neil for \$275,000 (\$275,000 sale price - \$300,000 adjusted basis). It appears that Sec. 267 will
prevent the recognition of the loss since Neil and Spring Harbor are related parties under Sec. 267(b).
An additional issue is whether Neil has a constructive dividend. If similar land has sold recently for
\$400,000, it appears that the sale price should have been \$400,000 instead of \$275,000. The
\$125,000 difference between the actual sales price and the price paid for similar land therefore
should be considered a constructive dividend taxed at 15%. Classifying the difference as a
constructive dividend causes Spring Harbor to recognize a \$100,000 (\$400,000 - \$300,000) capital
gain on the deemed land sale under Sec. 311(b) when appreciated property is distributed. It also will
trigger a \$34,000 (\$100,000 x 0.34) income tax liability that will reduce E&P. Neil will take a
\$400,000 basis in the land. The distribution will reduce E&P by \$125,000. pp. C:4-8 through C:4-
13.

C:4-26 •       What is Penny's stock ownership before and after the redemption?
•      Are any shares attributed to Penny from her mother?
•      Can Penny elect to waive the family stock ownership attribution rules?
•       What is the amount and character of Penny's gain or income on the stock
redemption?
•      What is Penny's basis in the 30 shares of stock she received as a gift from her
mother?
•      If the distribution is treated as a dividend, what happens to Penny's basis in
her stock?
•      What is Penny's mother's basis in her stock after the redemption (i.e., is any
of Penny's remaining basis transferred to her mother)?
•       Does the corporation recognize any gain on the repurchase of the shares?
•       What is its basis for the shares repurchased?
•       What effect does the redemption have on Price Corporation's E&P?

The issue is whether the redemption should be treated as a sale or a dividend. Penny is

C:4-6
deemed to own the shares owned by her mother. Therefore, she is deemed to have owned 70 shares
before the redemption (70/100 = 70% of the Price stock) and 40 shares after the redemption (40/70 =
57% of the Price stock) after the redemption. Thus, the redemption is not substantially
disproportionate under Sec. 302(b)(2).
The second issue is whether Penny can have the family attribution rules waived under Sec.
302(b)(3). The problem is that she received her shares as a gift from her mother. If Penny can show
that tax avoidance was not the principal purpose for the gift of the Price stock, she can sign a waiver,
and the redemption will be treated as a sale. In such case, she has a \$19,000 (\$35,000 - \$16,000)
LTCG taxed at a maximum 15% rate. E&P will be reduced by 30% of the current and accumulated
E&P, or \$30,000 (0.30 x \$100,000). If a waiver of the family attribution rules is not possible, Penny
will most likely have a \$35,000 dividend, also taxed at a maximum 15% rate. It is not likely that the
Sec. 302(b)(1) "not essentially equivalent to a dividend" rules will apply since Penny still maintains a
majority stock ownership position in Price following the redemption. If the distribution is treated as
a dividend, her basis for all 30 shares will be reallocated to her mother since she is the individual
whose stock ownership prevented the redemption from receiving capital gain treatment. E&P will be
reduced by the \$35,000 distributed to Penny. The corporation's basis in the redeemed shares is not
important since it recognizes no gain or loss when it issues new or treasury stock (Sec. 1032). pp.
C:4-16 through C:4-23.

C:4-27 •       What is Gumby's Pizza's E&P balance immediately preceding the distribution?
•       If \$50,000 in cash is withdrawn from the business, will it be treated as a dividend to
George?
•       Will the \$50,000 withdrawn from the business be considered to have been
received as part of George's stock sale?
•       Can the tax results for the transaction be improved if George has some of his
stock redeemed for the \$50,000 cash?
•       Are the tax consequences of the transaction different if the \$50,000 is
withdrawn from the business either before or as part of the stock sale?
•       Can the \$50,000 payment be classified as payment of back wages to George?
Would such an amount be deductible by the corporation?
•       What is the amount and character of the gain recognized on George's sale of the
stock?

The primary issue is whether the \$50,000 George receives from Gumby's Pizza is a dividend
or is part of the amount he receives for his stock. If Gumby redeems 25% of his stock for \$50,000 in
cash as part of the same transaction in which his remaining stock is sold to Mary for \$150,000, quite
likely he can treat the entire \$200,000 as being received in exchange for his stock under the bootstrap
redemption rules. In such case, he has a \$130,000 (\$200,000 - \$70,000) capital gain.
However, if he receives \$50,000 from Gumby's before entering into the sale agreement with
Mary, he will have a \$50,000 dividend and then an \$80,000 (\$150,000 - \$70,000) capital gain on a
later sale of his stock to Mary. In either case, the total \$130,000 is taxed at a 15% rate.
It is not likely that Gumby can treat the \$50,000 payment as additional compensation (e.g., a
bonus or payment made because of lower-than-normal salary payments made in prior years) and then

C:4-7
deduct the payment in computing its corporate tax liability. A possibility might be to treat the
\$50,000 as paid to George in exchange for a covenant not to compete for a certain period of time.
Such payment generally is ordinary income to the recipient but is deductible by the payer over a 15-
year period in accordance with Sec. 197. pp. C:4-3 through C:4-8, C:4-33, and C:4-34.

Problems

C:4-28 a.      Gross profit from operations                                 \$250,000
Dividends                                                      20,000
Interest                                                       10,000
Net capital gain (\$8,000 - \$1,200)                              6,800
Gross income                                                 \$286,800
Depreciation                           86,000       (201,000)
\$ 85,800
Charitable contribution [lesser of \$8,000
or 0.10 x (\$85,800 - \$40,000)]                               (    4,580)
\$   81,220
Dividends-received deduction (0.80 x \$20,000)                (   16,000)
NOL deduction (carryover)                                    (   40,000)
U.S. production activities deduction                         (    1,500)
Taxable income                                               \$   23,720

b.      Earnings and profits:
Taxable income                                               \$ 23,720
Plus: Municipal bond interest               \$ 12,000
Life insurance proceeds              100,000
Excess depreciation
(\$86,000 - \$42,000)                   44,000
NOL deduction (carryover)              40,000
U.S. production activities deduction    1,500          213,500
Minus: Excess charitable contribution
(\$8,000 - \$4,580)                   \$ 3,420
Penalties                                450
Taxes (\$25,220 x 0.15)                 3,783         ( 7,653)
Current earnings and profits                                 \$229,567

pp. C:4-3 through C:4-6.

C:4-8
C:4-29 Taxable income                                                           \$500,000
(0.70 x \$80,000)                                    \$ 56,000
NOL deduction (carryover)                            20,000
U.S. production activities deduction                 10,000
Excess depreciation                                  40,000         126,000

Minus: Long-term capital loss                            \$ 80,000
Fines and penalties                                 6,000
Federal income taxes
(\$500,000 x 0.34)                                170,000        (256,000)
Current earnings and profits                                             \$370,000
pp. C:4-3 through C:4-6.

C4-30 Beginning of 2005: (\$8,000) (The \$2,000 distribution is a return of capital and does not
affect the E&P deficit.)
Beginning of 2006: (\$20,000) [(\$8,000) - \$12,000]
Beginning of 2007: (\$15,000) [(\$20,000) + (\$10,000 - \$5,000)]
Beginning of 2008: (\$15,000) [(\$15,000) + (\$14,000 - \$14,000)] (The \$3,000 distribution
exceeding current E&P is a return of capital and does not reduce the accumulated E&P
deficit.)

p. C:4-3.

