Tax CHP 7 Answer Key

Chapter 07 - Corporate Taxation: Nonliquidating Distributions
Chapter 7
Corporate Taxation: Nonliquidating Distributions
SOLUTIONS MANUAL
DISCUSSION U!STIONS
1. [LO1 !hat is "eant b# the ter" double taxation of corporate income$
The term double taxation refers to the fact that under the U.S. system of taxation,
corporate earnings are first taxed when earned by a C corporation and then are taxed a
second time when the earnings are distributed to the shareholders as a dividend.
%. [LO1 &o' does the issue o( double taxation arise 'hen a )orporation de)ides bet'een
"a*ing a distribution to a shareholder e"plo#ee as a di+idend or )o"pensation$
A distribution characterized as a dividend is subect to double taxation, first at the
corporate level and then a second time at the shareholder level, because a corporation
cannot deduct it from taxable income. A distribution characterized as compensation is
taxed only once, at the recipient level, because it is deducted by the corporation.
,. [LO1 !h# "ight a shareholder 'ho is also an e"plo#ee pre(er re)ei+ing a di+idend
instead o( )o"pensation (ro" a )orporation$
An individual might prefer a dividend to compensation because the dividend is eligible for
a preferential tax rate if the individual employee!shareholder is below a certain income
level, whereas compensation is always taxed at the ordinary tax rates, which could be as
high as "#.$ percent.
-. [LO% !hat are the three potential tax treat"ents o( a )ash distribution to a shareholder$
.re these potential tax treat"ents ele)ti+e b# the shareholder$
A cash distribution to a shareholder can be characterized as %& dividend to the extent of
earnings and profits, '& tax(free return of capital to the extent of the shareholder)s tax
basis in the stoc*, or "& gain from sale of the stoc* +capital gain&. The tax law +section
",%+c&& prescribes the tax treatment of the distribution- it is not elective by the
shareholder.
/. [LO% 0n general1 'hat is the )on)ept o( earnings and pro(its designed to represent$
.arnings and profits is intended to represent the corporation)s ability to pay distributions
to its shareholders without eroding its invested capital. .arnings and profits is designed
to reflect the corporation)s economic income, a broader concept than its taxable income.
2. [LO% &o' does current earnings and profits di((er (ro" accumulated earnings and
profits$ 0s there an# )ongressional logi) (or *eeping the t'o a))ounts separate$
7-1
3 %01- b# 4)5ra'-&ill 6du)ation. This is proprietar# "aterial solel# (or authori7ed instru)tor use. Not authori7ed (or sale or distribution in
an# "anner. This do)u"ent "a# not be )opied1 s)anned1 dupli)ated1 (or'arded1 distributed1 or posted on a 'ebsite1 in 'hole or part.
Current earnings and profits represents the corporation)s earnings and profits of the
current year before reduction +/diminution0& by any distributions made during the year.
Accumulated earnings and profits represents undistributed earnings and profits from all
years prior to the current year. Congress created this distinction in %#"$ when distributed
current year earnings were taxed at the corporate level at a lower rate than undistributed
earnings. This dual level of taxation was repealed in %#"#, but the congressional
distinction between current and accumulated earnings and profits remained in the law.
7. [LO% True or 8alse. . )alendar-#ear )orporation has positi+e )urrent 69: o( ;100 and
a))u"ulated negati+e 69: o( ;%00. . )ash distribution o( ;100 to the )orporation<s sole
shareholder at #ear-end 'ill not be treated as a di+idend be)ause total 69: is negati+e
;100. 6xplain.
1alse. The 2%,, distribution will be treated as a dividend because it does not exceed
current earnings and profits.
=. [LO% True or 8alse. . )alendar-#ear )orporation has negati+e )urrent 69: o( ;100 and
a))u"ulated 69: o( ;100. . )ash distribution o( ;100 to the )orporation<s sole
shareholder on >une ,0 'ill not be treated as a di+idend be)ause total 69: at De)e"ber
,1 is ;0. 6xplain.
1alse. A portion of the distribution could be treated as a dividend based on accumulated
earnings and profits on 3une ",. 4f the current year deficit is earned ratably over the
year, accumulated earnings and profits on 3une ", would be 25, 62%,, ( %7%!"$5 x
+2%,,&8. A deficit in current earnings and profits is allocated on a per day basis unless
determined by tracing specific items that caused the deficit.
