TC 1 - Introduction and Corporate Tax by qingyunliuliu

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									                                 MGMT 227
                        CLASS 9 – Spring 2010

         CORPORATE TAXATION –GENERAL TAX RULES

I. Main Taxation Attributes of Corporation

     A. While other Business Entities may choose separate entity or “flow
        through” taxation (Form 8832) Corporations must be taxed as a
        separate entity (absent an “S” election).

     B. Double Taxation of Income

           1. Corporation pays taxes on its own income and cannot deduct
              distributions (dividends) paid to Shareholders.

           2. Shareholders must pay taxes on dividend income they receive.

     C. Losses do not flow through, but merely create an NOL for the
        corporation (see NOL discussion below)

II. GENERAL CORPORATE TAX FORMULA:

Gross Income - Deductions = Taxable Income X Tax Rate = Tax Liability

                 Note: No AGI because it's all business-related
                 No exemptions/personal deductions

                            Personal Holding Co. Tax
           Tax Liability +  Accumulated Earnings Tax = Total Tax Liability
                            Alternative Minimum TAX

           Minus Credits (many N/A to Corps.) = Tax Due


III. GROSS INCOME: Largely the same as what we see for Individual Tax.

     A. Method of Reporting Important: (see Chart)



                                      1
                      CASH             ACCRUAL
                      BASIS             BASIS
                      When                 When
    Income           Received              Earned

                       When              When
    Deductions         Paid            Incurred**


    ** if paid within 2 ½ mos. of next tax year

    B. Accrual Basis = Most corps. (and inventory-based businesses) must
       use this & NOT cash basis. Cash Basis allowed for corps. only for

                  S Corporations
                  Farming/Timber
                  Qualified PSC’s (Personal Service Corporations)
                  Corporations earning $ 5 million or less per year
                   (average the last 3 years)

IV. DEDUCTIONS:      Similar to Individuals, but some differences:

    A. Rule: All reasonable operating expenses and certain special
       deductions can be taken by corporation.

       SEE CHART OF CORPORATE DEDUCTIONS ON NEXT PAGE

    B. Special Deductions: Some deductions are considered “special
       deduction” with unique rules (discussed in more detail later):

          1.   Dividends Received Deduction
          2.   Charitable Deductions
          3.   NOL
          4.   Net Capital Losses




                                       2
                         CORPORATE DEDUCTIONS


           DEDUCTIBLE                          NOT DEDUCTIBLE

General Business Expenses             Fines, Penalties, Punitive Damages

Compensation to workers               Executive Compensation: Maximum
                                      of $1 million each for top 5 executives

Bad Debts on Accounts Receivable      Bad Debts on A/R (Corporation =
(Corporation = Accrual Basis)         Cash Basis)

50% Meals & Entertainment             Club Dues

Goodwill purchased – Amortize over    Self-created goodwill (e.g. trademark
15 years                              registered)

Organizational Costs – Deduct first   Stock Issue Costs (includes
$5K, amortize remainder 15 years      underwriter’s fees)

State and Local Taxes                 Federal Taxes

Life Insurance Premiums –             Life Insurance Premiums –
Corporation NOT Beneficiary           Corporation is Beneficiary


     C. Dividends Received Deduction: dividends paid to corp A by corp B

        1. Problem: Triple Taxation….ABC, Inc.  XYZ Inc.  XYZ S.H.

        2. Solution: Receiving Corporation may deduct amount of dividends
           received from its income as follows:

                  70% if Corp. owns <20% of stock
                  80% if Corp. owns 20-80% of stock
                  100% if Corp. owns 80% or more of stock

                 BUT…% may apply to Income if Income is < Dividend Rec'd


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     3. Four Step Approach to Compute:

           a. Step One: Multiply DIVIDEND x %age

           b. Step Two: Taxable Income(B4 DRD) – Step One Answer

                 (1) If NEGATIVE number results: Stop – Back to S-1

                 (2) If POSITIVE number results: Proceed to S-3

           c. Step Three: Multiply %age x Taxable Income (B4 DRD)

           d. Step Four: Take the lesser of the two as as the DRD

C. Net Operating and Capital Losses:

     1. NOL - Net Operating Loss (occurs when expenses of corporation
        exceed corporate income). Rules are….

           a. Loss cannot be used that year (no flow through to TP)

           b. But, CARRYBACK 2 years, CARRY FORWARD 20 years

                  (1) Must CB first unless Irrevocable Election is Made
                  (2) Once Irrevocable Election made, no turning back.