C:4-31 a.       \$40,000 dividend to Connie; \$15,000 out of current E&P and \$25,000 out of
accumulated E&P; \$10,000 is a return of capital that reduces Connie’s basis to zero; the excess
\$2,000 is taxable as a capital gain. Accumulated E&P at the beginning of next year is zero.
b.     \$30,000 is a dividend to Connie; \$10,000 is a return of capital that reduces Connie's
basis to zero; the excess \$12,000 is taxable as a capital gain. Accumulated E&P deficit at the
beginning of next year remains at (\$25,000).
c.     Clover's accumulated E&P as of April 1 (of a non-leap year) is \$50,000 - [(\$73,000 
365) x 90] = \$32,000. Therefore, \$32,000 is taxable as a dividend; \$10,000 is a return of capital that
reduces Connie's stock basis to zero; and the remaining \$10,000 distribution is taxable as a capital
gain. Accumulated E&P deficit at the beginning of next year is (\$55,000) [\$50,000 - \$18,000 prorata
deficit - \$32,000 dividend - \$55,000 remaining deficit].
d.     \$10,000 is a return of capital that reduces Connie's basis to zero; the excess \$42,000 is
taxable as a capital gain. Accumulated E&P deficit at the beginning of next year is (\$35,000).

pp. C:4-6 through C:4-8.

C:4-9
C:4-32 a.      Pete recognizes a dividend of \$40,000, and Cheryl recognizes a dividend of \$80,000.
Total E&P is \$160,000, so E&P is sufficient for all distributions to Pete and Cheryl to be dividends.
b.     Pete recognizes a dividend of \$22,000 [(\$40,000/\$120,000) x \$66,000], and Cheryl
recognizes a dividend of \$44,000 [(\$80,000/\$120,000) x \$66,000]. Because both distributions
occurred on the same date, current and accumulated E&P of \$66,000 are allocated pro rata to each
shareholder. The remaining \$18,000 to Pete is treated as a return of capital that reduces his stock
basis to \$7,000. The remaining \$36,000 to Cheryl reduces her stock basis to \$4,000. pp. C:4-3
through C:4-8.

C:4-33 a.

Current        Accumulated                       Return of
Individual     Date      Amount         E&P              E&P            Dividend         Capital
Charles         3/1      \$ 60,000      \$16,000         \$30,000          \$46,000          \$14,000
Donald          9/1        90,000       24,000              -0-          24,000           66,000
Total                    \$150,000      \$40,000         \$30,000          \$70,000          \$80,000

Thus, Charles has \$46,000 of dividend income and a \$14,000 return of capital, which reduces his
basis in the Pearl stock from \$80,000 to \$66,000. The basis reduction increases Charles's capital
gain on the sale to \$59,000 [\$125,000 - (\$80,000 - \$14,000)]. Donald has a \$24,000 dividend and a
\$66,000 return of capital, which reduces his stock basis at year-end from \$125,000 to \$59,000.

b.

Current        Accumulated                       Return of
Individual     Date      Amount         E&P              E&P             Dividend        Capital
Charles         3/1      \$ 60,000       \$ 40,000          \$ -0-            \$ 40,000        \$20,000
Donald          9/1        90,000         60,000            -0-              60,000         30,000
Total                    \$150,000       \$100,000          \$ -0-            \$100,000        \$50,000

The return of capital distributions reduce Charles' basis in his Pearl stock from \$80,000 to \$60,000
and Donald's basis from \$125,000 to \$95,000. This basis reduction increases Charles's capital gain
on the sale to \$65,000 [\$125,000 - (\$80,000 - \$20,000)].

C:4-10
c.

Current        Accumulated                        Return of
Individual      Date     Amount          E&P              E&P             Dividend         Capital
Charles          3/1     \$ 60,000        \$ -0-          \$60,000a             \$60,000         \$     -0-
Donald           9/1       90,000          -0-           35,700b              35,700           54,300
Total                    \$150,000        \$ -0-          \$95,700              \$95,700         \$ 54,300

a
59
x (\$36,500) = (\$5,900) E&P deficit for 1/1-2/28.
365
Acc. E&P on 3/1 = \$120,000 - \$5,900 = \$114,100 available.
b
243
x (\$36,500) = (\$24,300) E&P deficit for 1/1-8/31.
365

Acc. E&P on 9/1 = \$120,000 - \$24,300 - \$60,000 = \$35,700
Charles reports a \$45,000 capital gain (\$125,000 - \$80,000) on the stock sale because the distribution
does not affect the basis in his stock. The return of capital distribution reduces Donald's stock basis
from \$125,000 to \$70,700 (\$125,000 - \$54,300). pp. C:4-6 through C:4-8.

C:4-34 a.       Dina receives a taxable dividend of \$48,000 (\$56,000 - \$8,000).
b.      Dina's basis in the land is \$56,000, its FMV.
c.      Sedgwick Corporation recognizes a \$16,000 [(\$48,000 net FMV + \$8,000 release
from liability) - \$40,000] capital gain on the distribution.
d.      Sedgwick's E&P is increased by the \$16,000 E&P gain, which is the excess of the
land’s FMV over its E&P adjusted basis. (Note that the E&P gain and the tax gain are the same in
this problem.) E&P is decreased by the \$48,000 (\$56,000 FMV - \$8,000 mortgage) net amount of
the distribution and by the \$5,440 (0.34 x \$16,000) of federal income taxes imposed on the gain, or a
net reduction of \$37,440. pp. C:4-8 through C:4-11.

C:4-35 a.       The \$20,000 cash received by Arlene is taxable as a dividend. The amount of the
property (land) distribution is zero because the liability reduces the FMV, but not below zero. This
result occurs under either interpretation of FMV, i.e., whether actual FMV or the greater liability is
used (see Part b).
b.      Two alternatives exist for the basis amount. One approach is that the basis of the land
is \$50,000, or the property's actual FMV. Proponents of this approach argue that Sec. 311(b)(1)
applies only for gain recognition purposes. The other approach is that the land's basis is \$60,000 or
the FMV determined under Sec. 311(b)(1). See footnote in text.
c.      Stowe Corporation must recognize a \$45,000 (\$60,000 deemed FMV - \$15,000 tax
basis) capital gain on the distribution. pp. C:4-8 through C:4-11.

C:4-11
C:4-36 a.       Calvin recognizes a dividend of \$170,000 (\$250,000 FMV - \$80,000 mortgage
assumed), since Quick Corporation has E&P exceeding the amount distributed.
b.      Calvin's basis in the building is \$250,000.
c.      Quick must recognize a gain of \$100,000 (\$250,000 FMV - \$150,000 adjusted basis)
for taxable income purposes. Because the building was used in Quick's business, \$6,000 (\$30,000 x
0.20) of the gain is ordinary income recaptured under Sec. 291. The remaining \$94,000 (\$100,000 -
\$6,000) is Sec. 1231 gain.
d.      Quick's E&P is increased by the E&P gain of \$90,000 (\$250,000 FMV-\$160,000
E&P adjusted basis) and reduced by the \$170,000 net amount of the distribution and by \$34,000
(0.34 x \$100,000) in federal income taxes on the \$100,000 gain recognized for taxable income
purposes, thereby resulting in a net decrease of \$114,000. pp. C:4-8 through C:4-11.