?. [LO% List the (our basi) ad@ust"ents that a )orporation "a*es to taxable in)o"e or net
loss to )o"pute )urrent 69:. !hat is the rationale (or "a*ing these ad@ust"ents$
A corporation adusts its taxable income or loss by the following general items to
compute current .9:;
%. 4nclusion of income that is excluded from taxable income
'. <isallowance of certain expenses that are deducted in computing taxable income but
do not re=uire an economic outflow
". <eduction of certain expenses that are excluded from the computation of taxable
income but do re=uire an economic outflow
>. <eferral of deductions or acceleration of income due to separate accounting methods
re=uired for .9: purposes
10. [LO% !hat "ust a shareholder )onsider in )o"puting the a"ount o( a non)ash
distribution to in)lude in her gross in)o"e$
7-%
A shareholder must determine the fair mar*et value of the distribution and any liability
she will assume on receipt of the property. The shareholder)s dividend amount is the fair
mar*et value of the property received less any liability assumed on the property.
11. [LO% !hat in)o"e tax issues "ust a )orporation )onsider be(ore it "a*es a non)ash
distribution to a shareholder$
A corporation must determine if the property)s fair mar*et value exceeds or is less than
the property)s tax basis. To the extent the fair mar*et value exceeds the tax basis, the
corporation recognizes gain on the distribution. Corporations cannot recognize loss if
the property)s fair mar*et value is less than the tax basis.
1%. [LO% !ill the shareholder<s tax basis in non)ash propert# re)ei+ed equal the a"ount she
in)ludes in gross in)o"e as a di+idend$ Ander 'hat )ir)u"stan)es 'ill the a"ounts be
di((erent1 i( an#$
?ot always. @here the shareholder assumes a liability attached to the property, the
amount of the dividend income is computed as the property)s fair mar*et value less the
liability assumed +section ",%+b&&. The shareholder ta*es a tax basis in the property
e=ual to its fair mar*et value, not reduced by the liability assumed +section ",%+d&&.
1,. . shareholder re)ei+es appre)iated non)ash propert# (ro" his )orporation and assu"es a
liabilit# atta)hed to the propert#. &o' does the liabilit# assu"ption a((e)t the a"ount o(
di+idend he reports in gross in)o"e$
The shareholder)s assumption of a liability attached to noncash property reduces the
amount of the dividend income reported.
1-. . shareholder re)ei+es appre)iated non)ash propert# (ro" his )orporation and assu"es a
liabilit# atta)hed to the propert#. &o' does this assu"ption a((e)t the a"ount o( gain the
)orporation re)ogni7es$ 8ro" the )orporation<s perspe)ti+e1 does it "atter i( the liabilit#
assu"ed b# the shareholder ex)eeds the propert#<s gross (air "ar*et +alue$
4n general, the shareholder)s assumption of a liability attached to appreciated noncash
property distributed as a dividend does not affect the gain recognized by the corporation.
Aain recognized is the property)s fair mar*et value less the property)s tax basis. 4f the
liability assumed by the shareholder exceeds the property)s fair mar*et value, the property
is deemed to have a fair mar*et value e=ual to the liability assumed for purposes of
determining the gain recognized by the corporation.
1/. [LO% . )orporation distributes appre)iated non)ash propert# to a shareholder as a
di+idend. !hat i"pa)t does the distribution ha+e on the )orporation<s earnings and
pro(its$
The corporation reduces .9: by the lesser of the property)s fair mar*et value or .9:
adusted basis, reduced by any liability assumed by the shareholder on the distribution.
7-,
12. [LO, ."# is the sole shareholder o( her )orporation. Bather than ha+e the )orporation
pa# her a di+idend1 ."# de)ides to ha+e the )orporation de)lare a CbonusD at #ear-end
and pa# her tax-dedu)tible )o"pensation. !hat potential tax issue "a# arise in this
situation$ !hi)h parties1 ."# or the )orporation or both1 are a((e)ted b# the
)lassi(i)ation o( the pa#"ent$
The 4BS might argue that a portion of the distribution is really a disguised dividend if the
compensation is /unreasonable.0 4f the 4BS prevails, the corporation will be denied a
deduction for the portion of the /bonus0 determined to be a disguised dividend. Amy will
now be eligible for a reduced rate of tax on the dividend portion of her /bonus0 and will
not be subect to payroll taxes on the recharacterized amount.
17. [LO- !h# "ight a )orporation issue a sto)* di+idend to its shareholders$
Corporations often issue stoc* dividends as a goodwill gesture to their shareholders when
they do not have sufficient cash to ma*e a distribution. Cany times, corporations will
engage in a stoc* split to increase the number of shares outstanding and lower the trading
price of the stoc* to ma*e it more accessible to a broader class of investors.