     2. NCL – Net Capital Losses (remember for corporation):

           a. Can only use to offset or reduce Capital Gains

           b. No $ 3,000 per year as ordinary (like individuals can)

           c. CB 3 years and CF 5 years (all as STL)

D. Charitable…need to know:

        1. Usually limited to the basis of the asset (unless put to related
           use by the charity)



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           a. Compare to individuals where FMV is usually used

           b. Long Term Capital Property & Sec. 1231 Assets:

                  (1) Use FMV of property for deduction

                  (2) Exceptions: Use Basis if
                             Personal Property donated & put to
                               similar use by charity
                             Any property donated to Private NOF

           c. Ordinary Income Property:

                  (1) Use Basis of property for deduction

                  (2) Ordinary Income Property includes…

                            Inventory
                            Accounts Receivables
                            Portion of Sec. 1231 property that would
                             be ordinary gain on recapture if sold
                            Short Term Capital Property

        2. Max of 10% of Adjusted T.I.

        3. ATI includes Taxable Income, not counting the Charitable
           Cont., DRD nor loss carryback deductions (whether NOL or
           Capital)

        4. Carried Forward up to 5 years, but you must use the current
           year’s contributions first before using carried forward
           deduction

F. Organizational Expenses:

     1. Only deductible if taken in the first year of corporation’s
        existence.

     2. Deduct first $ 5,000, amortize remainder over 15 years.

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V. TAX CALCULATION:

     A. Current Tax Rates: (see inside front cover of book)

           1. Rates range from15% to 39% to 35%

           2. PSC’s = Taxed at a flat rate of 35% (PSC is an employee owned
              company usually in a service industry)

     B. Additional Taxes: (we’ll study later)

           1. Alternative Minimum Tax

           2. PHC Tax

           3. Accumulated Earnings Tax

VI. PROCEDURAL MATTERS

     A. Return always required (unlike individuals who can avoid if income is <
        standard deduction and exemption).

     B. Form 1120 usually (special short forms and Sub S forms too)

     C. Book Income vs. Taxable Income:

           1. Adjusted in the M-1 Schedule

           2. Examples: The following items are reflected in Book Income or
              Expenses but are not taxable income or deduction.

                               Book                Tax Reporting

Municipal Bond Interest        Yes                       No
Life Insurance Proceeds        Yes                       No
Deduct Federal Taxes            Yes                      No



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Deduct Charitable Cont.        Yes (100%)             Up to 10% of ATI

Deduct Exec. Compensation      Yes (100%)             No > $ 1M per exec.
                                                      (top 5 executives)

        Corporate Taxation - Organization/Capital Structure

I. Corporate Formation Tax Issues:

     A. BUYING STOCK

        1. Potential Gain: SH contributes land with a Basis of $ 10,000 (FMV
           or $ 25,000) to corporation in exchange for Stock worth $ 25,000
           FMV. Has a realized gain of $ 15,000. Should we recognize?

        2. Code distinguishes between a Realized Gain (actual money made
           on the deal) and Recognized Gain (what the tax law requires a TP
           to declare in his or her return as income).

        3. Sec. 351 provides for non-recognition of investing in corporate
           stock, if certain criteria are met.

     B. SECTION 351

           1. NO GAIN RECOGNIZED where…3 conditions ALL met:

                 Money or Property given/paid for the stock
                 Only Stock is issued to SH’s
                 SH is in “control”

           2. GAIN IS RECOGNIZED where…any 1 of the following met:

                 Services given in exchange for stock
                 Boot is received by SH (cash, debt securities, etc.)
                 SH is not “in control”

           3. Basis for SH or Corporation

                a. For SH: Basis of Property Given           Boot



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                  + Gain Recognized          lower of   <    or
                   - Boot Received                       Realized Gain
                  ___________________
                   SH’s Basis in Stock

     b. For Corporation:      Basis of Property from SH
                               + Gain to SH
                               ___________________
                               Corp’s Basis in Asset

4. What is considered Property?

      Equipment
      Accounts Receivables
      Installment Obligations (Notes Receivable)
      Intellectual Property Rights
          **Patents, Copyrights, Trademarks, Trade Names YES
          **Trade Secrets or Know How – MAYBE NOT

5. Services: Where SH donates services for stock….

     a. Gain to SH & Deduction by Corp as either ordinary or
        organizational cost (dep. 5 years).

     b. A SH giving predominantly service cannot be “counted” to
        establish the 80% control factor (see below).

     c. BUT: If SH gives property and services = Gain on services,
        but law allows SH to be “counted” to arrive at 80% plateau.
        (as long as property is not “nominal”: = or >10% of services value)

6. Only Stock Received: No $, property, debt securities or non-
   qualified preferred stock received by SH trying to qualify under
   Sec. 351 (issuance of either preferred or common stock typically
   DOES qualify).