C:4-37 a.      Susan has \$200,000 of dividend income and a \$200,000 basis in the land. Zeta
Corporation recognizes a \$75,000 Sec. 1231 gain. Zeta's E&P is increased by \$75,000 and reduced
by the land's \$200,000 FMV and by the \$25,500 (\$75,000 x 0.34) of federal income taxes on the
gain.
b.     Susan has \$60,000 (\$200,000 - \$140,000) of dividend income and a \$200,000 basis in
the land. Zeta recognizes a \$75,000 Sec. 1231 gain. Zeta’s E&P is increased by \$75,000 and
reduced by the land's \$60,000 (\$200,000 - \$140,000) net FMV and by the \$25,500 (\$75,000 x 0.34)
of federal income taxes on the gain.
c.     Susan has \$25,000 of dividend income and a basis of \$25,000 in the inventory. Zeta
recognizes \$7,000 of ordinary income. Zeta's E&P is increased by \$7,000 and reduced by the
inventory's \$25,000 FMV and by the \$2,380 (\$7,000 x 0.34) of federal income taxes on the gain.
d.     Susan has \$450,000 of dividend income and a basis of \$450,000 in the building. Zeta
recognizes a \$300,000 (\$450,000 - \$150,000) gain for taxable income purposes of which \$15,000
(\$75,000 x 0.20) is ordinary income under Sec. 291 and \$285,000 (\$300,000 - \$15,000) is Sec. 1231
gain. For E&P purposes, the basis of the building is \$165,000 (\$225,000 - \$60,000). The E&P gain
(excess of FMV over E&P adjusted basis) is \$285,000 (\$450,000 - \$165,000). Zeta’s E&P is
increased by \$285,000 and reduced by the building's \$450,000 FMV and by the \$102,000 (\$300,000
x 0.34) of federal income taxes on the gain.
e.     Susan has \$8,000 of dividend income and an \$8,000 basis in the automobile. Zeta
recognizes \$2,240 of ordinary gain (\$8,000 - \$5,760) for taxable income purposes. For E&P
purposes, the basis of the automobile is \$6,800 (\$12,000 - \$5,200). The E&P gain (excess of FMV
over E&P adjusted basis) is \$1,200 (\$8,000 - \$6,800). Zeta’s E&P is increased by \$1,200 and
reduced by the automobile's \$8,000 FMV and by the \$762 (\$2,240 x 0.34) of federal income taxes on
the gain.

C:4-12
f.     Susan has \$35,000 of dividend income and a \$35,000 basis in the obligation. Zeta
recognizes a \$10,500 Sec. 1231 gain on the distribution from sale of property in a prior year (the
character of the gain depends on the character of the property sold when the obligation was
received). Zeta's E&P is reduced by the obligation's \$35,000 FMV and by the \$3,570 and by
(\$10,500 x 0.34) of federal income taxes on the gain. E&P is not increased by the E&P gain on the
installment obligation because E&P was increased by the entire gain in the year of sale. pp. C:4-8
through C:4-11.

C:4-38 a.       \$220,000 (\$500,000 paid - \$280,000 reasonable compensation) would be
nondeductible by the corporation and a constructive dividend to Wilma.
b.      \$400,000 would likely be a constructive dividend to Harry.
c.      The net FMV of the property sold is \$290,000 (\$350,000 - \$60,000). Because Wilma
paid only \$150,000, she has a constructive dividend of \$140,000 (\$290,000 - \$150,000). King
Corporation must recognize a total gain of \$260,000 (\$350,000 FMV - \$90,000 basis) on the sale of
a portion of the building and the distribution of the remainder of the building.
d.      Harry has a constructive dividend of \$15,000 per year. King's rent expense is reduced
by \$15,000.
e.      Wilma has a constructive dividend of \$65,000 (\$250,000 - \$185,000). King's basis in
the land is reduced from \$250,000 to \$185,000.
f.      Harry and Wilma have a constructive dividend of \$8,000. King's deductions for its
airplane use are reduced by \$8,000. pp. C:4-11 through C:4-13.

C:4-39 The \$200,000 in disallowed salary and bonuses will be nondeductible by Forward
Corporation and taxable as a dividend to Alvin. Forward will lose its salary deduction for a tax cost
of \$68,000 (\$200,000 x 0.34). Alvin will save \$40,000 [\$200,000 x (0.35 – 0.15)] because of the
difference between his ordinary tax rate and the 15% tax rate on the dividend income. Thus, the net
tax cost is \$28,000 (\$68,000 - \$40,000). pp. C:4-12 and C:4-13.

C:4-40 a.      None. The stock dividend is nontaxable under Sec. 305(a).
b.     Robert's basis in each share is \$909.09 (\$100,000  110 shares). His gain on the sale
is computed as follows:
Minus: Basis of five shares (5 x \$909.09)                                 (4,545.45)
Recognized gain                                                          \$2,454.55
c.     Total basis in the 105 remaining shares is \$95,454.55 (\$100,000 - \$4,545.45), or
\$909.09 per share. Robert's holding period for all shares begins in 2001 when he acquired the
original 100 shares. pp. C:4-13 through C:4-15.

C:4-41 a.      Tillie recognizes no income when she receives the preferred stock. Tillie's basis in
her common and preferred stock is:
Basis for 100 preferred shares: \$100,000 x \$ 10,000 = \$ 5,263.16
\$190,000

C:4-13
Basis for 1,000 common shares: \$100,000 x \$180,000 = \$94,736.84
\$190,000
b.      Tillie must recognize a long-term capital gain of \$2,368.42 (\$5,000 - \$2,631.58) on
the sale of one-half of the preferred stock.
c.      Tillie's basis in her common stock is \$94,736.84. Tillie's basis in her remaining
preferred stock is \$2,631.58. Her holding period begins in 2003 when she purchased the common
stock. pp. C:4-13 through C:4-15.

C:4-42 a.       Jim recognizes no income when he receives the rights.
b.      Because the value of the rights (\$15) is more than 15% of the value of the underlying
stock (\$75), the basis of the stock must be allocated to the stock and the right. Jim's basis in his
stock is: \$10,000 x (\$75/\$90) = \$8,333.33 (\$41.67 per share). Jim's basis in his rights is \$10,000 x
(\$15/\$90) = \$1,666.67 (\$8.33 per right). Jim recognizes a long-term capital gain of \$1,166.67
(\$2,000 - \$833.33) when he sells the 100 rights.
c.      Jim recognizes no gain when he exercises the rights. Their basis is added to the basis
of the stock purchased with the rights (\$6,000 + \$833.33 = \$6,833.33).
d.      Jim recognizes a gain of \$700 [(60 x \$80) - (60 x \$68.33)] on the stock sale. The gain
is a short-term capital gain since the holding period begins on the September 10 exercise date.
e.      Jim's basis in his remaining shares is as follows: Jim's original 200 shares: \$8,333.33
(\$10,000 - \$1,666.67). Jim's 40 remaining shares purchased with the rights: \$2,733.33 (40 shares x
\$68.33). pp. C:4-15 and C:4-16.

C:4-43 George's stock will be attributed to: a, his wife; b, his father; e, his daughter; and g, his
grandfather. pp. C:4-18 through C:4-20.

C:4-44 Lara owns:    60 shares directly
10 shares through LMN Partnership (0.20 x 50 shares)
70 shares through LST Partnership (0.70 x 100 shares)
-0- shares through Lemon Corporation
54 shares through Lime Corporation (0.60 x 90 shares)
Thus, total deemed constructive ownership is 194 shares. pp. C:4-18 through C:4-20.

C:4-45 Because Paul still owns 100% of Presto Corporation's stock, the redemption is treated as a
dividend under Sec. 301. Paul recognizes a \$30,000 dividend to be taxed at a 15% rate. His \$2,500
(\$10,000 x 25/100) basis in the redeemed shares is added to his \$7,500 (\$10,000 - \$2,500) basis in
his remaining 75 shares, so his basis in the remaining 75 shares is \$10,000. Presto’s E&P is reduced
by the amount distributed, or \$30,000.
pp. C:4-18 through C:4-20, and C:4-27.

C:4-46 a.      Ethel owns 50% of the Benton stock before the redemption and 53⅓% (160  300)
after the redemption. Therefore, Ethel treats the redemption as a dividend and must recognize
\$20,000 (40 shares x \$500) of dividend income. Ethel's remaining 160 shares have a total basis of
\$46,000 (200 shares x \$230 each) or \$287.50 per share.