1=. [LO- !hat tax issue arises 'hen a shareholder re)ei+es a nontaxable sto)* di+idend$
The shareholder must allocate some of the tax basis of the existing stoc* to the new stoc*
received based on the relative fair mar*et values of the existing and newly issued stoc*.
1?. [LO- 0n general1 'hat )auses a sto)* di+idend to be taxable to the re)ipient$
Stoc* dividends generally are taxable when they result in, or have the potential to result
in, a change in the proportionate stoc* ownership of the existing shareholders. 1or
example, where a shareholder can choose between cash or stoc*, there exists the
possibility that some shareholders will choose cash and some will choose stoc*. Those
who choose stoc* will increase their ownership percentage relative to those who choose
cash. 4n this cash, the stoc* dividend will be taxable to those who choose to receive stoc*.
%0. [LO/ !hat are the potential tax )onsequen)es to a shareholder 'ho parti)ipates in a
sto)* rede"ption$
A shareholder who participates in a stoc* redemption potentially could treat the
distribution as an exchange +section ",'& or as a property distribution +potentially a
dividend& under section ",%.
%1. [LO/ !hat sto)* o'nership tests "ust be "et be(ore a shareholder re)ei+es ex)hange
treat"ent under the substantiall# disproportionate )hange-in-sto)*-o'nership test in a
sto)* rede"ption$ !h# is a )hange in sto)* o'nership test used to deter"ine the tax
status o( a sto)* rede"ption$
7--
A shareholder meets the substantially disproportionate change(in(stoc*(ownership test by
satisfying three mechanical stoc* ownership tests;
%. 4mmediately after the exchange the shareholder owns less than 5,D of the total
combined voting power of all classes of stoc* entitled to vote-
'. The shareholder)s percentage ownership of voting stoc* after the redemption is less
than 7,D of his or her percentage ownership before the redemption- and
". The shareholder)s percentage ownership of the aggregate fair mar*et value of the
corporation)s common stoc* +voting and nonvoting& after the redemption is less than 7,D
of his or her percentage ownership before the redemption.
The Code uses a change in stoc* ownership test to determine the tax status of a stoc*
redemption to distinguish between transactions that resemble sales from transactions that
are in substance a dividend distribution +that is, a transaction in which the shareholder
does not meaningfully change her stoc* ownership in the company&.
%%. [LO/ !hat are the )riteria to "eet the Cnot essentiall# equi+alent to a di+idendD )hange-
in-sto)*-o'nership test in a sto)* rede"ption$
To satisfy the /not essentially e=uivalent to a dividend0 re=uirement, the 4BS or a court
must conclude that there has been a /meaningful0 reduction in the shareholder)s
ownership interest in the corporation as a result of the redemption. The Code does not
provide any mechanical tests to ma*e this determination. At a minimum, the 4BS and
courts generally re=uire the shareholder to reduce his stoc* ownership as a result of the
transaction and own 5, percent or less of the stoc* after the transaction.
%,. [LO/ !hen "ight a shareholder ha+e to rel# on the not essentiall# equi+alent to a
di+idend test in arguing her sto)* rede"ption should be treated as an ex)hange (or tax
purposes$
A shareholder will have to rely on this test if she cannot meet either the /substantially
disproportionate test0 or the /complete termination of interest0 test, which rely on a
mechanical set of criteria.
%-. [LO/ !h# do #ou thin* the tax la' i"poses )onstru)ti+e sto)* o'nership rules on sto)*
rede"ptions$
The tax law imposes constructive ownership tests to prevent a shareholder from
technically disposing of his stoc* interest while effectively continuing to own stoc*
through family members or through ownership in an entity that nominally owns the stoc*.
%/. [LO/ !hi)h "e"bers o( a (a"il# are in)luded in the (a"il# attribution rules$ 0s there
an# rationale (or the (a"il# "e"bers in)luded in the test$
7-/
1amily members include spouse, children, parents, and grandchildren. These are the
family members that are the most closely related to the shareholder by blood. 1amily
members excluded are grandparents, brothers and sisters, aunts and uncles, and nieces,
nephews, and cousins.
%2. [LO/ 0l#a and Olga are brother and sister. 0l#a o'ns %00 shares o( sto)* in :ar*er
Corporation. 0s Olga dee"ed to o'n 0l#a<s %00 shares under the (a"il# attribution rules
that appl# to sto)* rede"ptions$
?o. A brother and sister are not included under the family attribution rules.