7. Determining CONTROL: SH buying stock must have 80% Voting
   Power AND 80% of the Shares in the corporation, or the group



                              8
  that invested with said SH together with the SH has a total of
  80%.(and no plan for immediate resale).

8. Liabilities Assumed by Corp from SH: Has two effects….

     a. Does not count as “Boot” for Gain recognition purposes,
        unless
                Done to avoid taxes or for no bus. purposes
                Liability > Basis (called “excess liability”)

     b. DOES reduce SH’s basis in stock

9. Avoiding taxation for “sweat equity” or other situations where
   stock is not issued for cash or property:

  a. SRF – Substantial risk of forfeiture (if SH does not yet have
     “unfettered rights” in stock – e.g. subject to redemption unless
     SH works for the corporation for 3 years).

  b. Two Classes of Stock: Issue preferred stock only to non
     service providers and common stock to service providers
     (therefore value of services can be relatively low and we
     minimize taxation).

  c. ISO (Incentive Stock Options): No gain when ISO is issued nor
     is there gain when exercised. Recognition of Gain only occurs
     when stock is sold by SH.

  d. Accounts Receivables: If SH has A/R from unrelated parties,
     can transfer those in as “property”.

  e. Contract Rights: E.g. promoter signs favorable lease with
     landlord before corporation is formed and then transfers the
     contract to the corporation (it is considered intangible property)




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                 ADDITIONAL CORPORATE TAXES

I. ALTERNATIVE MINIMUM TAX

    A. Basically it is an alternative FLAT TAX charged against a corporation
       after certain adjustments are made to its income.

    B. The tax is 20% and there is an exemption.

    C. If the AMT is higher than the Regular Income Tax, then the corporation
       pays the higher of the two.

    D. Not imposed on “small corporations” (< $5 million per year in income
       for the last 3 years)

II. ACCUMULATED EARNINGS TAX:

    A. Why the Tax?

      1. Problem: Corporation helps a SH avoid taxation by retaining
         earnings instead of paying them out in dividends.

      2. Solution: Accumulated Earnings Tax (AET) when a corporation
         keeps “too much” of its earnings and doesn’t distribute to SH’s.

    B. Basics:

      1. Retained earnings for purposes of avoiding SH taxation will be
         subject to the maximum tax for individuals (now 35%).

      2. INTENT is required:

         a. Usually a problem for small or closely-held corporations where
            SH’s & corporate board have close interactions and can plan "tax
            avoidance schemes”.

         b. If the corporation is a holding company or investment company =
            presumed to be for tax avoidance (although remember: The



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             PHC and AET tax will not BOTH be imposed. Only one or the
             other).

   C. The Tax:

     1. Not applicable to…

          a. Subchapter S corporations
          b. PHC
          c. Non-profit corporations

     2. Imposed ON TOP OF regular income tax and alternative minimum
        tax (so a TP corporation could easily pay ¾ of its income to the IRS
        if it doesn’t plan carefully).

     3. Minimum Credit: Regardless of business needs, corporations can
        keep the following amounts even if not “needed” for business
        reasons, and there will be no tax…

                (1) $ 250,000 for trading company (inventory, goods)

                (2) $ 150,000 for non-trading (service) companies

   D. Reasonable Needs of Business: Includes the following…

     1.   Expansion of the business.
     2.   To retire debt (pay off corporate loans, bonds, etc.)
     3.   Working Capital needs
     4.   Extending credit to customers or suppliers
     5.   Realistic business contingencies (e.g. lawsuits)

   E. Avoiding the AET: To reduce the income subject to the AET, a
      corporation can issue Actual Dividends (before the tax year closes) or
      Consent Dividends (after tax year closes – see discussion of Consent
      Dividends in PHC section)

III. PERSONAL HOLDING COMPANY TAX

   A. Why the Tax:


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  1. Rich folks will incorporate to lower their tax rate (individuals pay
     higher rates than corporations).

  2. SOLUTION: Penalty Tax = 15% (current dividend tax) for income
     retained by PHC (and not distributed to its high income SH’s).

  3. PHC – What is it?

  1. A corporation that meets two tests (both must be met):

     a. Stock Ownership Test: > 50% of shares held by 5 or fewer SH’s
        in last ½ of the year.

     b. Gross Income Test: At least 60% of corporate income is from one
        of the following sources…

        (1) Passive income
                 --or--
        (2) Personal services of a key SH

     a. Related parties are lumped together and = 1 SH.