C:4-14
Fran owns 25% of the Benton stock before the redemption and 23⅓% (70  300) after the
redemption. The 23⅓% is not less than 80% of Fran’s prior percentage ownership. Therefore, the
redemption is not substantially disproportionate. Thus, unless Fran can establish that the redemption
is not essentially equivalent to a dividend under Sec. 302(b)(1), she treats the redemption as a
dividend distribution and must recognize \$15,000 (30 shares x \$500) of dividend income. Fran's
remaining 70 shares have a total basis of \$23,000 (100 shares x \$230 each), or \$500 per share.

Georgia owns 12.5% of the Benton stock before the redemption and 6⅔% (20  300) after the
redemption. Therefore, the redemption is substantially disproportionate and Georgia treats the
redemption as a sale of stock under Sec. 302(b)(2) and recognizes a long-term capital gain of \$8,100
[30 x (\$500 - \$230)]. Georgia's remaining 70 shares have a basis of \$230 each.

b.     Ethel is considered to own 62.5% of the Benton stock (250  400) before the
redemption and 60% (180  300) after the redemption. Therefore, Ethel still would have to treat the
redemption distribution as a dividend. Georgia also is considered to own 62.5% before the
redemption and 60% after the redemption and will be considered to have received a dividend. Thus,
the tax consequences to Ethel and Fran do not change from Part a. However, Georgia must report a
dividend of \$15,000 (30 shares x \$500) instead of a capital gain of \$8,100 as in Part a. pp. C:4-16
through C:4-23.

C:4-47 The redemption is treated as a sale of stock by Amy, Beth, and Carla. Each recognizes a
\$15,000 (\$20,000 - \$5,000) capital gain on their redeemed shares. All these shareholders have a
\$1,000 per share basis for their remaining shares. Delta Corporation recognizes a \$20,000 dividend
because it does not experience a change in its stock ownership percentage and because the
redemption does not qualify for exchange treatment under Sec. 302(b)(4). Delta's basis in its
remaining 20 shares is \$25,000, or \$1,250 per share. Delta is entitled to an 80% dividends-received
deduction for the distribution. pp. C:4-23 through C:4-25.

C:4-48 a.      A redemption of stock held by either John's estate or John, Jr. will qualify as a sale
under Sec. 303. The value of the stock in the gross estate (\$1,500,000) is more than 35% of the
adjusted gross estate [\$787,500 = 0.35 x (\$2,500,000 - \$250,000)]. John, Jr. is eligible for Sec. 303
treatment because he is responsible for all the taxes and expenses of the estate. The maximum
qualified redemption under Sec. 303 is \$600,000 (\$250,000 + \$350,000). A redemption of stock
held by John's wife will not qualify under Sec. 303 because it is not included in the gross estate.
b.     The redemption qualifies under Sec. 303. However, only \$600,000 (150 shares x
\$4,000 per share) qualifies for sale treatment under Sec. 303. The estate will report a \$37,500 capital
gain [\$600,000 - (\$1,500,000 x 150/400)] on this part of the redemption. The remaining \$200,000 of
the redemption proceeds is taxed as a dividend to the estate at the maximum 15% rate. pp. C:4-25
through C:4-27.

C:4-15
C:4-49 a.      White's E&P is reduced by 30%, the percentage of stock that was redeemed. Thus, it
is reduced by \$24,000 (0.30 x \$80,000). The remaining \$6,000 of the distribution reduces the
balance in the capital account.
b.      White's E&P is reduced by \$30,000. p. C:4-27.

C:4-50 a.       This redemption is a complete termination of interest. Alan recognizes a gain of
\$40,000 (\$100,000 - \$60,000 basis). Barbara and Dave each retain a basis of \$60,000 in their
remaining shares. Time's E&P is reduced by \$80,000 (100/300 shares x \$240,000). Time’s tax basis
paid-in capital is reduced by \$20,000 (\$100,000 redemption amount - \$80,000).
b.      If Barbara is Alan's mother, Alan is considered to own 200/300 =66 2/3% before the
redemption and 100/200 = 50% after the redemption. This redemption is not substantially
disproportionate. Therefore, the redemption could be treated as a \$100,000 dividend to Alan. If so,
Barbara's basis in her shares is increased by Alan's basis in the 100 shares surrendered, so her basis is
\$120,000 (\$60,000 + \$60,000); Dave's basis remains at \$60,000; and Time's E&P is reduced by
\$100,000, the amount of the dividend to Alan. However, the IRS in Rev. Rul 75-502, 1975-2 C.B.
111, held that a redemption was not essentially equivalent to a dividend where a shareholder’s
interest dropped from 57% before the redemption to 50% after the redemption. Hence, the
shareholder received sale treatment on the redemption. Because the facts in Alan’s situation are
similar to those in Rev. Rul. 75-502, he probably can assert that the redemption of his stock is not
essentially equivalent to a dividend and claim sale treatment similar to Part a. See Part c, for yet
another option.
c.      If Alan signs an agreement not to obtain any interest in Time for ten years, the family
attribution rules can be waived. Therefore, the redemption could be treated as a sale, and Alan could
recognize a \$40,000 gain. Barbara and Dave each retain a \$60,000 basis in their remaining shares.
Time's E&P is reduced by \$80,000 [(100/300) x \$240,000]. Time’s tax basis paid-in capital is
reduced by \$20,000 (\$100,000 redemption amount - \$80,000). pp. C:4-16 through C:4-23.

C:4-51 a.       Before redemption: 30 + 7.5 = 37.5 shares (37.5%)
After redemption: 5 + 7.5 = 12.5 shares (16.67%)
The redemption is treated as a sale since it is substantially disproportionate. Bea has a capital gain of
\$25,000 (\$30,000 - \$5,000). Excel Corporation's E&P is reduced by \$25,000 (0.25 x \$100,000).
Excel’s tax basis paid-in capital is reduced by \$5,000 (\$30,000 redemption amount - \$25,000).
b.      Before redemption: 30 + 7.5 = 37.5 shares (37.5%)
After redemption: 20 + 7.5 = 27.5 shares (30.55%)
Generally, this redemption is treated as a \$12,000 dividend to Bea because the 80% test is not met
(0.80 x 37.5% = 30.00%). Alternatively, sale or exchange treatment may be available under Sec.
302(b)(1) since Bea goes from one minority position to another. If so, she recognizes a \$10,000
(\$12,000 - \$2,000) long-term capital gain. If the transaction is a dividend, Excel’s E&P is reduced by
\$12,000 (amount distributed). If it is a sale, E&P is reduced by \$10,000 (0.10 x \$100,000), and tax
basis paid-in capital is reduced by \$2,000 (\$12,000 redemption amount - \$10,000).