%7. [LO/ 4aria has all o( her sto)* in 4a#an Corporation redee"ed. Ander 'hat
)onditions 'ill 4aria treat the rede"ption as an ex)hange and re)ogni7e )apital gain or
loss$
Caria will treat the stoc* redemption as an exchange if she does not own any additional
stoc* through attribution that causes her to fail either of the other two stoc* ownership
tests. 4f she only owns stoc* constructively through the family attribution rules, she can
waive the family attribution rules by filing a triple i agreement with the 4BS and avoid
ac=uiring a prohibited interest in the corporation for %, years +for example, as an
employee or independent contractor&.
%=. [LO/ !hat "ust a shareholder do to 'ai+e the (a"il# attribution rules in a )o"plete
rede"ption o( sto)*$
A shareholder must file a triple i agreement with the 4BS and refrain from having a
prohibited interest +shareholder, employee, director, officer, or consultant& for %, years.
The shareholder must agree to notify the 4BS district director within ", days if he or she
ac=uires a prohibited interest within %, years after the redemption.
%?. [LO/ &o' does a )orporation<s )o"putation o( earnings and pro(its di((er based on the
tax treat"ent o( a sto)* rede"ption to the shareholder Ethat is1 as either a di+idend or
ex)hangeF$
4f the redemption is treated as a dividend, the corporation reduces .9: using the
dividend reduction rules. 4f the redemption is treated as an exchange, the corporation
reduces .9: at the date of distribution by the percentage of stoc* redeemed, not to
exceed the fair mar*et value of the property distributed. The distributing corporation
reduces its .9: by any dividend distributions made during the year before reducing its
.9: for redemptions treated as exchanges.
,0. [LO2 &o' does the tax treat"ent o( a partial liquidation di((er (ro" a sto)* rede"ption$
4n a partial li=uidation, the shareholders have prescribed tax treatments; individuals
receive exchange treatment and corporations treat the distribution as a dividend to the
7-2
extent of earnings and profits. 4n a stoc* redemption, each shareholder)s tax treatment
depends on whether a change in stoc* ownership re=uirement is met.
,1. [LO2 Ge+o Corporation experien)ed a )o"plete loss o( its "ill as the result o( a (ire.
The )o"pan# re)ei+ed ;% "illion (ro" the insuran)e )o"pan#. Bather than rebuild1 Ge+o
de)ided to distribute the ;% "illion to its t'o shareholders. No sto)* 'as ex)hanged in
return. Ander 'hat )onditions 'ill the distribution "eet the require"ents to be a partial
liquidation and not a di+idend$ !h# does it "atter to the shareholders$
1or a distribution to be in partial li=uidation of the corporation, it must either be /not
essentially e=uivalent to a dividend0 +as determined at the corporate level& or be the
result of the termination of a /=ualified trade or business.0 4n this case, the test li*ely
will be whether the use of the mill constituted a =ualified trade or business. The
determination matters most to individuals, who will receive exchange treatment if the
transaction is a partial li=uidation and a potential dividend if not.
Problems
,%. [LO1 5opher Corporation reported taxable in)o"e o( ;/001000 this #ear. 5opher paid a
di+idend o( ;1001000 to its sole shareholder1 H+en .nderson. 5opher Corporation is
sub@e)t to a (lat rate tax o( ,-I. The di+idend "eets the require"ents to be a quali(ied
di+idend and H+en is sub@e)t to a tax rate o( 1/I on the di+idend. !hat is the in)o"e tax
i"posed on the )orporate in)o"e earned b# 5opher and the in)o"e tax on the di+idend
distributed to H+en$
Corporate tax; 25,,,,,, ">D 2%E,,,,,
Shareholder tax; 2%,,,,,, %5D %5,,,,
Total income tax 2%75,,,,
,,. [LO1 Gulldog Corporation reported taxable in)o"e o( ;/001000 this #ear be(ore an#
dedu)tion (or an# pa#"ent to its sole shareholder and e"plo#ee1 5eorgia Gro'n. Gulldog
)hose to pa# a bonus o( ;1001000 to 5eorgia at #ear-end. Gulldog Corporation is sub@e)t
to a (lat-rate tax o( ,-I. The bonus "eets the require"ents to be CreasonableD and is
there(ore dedu)tible b# Gulldog. 5eorgia is sub@e)t to a "arginal tax rate o( ,/I on the
bonus. !hat is the in)o"e tax i"posed on the )orporate in)o"e earned b# Gulldog and
the in)o"e tax on the bonus paid to 5eorgia$
Corporate tax; 2>,,,,,, ">D 2%"$,,,,
Shareholder tax; 2%,,,,,, "5D "5,,,,
Total income tax 2%E%,,,,
Fulldog Corporation reduces the /double tax0 imposed on the distribution by 2">,,,,
+2%,,,,,, x ">D& by reducing its taxable income through the use of tax(deductible
compensation.