B. Calculating the Tax:

  1. Penalty Tax (highest individual bracket) on top of regular income
     tax.

  2. Dividends Paid Deduction: Lower the PHC Income by…

     a. Dividends actually paid during the tax year IF pro-rata.

     b. Consent Dividends (= income to SH), even if made after the tax
        year has closed, as long as made by time return is filed.

     c. Deficiency Dividends: Paid within 90 days of determination that
        PHC tax is due.

     d. Federal Income Taxes Paid




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    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. E & P = similar to book income:

     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: CEP and AEP must be combined in the
        following way to arrive at overall E&P:

             Current E&P      Acc. E&P     E&P

                +                 +        Add together - all income

                -                 -        All=return of capital; no income

                +                 -        Ignore AEP; treat CEP as income

                -                 +        Net together: if positive = income

     E. Property Distributions: Effects are as follows…

          1. To SH’s: 3 things to know…

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

                b. Reduce FMV by any liability assumed by SH.

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

          2. To Corporation: Must recognize a “gain” if property distributed
             when FMV>Inside Basis. CANNOT, however, recognize a “loss”


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                 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.

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.


      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:


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  1. Retirement
  2. Death
  3. Divorce

D. To qualify for sale or exchange treatment (as capital
   gain/loss)…various methods possible:

  1. Not Essentially Equivalent:

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

     b. Look for reductions in VOTING AND EARNING Power…

     c. EXAMPLES:

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

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

     d.    Effect on Stock Basis:

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

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

  2. Disproportionate Redemption: If 2 tests met, redemption qualifies:

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

             --AND--



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

         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).

       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
               Loss.

         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.

         2. Exceptions:

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

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

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     C. Effect on SH:

       1. CASH = Capital Gain or Loss

       2. PROPERTY = Treat FMV as “cash”…results in 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
                      survivor
                          (1) A + B = A
                         (2) SH’s of A & B receive shares of the “new” A
                   b. Triangular Merger:
                          (1) Parent Corporation buys Target Corporation.
                          (2) Target Corporation SH’s get shares of Parent (so
                              tax free0
                          (3) Target Corporation is merged into Subsidiary of
                              Parent Corporation
                          (4) Result:
                                i. Target’s assets & liabilities now part of
                                   subsidiary, but Target SH’s now own shares
                                   in the Parent Corporation.
                                ii. Target has now “disappeared”. Parent &
                                    Subsidiary “survive”.
                               iii. P buys T; T + S = S; now P & S survive
                               iv. Picture this…
                                                 buys
                                        P
                                                           T
                                        .
                                            17
                                            merges into

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

                          P
                          .             merges into
                                                          T
                              creates


                                        S

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


                              18
                 A shares.

II.   TAXATION OF MERGERS & ACQUISITIONS
      A. Basic Corporate Taxation:

            1.   Sale of Stock – Leads to Capital Gains & special 0/15% tax
                 rates
            2.   Sale of Assets – Leads to § 1231 Gains at 0/15% or ordinary
                 gains (or 25%) on depreciation recapture.

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

            1.   368(a) – Called a Type A Merger
                   a.   Applies to Mergers and Consolidations
                   b.   Tax Free exchange – no tax to SH’s or corporations
                   c.   REQUIREMENT: Must be a “continuity of interest” – in
                        other words, the disappearing corporation’s SH will
                        continue to have an interest (stock ownership, for
                        example) in the survivor corporation.
                   d.   Stock and Asset basis from “disappearing” corporation
                        carries over to “surviving” corporation.
                   e.   Any cash involved = Boot = taxable income to SH’s
                        (capital gains)
                   f.   If Debt and Stock involved…
                            (1) Still qualifies so long as stock is “a substantial part”
                                [generally > 50%] of the deal.
                           (2) Debt Securities portion of it, however, is
                               considered boot = taxable income.
                   g. Rules apply the same to Triangular Mergers.
                   h. Reverse Triangular Mergers, however, requires that at
                      least 80% of the acquired stock of the target must be
                      acquired solely with stock (and not boot or cash).
                   i. BETTER than a Stock Exchange (Type B) because
                      boot/cash/debt can be partially involved and the deal still
                      qualifies for non-recognition.


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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
               stock.
           (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 &
         corporation.
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
              assets
                    90% or more of FMV of selling corporation’s
                      net assets
                    70% of the FMV of gross (total) assets
           (3) Acquired solely for stock of acquiring corporation
               (no boot)
           (4) Assumption of liabilities is allowed as part of the
               deal (still considered “tax free”)
           (5) Boot permitted (cash/debt securities/assumption of
               liability) so long as long as 80% of assets
               purchased with stock only.
           (6) DISTRIBUTION TO SH’S: The selling corporation
               must distribute all of the stock received and any
               remaining assets it has to its SH’s.



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