C:4-16
c.       Before redemption: 25 + 15 = 40 shares (40%)
After redemption: 15 shares (20%)
The redemption is treated as a sale because it is substantially disproportionate. Carl must recognize a
\$26,000 (\$30,000 - \$4,000) capital gain. Excel has a \$25,000 (0.25 x \$100,000) reduction in its E&P,
and a \$5,000 reduction in its tax basis paid-in capital. This redemption also qualifies as a complete
termination if the family attribution rules are waived.
d.      The redemption qualifies as a sale. Carl's estate must recognize a \$2,000 gain (\$30,000
- \$28,000 FMV of the Excel stock on Carl's date of death). Excel again has a \$25,000 reduction in its
E&P, and a \$5,000 reduction in its tax basis paid-in capital.
e.      Before redemption: 20 shares (out of 100) (20%)
After redemption: -0- shares (out of 80) (0%)
The redemption is either a complete termination or substantially disproportionate. (No stock is
attributed from Tetra Corporation to Andrew because Andrew owns less than 50% of the Tetra stock.)
Andrew must recognize a \$21,000 (\$24,000 - \$3,000) capital gain. Excel must recognize an \$18,000
(\$24,000 - \$6,000) gain on the distribution of the land. Its E&P is increased by \$18,000 minus the
\$6,120 (\$18,000 x 0.34) of federal income taxes attributable to the gain and minus \$22,376 [0.20 x
(\$100,000 + \$18,000 - \$6,120)], which is less than the \$24,000 distribution. Tax basis paid-in capital
is reduced by \$1,624 (\$24,000 - \$22,376).
f.      Before redemption: 25 + 75 = 100 shares (100%).
After redemption: 25 shares (out of 25) (100%).
Because of the attribution rules, Carl owns 100% of Excel stock before and after the
redemption. Thus, the substantially disproportionate requirements are not met as they were in Part c.
To qualify for sale treatment, Carl must waive the family attribution rules. If Carl does so, he will
recognize a \$26,000 (\$30,000 - \$4,000) capital gain. Excel has a \$25,000 (0.25 x \$100,000) reduction
in E&P. pp. C:4-16 through C:4-27.

C:4-52 a.       Bailey recognizes a dividend of \$100,000 subject to the 15% tax rate. Checker
Corporation reduces its E&P by \$100,000, the amount of the dividend.
b.      Bailey has a dividend of \$100,000, which is ordinary income. However, Bailey is
entitled to an 80% dividends-received deduction. Checker reduces its E&P by \$100,000, the amount
of the dividend.
c.      Bailey recognizes a long-term capital gain of \$60,000 (\$100,000 - \$40,000 basis).
Checker reduces its E&P by \$70,000 (25% of the \$280,000 balance) because she surrendered 25% of
the outstanding stock in a redemption qualifying as a sale.
d.      The results are the same as Part c. Bailey recognizes a \$60,000 long-term capital gain,
and Checker reduces its E&P by \$70,000.

C:4-17
e.      If Bailey is an individual, she would prefer long-term capital gain treatment. Although
capital gains and dividends are both taxed at a maximum rate of 15%, she deducts her basis in her
stock in calculating her \$60,000 of capital gain, whereas dividend treatment does not allow the
deduction of basis so she would have to report \$100,000 of dividends. Furthermore, she may be able
to offset some or all of her capital gains with capital losses. If Bailey is a corporation, it normally
would prefer dividend treatment. A dividend would increase Bailey’s taxable income by \$20,000
(\$100,000 - \$80,000 DRD). A capital gain would increase taxable income by \$60,000, with no special
rate on capital gains for corporations. However, if the corporation realized a \$60,000 capital loss, it
could offset the loss against the \$60,000 capital gain. In such case, Bailey Corporation might prefer
the capital gain. pp. C:4-16 through C:4-27.

C:4-53 a.       Yes. Beth has a deemed dividend to the extent of the issuing corporation's E&P at the
time the Sec. 306 stock was issued. The remainder is treated as a return of capital or capital gain.
b.      Yes. All amounts received are treated as a return of capital or capital gain under the
general rules of Sec. 301.
c.      Yes. Under the Sec. 301 dividend rules, Ruth recognizes dividend income to the
extent of Zero's E&P at the end of the year in which the redemption occurs. The remainder, if any, is
treated as a return of capital or capital gain.
d.      Maybe. No tax is due at the time of the gift, but the stock retains its Sec. 306 taint in
the hands of the donee, Barry.
e.      No. Because Ed completely terminates his interest in Zero, the redemption is treated
as a sale, and Sec. 306 does not apply.
f.      No. Section 306 does not apply to inherited stock. pp. C:4-28 through C:4-30.

C:4-54 a.       The preferred stock is Sec. 306 stock. Fran's basis in the preferred and common stock
is allocated as follows:
Preferred:    \$150,000 x \$60,000 = \$20,000
\$450,000

Common:        \$300,000 x \$60,000 = \$40,000
\$450,000

When Fran sells the preferred stock, \$100,000 (the E&P at the time the stock was distributed) is a
deemed dividend to Fran, \$20,000 is a return of capital, and \$80,000 is a capital gain. Star
Corporation makes no adjustment to its E&P.
b.      \$100,000 is a deemed dividend and \$10,000 is a return of capital. Fran's remaining
\$10,000 basis is added to her basis in the common stock, so the common stock basis is \$50,000
(\$40,000 + \$10,000). Star makes no adjustment to its E&P.
c.      Under the Sec. 301 rules, \$175,000 is a dividend [up to the amount of E&P in the year
of the redemption (\$100,000 + \$75,000)]; Fran's \$20,000 basis in the preferred shares is recovered
tax-free; and the remaining \$5,000 of the distribution is a capital gain. Star’s E&P is reduced by
\$75,000. pp. C:4-28 through C:4-30.

C:4-18
C:4-55 a.       The sale is recast as a redemption of Razzle stock issued as a result of Bob's capital
contribution of the Dazzle stock to Razzle. The Sec. 302 stock ownership is tested by looking at
Bob's ownership of the Dazzle stock.
•       Bob's ownership of Dazzle stock before the redemption: 60% of Dazzle stock.
•       Bob's ownership after the redemption: 30 shares directly and 80% x 30 shares
indirectly = 54 shares = 54% of Dazzle stock.
The redemption is treated as a \$50,000 dividend to Bob because the combined E&P of Dazzle and
Razzle is \$65,000 (\$25,000 + \$40,000).
b.      Bob's basis in his remaining Dazzle stock is \$6,000 (30/60 x \$12,000). Bob's basis in
his Razzle stock is increased to \$14,000 by his \$6,000 basis in the redeemed Razzle stock.
c.      Razzle's E&P is reduced by the first \$40,000 of the distribution, and Dazzle's E&P is
reduced by the remaining \$10,000 (\$50,000 - \$40,000) of the distribution.
d.      Razzle's basis in its Dazzle shares is \$6,000, the same as Bob's pre-sale basis.
e.      If Bob owned only 50% of the Razzle stock before the sale, Bob owns 60% of the
Dazzle stock before and 45% after the sale [30 shares + (50% x 30 shares)], so the redemption is
treated as a sale under Sec. 302(b)(2). Bob recognizes a capital gain of \$44,000 (\$50,000 - \$6,000
basis). pp. C:4-30 through C:4-32.

C:4-56 a.      The sale is recast as a redemption. Because Jane still owns more than 50% of Parent
after the redemption, [100 shares directly and 20 (50% x 80% x 50) shares indirectly out of 200
outstanding shares], or 60% of Parent's stock, the \$40,000 is taxed as a dividend to Jane.
b.     Jane's basis in her remaining 100 shares of Parent stock is \$15,000.
c.     Subsidiary’s E&P is reduced to \$20,000 (\$60,000 - \$40,000).
d.     Subsidiary’s basis in the Parent shares is \$40,000.
e.     The recast redemption is substantially disproportionate {75% before the redemption
and 70 [50 + 20 (25% x 80% x 100)] shares, or 35%, after the redemption}. Therefore, Jane
recognizes a capital gain of \$70,000 [\$80,000 - (100/150 x \$15,000)]. pp. C:4-32 and C:4-33.

C:4-57 a.        Jana will recognize \$450,000 (\$750,000 - \$300,000) of capital gain on her sale of 75
shares of Stone Corporation stock to Michael. She will recognize an additional \$150,000 (\$250,000
- \$100,000) of capital gain on the redemption of her remaining shares by Stone. Michael will take a
basis in his stock of \$750,000, the amount paid for the 75 shares purchased. Stone will recognize no
gain or loss on the redemption if the redemption is for cash. If Stone uses property to redeem Jana's
stock, it will recognize gain (but not loss) on the property used as though the property was sold.
Because the redemption of one-fourth of the Stone stock is treated as a sale, the corporation's E&P
will be reduced by \$150,000, which is one-fourth of the available E&P.
b.       The results are the same even though the redemption takes place before the sale. As
long as the redemption and sale are part of one transaction, the redemption will qualify as a sale. pp.
C:4-34 and C:4-35.

C:4-19
Comprehensive Problem
C:4-58 a.   Sigma Corporation’s taxable income and tax liability:

Income:
Operating gross profit                       \$290,000
Long-term capital gain                         20,000
Total income                                          \$310,000
Deductions:
Salary to Brian                             \$ 80,000
Payroll tax on Brian’s salary                   6,000
Depreciation                                   25,000
Other operating expenses                       89,000
Total deductions                                      \$200,000
Taxable income                                          \$110,000
Income tax [\$22,250 + 0.39 (\$110,000 - \$100,000)]                \$26,150
Sigma’s portion of payroll tax                                     6,000
Total corporate tax liability                                    \$32,150

Brian’s taxable income and tax liability:

Salary income                                   \$ 80,000
Dividend income                                   60,000
AGI                                                        140,000
Minus: Standard deduction                       \$ 5,350
Personal exemption                        3,400
Total deductions                                   ( 8,750)
Taxable income                                             \$131,250

Ordinary taxable income (\$131,250 - \$60,000 dividend income)          \$71,250

Tax on ordinary taxable income [\$4,386.25 + 0.25 (\$71,250 - \$31,850)] 14,236
Tax on dividend income (0.15 x \$60,000)                                9,000
Brian’s portion of payroll tax                                         6,000
Total tax on Brian                                                  \$ 29,236

Total corporate and individual tax (\$32,150 + \$29,236)                \$ 61,386

Sigma Corporation’s E&P:

Taxable income                                                       \$110,000

C:4-20
Plus:   Tax-exempt income                                       \$ 7,000
Excess of tax depreciation over
E&P depreciation (\$25,000 - \$21,000)                     4,000
Minus: Federal income taxes                                     \$26,150
Dividend distribution                                    60,000
Total reductions                                                  ( 86,150)
Current E&P after dividend distribution                                   \$ 34,850

b.   Brian’s taxable income and tax liability:
Operating gross profit                                              \$290,000
Depreciation                                      25,000
Other operating expenses                          89,000
Total deductions                                         (114,000)
Plus: Long-term capital gain                                          20,000
Minus: One-half self-employment tax                                 ( 8,500)
AGI                                                                 \$187,500
Minus: Standard deduction                                   \$ 5,350
Personal exemption (after reduced phase out for 2007) 2,811
Total deductions                                             ( 8,161)
Taxable income                                                      \$179,339

Ordinary taxable income (\$179,339) - \$20,000 LTCG                         \$159,339

Tax on ordinary income [\$15,698.75 + 0.28 (\$159,339 - \$77,100)]           \$ 38,726
Tax on long-term capital gain (\$20,000 x 0.15)                               3,000
Total income tax                                                          \$ 41,726
Self-employment tax                                                         17,000
Total tax                                                                 \$ 58,726

c.   In the sole proprietorship case, long-term capital gains are taxed once at the
individual’s preferential capital gains tax rate (e.g., 15%), tax-exempt income is
excluded from gross income, and operating profits are taxed once at the individual’s
ordinary tax rate. In the C corporation case, long-term capital gain is taxed once at
the corporation’s ordinary tax rate and again at the shareholder’s 15% tax rate when
distributed as a dividend. Tax-exempt income is excluded from the corporation’s
gross income but is taxed at the shareholder’s ordinary tax rate when distributed as a
dividend. Operating profits are taxed once at the corporation’s ordinary tax rate and
again at the shareholder’s capital gain tax rate when distributed as a dividend.

C:4-21
Tax Strategy Problem

C:4-59 a.       John would have a \$50,000 dividend. Jamaica Corporation would reduce its E&P by
\$50,000.
b.      John would have a \$50,000 dividend and a \$50,000 basis in the XYZ stock. Jamaica
would recognize a \$40,000 gain on the XYZ stock. Jamaica’s E&P would be increased by \$40,000
assuming taxable income basis and E&P basis are equal and reduced by the XYZ stock’s \$50,000
FMV and by the \$13,600 (\$40,000 x 0.34) of federal taxes on the gain, for a net reduction of
\$23,500. The disadvantage of this choice is that the corporation must recognize \$40,000 and pay tax
of \$13,600 even though it has not sold the stock and has not received any cash.
c.      John would have a dividend of \$50,000 and a \$50,000 basis in the ABC stock.
Jamaica’s E&P would be reduced by the \$72,000 E&P adjusted basis of the stock to Jamaica. The
disadvantage of this choice is that, if the stock is distributed to John, neither John nor Jamaica can
ever take the \$22,000 loss that Jamaica sustained on this stock before the distribution.
d.      John would recognize a \$50,000 dividend (\$81,000 FMV - \$31,000 liability
assumed). Jamaica would recognize \$59,000 of ordinary income under Sec. 1245, the amount by
which the \$81,000 FMV exceeds Jamaica’s tax basis in the equipment distributed. Jamaica’s E&P
would be increased by the \$41,000 (\$81,000 FMV - \$40,000 E&P adjusted basis) E&P gain and
reduced by the equipment’s net FMV of \$50,000 (\$81,000 FMV - \$31,000 liability) and by the
\$20,060 (\$59,000 x 0.34) tax on the gain, for a net reduction of \$29,060 (\$41,000 - \$50,000 -
\$20,060). The disadvantage of this choice is similar to that in Part b. Jamaica must recognize a
\$59,000 gain even though it has not sold the equipment and has not received any cash.
e.      John would recognize a \$50,000 dividend and take a \$50,000 basis in the installment
obligation. Jamaica would recognize an \$18,000 capital gain in the year it distributes the obligation.
Its E&P would be increased by the \$18,000 gain (assuming taxable income basis and E&P basis are
equal) and decreased by the obligation’s \$50,000 FMV and by the \$6,120 (\$18,000 x 0.34) of federal
tax on the gain, for a net reduction of \$38,120 (\$18,000 - \$50,000 - \$6,120). The disadvantage of
this choice is that Jamaica’s gain on the installment obligation is accelerated to the year of
f.      It would not make any difference if John’s stock were redeemed for the property
listed. Because John owns all the Jamaica stock, any redemption will be treated as a dividend to the
extent of Jamaica’s E&P.
g.      The best option probably would be cash so that Jamaica would not have to recognize
any gain. The worst option probably would be the ABC stock because the loss of \$22,000 on the
stock could never be recognized by John or Jamaica. This option should be avoided. Of the property
distributions resulting in gains, the installment obligation seems least objectionable because it
triggers the least gain recognition to the corporation.

C:4-22
Case Study Problems

C:4-60 The points listed below should be mentioned in the memorandum to the three sisters. The
student should prepare a properly formatted memorandum with good grammar and punctuation.

Purchase Transaction

1.      Amy will report a \$60,000 (\$100,000 - \$40,000) long-term capital gain on the sale of the
Theta stock to Beth and/or Meg. She might consider an installment sale, which will defer the
recognition of the gain over the payment period and provide some interest income for Amy.

2.      The purchasing shareholder(s) will take a \$100,000 cost basis in the new block of stock and
may control up to two-thirds of the Theta stock. Beth and Meg instead may purchase one-
half of Amy's stock so that they are equal shareholders immediately following the sale.

3.      The sale transaction does not result in any reduction of the Theta’s earnings and profits.

4.      A sale transaction might be preferred since it does not require an outlay of any of Theta’s
assets. If Beth and/or Meg encounter difficulties in raising the required \$100,000, a properly
structured bootstrap acquisition could be used where Theta redeems some of the shares and
Beth and/or Meg purchase the remaining shares.

Redemption Transaction

1.      Amy will report a \$60,000 long-term capital gain on the redemption. No attribution of stock
occurs from either Beth or Meg to Amy because the family attribution rules do not apply to
siblings. Therefore, the redemption of Amy's stock is considered a complete termination of
Amy's interest under Sec. 302(b)(3).

2.      The two sisters may prefer to have the corporation redeem the shares because each sister will
control one-half of the outstanding stock after the redemption. The redemption also does not
require any economic outlay by any of the three shareholders.

3.      The stock redemption will result in a \$50,000 (\$150,000 x 0.333) reduction in Theta's
earnings and profits, and a \$50,000 reduction in paid-in capital.

C:4-61 If Maria has a good faith belief that her position relating to the compensation amounts has a
realistic possibility of being sustained administratively or judicially on its merits, if challenged, then
according to Statements on Standards for Tax Services (SSTS) No. 1, Tax Return Positions (see
Appendix E in the text), she may recommend that such a position be taken on the tax return. If she
does not have such a good faith belief, she may recommend the position anyway if it is not frivolous
and it is disclosed on the return. If she does not have such a good faith belief, and the position is not
disclosed on the return, she should not recommend the position be taken, and she should not prepare

C:4-23
or sign the return. Generally, the tax return preparer can avoid IRS penalties if it is anticipated that
the position has a one-in-three probability of being sustained.

The advice Maria gives regarding the deductibility of the compensation should be written and
supported by adequate work papers. Although oral advice may serve a client's needs appropriately in
routine matters, SSTS No. 8, Form and Content of Advice to Taxpayers, Para. 8, recommends
written communications in important, unusual, or complicated transactions (see Appendix E in the
text). The letter to the client should indicate what kind of support exists for the current and prior
years' compensation amounts, what kinds of audit risk exists, and the possible consequences of a
subsequent audit.

Tax Research Problems

C:4-62 In drafting the letter, the student should follow the basic steps in the tax research process.
The letter should set forth the facts, identify key issues, discuss Sec. 302 and other applicable law,
analyze the facts in terms of the law, derive logical conclusions, and present sound
recommendations.

A key issue that the student should address is whether the management of WEA facilities by
a company wholly owned by Weymouth, in consideration for 20% of WEA’s revenues, violates Sec.
302(c)(2)(A)(ii) and Weymouth’s agreement with the IRS. Contractually, under the Widells’
proposal, Fortunelle will provide management services for WEA in return for arms length
compensation. However, through his 100% ownership of Fortunelle, Weymouth may be deemed to
have reacquired an interest in WEA. Facts that may be significant in determining the outcome
include
•      Weymouth’s family relationship with WEA’s shareholders
•      His past equity interest in WEA
•      His past WEA management role
•      His 100% ownership interest in Fortunelle
•      Fortunelle’s proposed management role
•      Fortunelle’s proposed revenue-sharing arrangement

Section 302(b)(3) provides that, if a redemption is in complete redemption of all the stock of
the corporation owned by the shareholder, the redemption will be treated as a sale. Therefore, any
gain or loss realized by the shareholder will be capital in character. Under Sec. 318(a)(1)(A), for
purposes of Sec. 302, corporate stock owned by parents is attributed to their children. Under Sec.
302(c)(2)(A), the Sec. 318(a)(1)(A) attribution rules may be waived if the shareholder meets all the
following conditions:
i.      Immediately after the distribution, the shareholder retains no interest in the
corporation (including an interest as officer, director, or employee) other than an
interest as a creditor,
ii.      The shareholder does not acquire any such interest within ten years from the date of
the distribution, and

C:4-24
iii.      The shareholder files an agreement to notify the IRS if he or she acquired such
interest.

Under the terms of the Widells’ proposal, it appears that Weymouth will have met all three
conditions. First, immediately after the corporate distribution of the WEA property, Weymouth
retained no interest in WEA. Second, Weymouth will not have acquired an interest within ten years
from the date of the distribution. (Fortunelle as a legal entity, not Weymouth as an individual, will
have provided management services in an independent contractor capacity.) Third, Weymouth filed
an agreement to notify the IRS if he acquires any interest.

Weymouth, however, might not have satisfied condition (ii). Because of (1) his 100%
ownership of Fortunelle, (2) the nature of the services that Fortunelle would provide for WEA, and
(3) the proposed revenue-sharing arrangement, Weymouth might be deemed to have reacquired an
interest in WEA, both as an owner and as an officer, within the ten-year period. Therefore, the Sec.
318(a)(1)(A) family attribution rules might not be waived, the redemption will not have been in
complete redemption of all WEA stock owned by Weymouth, and the distribution would not have
qualified for sale treatment.

In Rev. Rul. 70-104, 1971 C.B. 66, the IRS ruled that a father’s performance of services for a
corporation pursuant to a consulting agreement gives rise to an interest in the corporation for Sec.
302 waiver purposes. On the other hand, in Estate of Milton S. Lennard, 61 T.C. 554 (1974), the
Tax Court ruled that a corporation’s employing a former shareholder did not give rise to an interest
for Sec. 302 waiver purposes where (1) the former shareholder was employed as an independent
contractor, (2) the corporation determined operating policy, (3) the corporation could terminate the
employment at will, and (4) the compensation was reasonable in amount relative to the services
performed.

The facts of the present case are analogous to those of Chertkof v. Commissioner, 48 AFTR
2d 81-5194, 81-1 USTC ¶9462 (4th Cir, 1981). In Chertkof, a closely held family corporation
distributed real estate to the principal owner’s son in complete redemption of the son’s equity
interest. At the time of the distribution, the son had the Sec. 318 family attribution rules waived by
executing with the IRS an agreement not to reacquire an equity interest within ten years and to notify
the IRS if he did so. As a result of the waiver, the distribution was treated as a sale, and the son
recognized capital gain. Following the distribution, the son organized his own real estate company
and capitalized it with the distributed real estate.

C:4-25
Years later, the son’s wholly owned company entered into an agreement to manage the real
estate of the family corporation in consideration for a percentage of its annual revenues. Contending
that the real parties to the agreement were the son and the closely held family corporation, the Fourth
Circuit Court of Appeals held that the son effectively had reacquired an interest in the family
corporation and that this reacquisition violated Sec. 302(c)(2)(A)(ii). Consequently, the Sec.
318(a)(1)(A) family attribution rules effectively were not waived, the redemption was not in
complete redemption of the son’s equity interest, and the son should have recognized a dividend, not
capital gain.

C:4-63 Section 274 requires a corporation to meet strict substantiation requirements to deduct travel
and entertainment expenses. These substantiation requirements can be found in Reg. Secs. 1.274-1
and -2. If the corporation does not meet these requirements, the outlays are nondeductible under Sec.
162. The question here is whether these disallowed expenses are considered a dividend to Charles
who incurred the expenses.

In Henry Schwartz Corp., 60 T.C. 728 (1973), a corporation was denied travel and
entertainment expense deductions because it failed to adequately substantiate the costs as required by
Sec. 274(d). It was obvious in this case that some of these expenses were for the corporate business
and thus were ordinary and necessary expenses. To the extent the outlay was ordinary and necessary
to the corporation's business; the expenses were not considered a dividend to the shareholder even
though they were disallowed to the corporation.

The IRS originally acquiesced in the Henry Schwartz Corp. decision (1974-2 C.B. 4)
concerning the portion of the disallowed expenses that were a constructive dividend. It subsequently
has nonacquiesced (1981-2 C.B. 3). Thus, the IRS likely will consider the \$10,000 expense to be a
dividend to Charles. Charles might prevail in omitting the \$10,000 from gross income if he litigated
the matter in the Tax Court based on the Henry Schwartz Corp. decision.

Additional support for the taxpayer's position may come from Palo Alto Town & Country
Village, Inc. v. CIR, 41 AFTR 2d 78-517, 78-1 USTC ¶9200 (9th Cir., 1977), where the appeals
court held that the test for a constructive dividend was twofold; "not only must the expenses be non-
deductible to the corporation, but also they must represent some economic gain or benefit to the
owner-taxpayer."

C:4-64 The points listed below are the major ones that should be covered in the memorandum to the
tax manager. The student should prepare the memorandum using proper form with good grammar
and punctuation.
1.     Under Sec. 311(b)(1), Benson Corporation must recognize gain on the distribution of
Parcel A to Scott Brown. The amount of the gain is \$35,000 (\$75,000 - \$40,000) and
its character is capital. However, under Sec. 311(a), the corporation recognizes no
loss on the distribution of Parcel B to Lynn Brown.

C:4-26
2.      Under Sec. 312, Benson must reduce its E&P by the FMV (\$75,000) of Parcel A and
by the E&P adjusted basis (\$120,000) of Parcel B. Note that the recognized gain of
\$35,000 on Parcel A was included in Benson’s taxable income and therefore
increased Benson’s E&P net of applicable tax [i.e., \$35,000 - (0.34 x \$35,000) =
\$23,100]. If Benson’s E&P basis did not equal its taxable income basis, Benson
would further adjust E&P to reflect the difference between the taxable income gain
and the E&P gain.

3.      Under APB Opinion No. 29, Benson must record both the gain on Parcel A
(\$35,000), and the loss on Parcel B (\$45,000). The dividend is then recorded as a
debit to retained earnings and a credit to property dividends at an amount equal to the
property’s FMV.

The entries then would be:

At date of declaration:

Investment in Land                                                   35,000
Gain on Appreciation of Land                                                      35,000
Loss on Depreciation of Land                                         45,000
Investment in Land                                                                45,000
Retained Earnings (Property Dividends Declared)                     150,000
Property Dividends Payable                                                       150,000

At date of distribution:

Property Dividends Payable                                          150,000
Investment in Land                                                               150,000

4.      Schedule M-1 would report the difference between the \$10,000 loss reported for book
purposes and the \$35,000 gain reported for tax purposes, which is the \$45,000 loss
disallowed for tax purposes.
C:4-65 There does not appear to be any compensatory intent for the bonus payments to John and
Jean. Rather, the bonus payments appear to be “disguised dividends.” Therefore, these payments are
likely to be treated as dividends to John and Jean and no deduction will be allowed to Plum
Corporation. See O.S.C. & Associates, Inc. v. Comm., 84 AFTR 2d 99-5735, 99-2 USTC ¶50,765
(9th Cir., 1999). In this case with similar facts, the Ninth Circuit affirmed the Tax Court in declaring
that compensation based on gross profits and proportional to stock holdings were disguised
dividends. The Court held that it was irrelevant whether the compensation or any part of it might
have represented reasonable compensation. The method of calculation of the bonuses was not based
on the value of services performed but was structured to distribute profits in proportion to stock
holdings.

C:4-27
C:4-66 Section 162(a)(1) permits a taxpayer to deduct a reasonable allowance for salaries or other
compensation for personal services actually rendered that is paid or incurred during the tax year.
Regulation Sec. 1.162-8 holds that, “The income tax liability of the recipient in respect of an amount
ostensibly paid to him as compensation, but now allowed to be deducted as such by the payor, will
depend upon the circumstances of each case.” Such amounts may be taxed to the recipient as a
dividend. But, “in the absence of evidence to justify other treatment, excessive payments for salaries
or other compensation for personal services will be included in gross income of the recipient.”
In the case at hand, it seems likely that Sara will be required to include all the amounts paid
to her as compensation, despite the disallowance of a deduction for the “unreasonable” part of the
payments by the corporation. The IRS is unlikely to reclassify the excess compensation as a
dividend because, under current law, dividends for years 2003-2010 would be taxed at a maximum
rate of 15%. The IRS is likely to follow the Sterno case (Sterno Sales Corp. v. U.S., 15 AFTR 2d
979, 65-1 USTC ¶9419 (Ct. Cl. 1965)) where the Court ruled that the taxpayer could not treat excess
compensation as a dividend just because it was more advantageous than compensation. The Court
required the taxpayer to treat the excess amounts as compensation because that was how they were
classified when paid to the taxpayer.
Revenue Ruling 69-115, 1969-1 C.B. 50, holds that shareholder-employees of a closely held
corporation are entitled to deduct as a business expense in the year of repayment the portion of the
salaries they received that were declared unreasonable compensation. Only the amounts they were
legally obligated to repay under an agreement with the corporation can be deducted. The obligation
to repay the salaries must be enforceable under state law. No deduction is available for any amounts
that are voluntarily repaid. Also see Vincent E. Oswald, 49 T.C. 645 (1968), acq. 1968-2 C.B. 2,
where the Tax Court held that a repayment was denied a deduction for amounts the shareholder
voluntarily repaid prior to the adoption of a by-laws amendment requiring such repayments.
Amounts were deductible, however, when paid after the corporation adopted a by-laws agreement
requiring repayment of nondeductible compensation payments.
In the case at hand, the unreasonable compensation equals: 2004, \$40,000; 2005, \$75,000;
and 2006, \$115,000. All the compensation is taxed in the tax year in which it is received. Only the
portion of the compensation repaid after the adoption of the by-laws amendment on December 15,
2005 can be deducted. This amount should be: 2004, \$0; 2005, \$3,125 (1/24 x \$75,000); and 2006,
\$115,000. One could treat a ratable share of the repayment as being deductible in each of the five
years in which a payment is made so that one-fifth of the 2005 and 2006 amounts [\$23,625 = 0.20 x
(\$3,125 + \$115,000)] is deductible in years 2008 through 2012.

“What Would You Do In This Situation?” Solution

Ch. C:4, p. C:4-35. The IRS Wants a Bonus Too.

You should first alert your clients that this issue is subject to scrutiny. You also should
advise your clients of the parameters used by the IRS on this issue. These would include, but not be
limited to, the contractual arrangements entered into by members of the firm, the existence of other
payments characterized as dividends (if any), and the revenue paid out during the year in proportion
to the estimated fair market value of the services rendered by the individual members of the firm.

C:4-28
You should examine the formula used to derive the bonus payment. Was it based on the percentage
of revenue earned by each shareholder, or was it based on his or her percentage of ownership in the
professional corporation?

You also should determine the tax consequences to the corporation and the shareholders.
Paying some dividends instead of all salary may not be costly because, under the 2003 Act, dividends
are taxed at a maximum rate of 15%. Also, dividends are not subject to payroll taxes. Therefore,
even though the corporation cannot deduct dividend payments, the difference in overall tax between
salary payments and dividend payments may not be great.

In any event, the final position you take should be in accordance with Para. 1.02 of the
AICPA's Statement on Standards for Tax Services No. 1, Tax Return Positions (reproduced in
Appendix E of the text). Your position should be based on a good faith belief that it has a realistic
possibility of being sustained administratively or judicially on its merits. If your views on this issue
are at variance with your client's views, you should consult your own counsel before deciding on
further recommendations and/or on whether to continue a professional relationship with that client.
As a practical matter, if your clients insist on taking a position that is at variance with that of the IRS,
you can file protective claims for the clients while these cases are litigated in court.

C:4-29

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