7-7
,-. [LO% &a'*e#e Co"pan# reports )urrent 69: o( ;,001000 this #ear and a))u"ulated
69: at the beginning o( the #ear o( ;%001000. &a'*e#e distributed ;-001000 to its sole
shareholder1 Ba# Jinsella1 on De)e"ber ,1 o( this #ear. Ba#<s tax basis in his &a'*e#e
sto)* is ;7/1000.
a. &o' "u)h o( the ;-001000 distribution is treated as a di+idend to Ba#$
All 2>,,,,,, is treated as a dividend because the distribution is less than the
company)s total earnings and profits of 25,,,,,,.
b. !hat is Ba#<s tax basis in his &a'*e#e sto)* a(ter the distribution$
Bay)s tax basis in his Gaw*eye stoc* remains 2E5,,,,.
). !hat is &a'*e#e<s balan)e in a))u"ulated 69: as o( >anuar# 1 o( next #ear$
Accumulated .9: as of 3anuary % is 2%,,,,,,, computed as 25,,,,,, ( 2>,,,,,,.
,/. [LO% >a#ha'* Co"pan# reports )urrent 69: o( ;,001000 and a))u"ulated 69: o(
negati+e ;%001000. >a#ha'* distributed ;-001000 to its sole shareholder1 Christine Bo)*1
on the last da# o( the #ear. Christine<s tax basis in her >a#ha'* sto)* is ;7/1000.
a. &o' "u)h o( the ;-001000 distribution is treated as a di+idend to Christine$
Christine has dividend income of 2",,,,,,, all of which is from the company)s
current .9:.
b. !hat is Christine<s tax basis in her >a#ha'* sto)* a(ter the distribution$
Christine reduces her tax basis in the 3ayhaw* stoc* by 2E5,,,, to 2,, which is the
lesser of the distribution in excess of current .9: +2%,,,,,,& or her basis in the
3ayhaw* stoc* +2E5,,,,&. The remaining 2'5,,,, is treated as gain from sale of the
3ayhaw* stoc* +capital gain&.
). !hat is >a#ha'*<s balan)e in a))u"ulated 69: on the (irst da# o( next #ear$
3ayhaw* has a deficit in accumulated .9: of negative 2',,,,,,. Current .9:
was reduced to 2,, leaving a carryover of the beginning of the year accumulated
.9:.
,2. [LO% This #ear Hooner Co"pan# reports )urrent 69: o( negati+e ;,001000. 0ts
a))u"ulated 69: at the beginning o( the #ear 'as ;%001000. Hooner distributed
;-001000 to its sole shareholder1 Goo"er !ells1 on >une ,0 o( this #ear. Goo"er<s tax
basis in his Hooner sto)* is ;7/1000.
a. &o' "u)h o( the ;-001000 distribution is treated as a di+idend to Goo"er$
7-=
Foomer reports a dividend of 25,,,,,. Ge first computes balance in .9: as of
3une ",, ',%, by allocating the deficit in current .9: pro rata over the year. The
deficit in current .9: on 3une ", is negative 2%5,,,,,, computed as 6+2",,,,,,& x
$!%'8. Gence, accumulated .9: as of 3une ",, ',%, is 25,,,,,, computed as
2',,,,,, ( 2%5,,,,,.
b. !hat is Goo"er<s tax basis in his Hooner sto)* a(ter the distribution$
Foomer)s tax basis in his Sooner stoc* is 2,, which is his beginning tax basis of
2E5,,,, less the lesser of the distribution in excess of accumulated .9: +2"5,,,,,&
or his basis in the Sooner stoc* +2E5,,,,&. The remaining 2'5,,,,, is treated as
gain from sale of the Sooner stoc* +capital gain&.
). !hat is Hooner<s balan)e in a))u"ulated 69: on the (irst da# o( next #ear$
Sooner)s balance in accumulated .9: is 2+%5,,,,,&, computed as follows;
Accumulated .9:, beginning of this year 2',,,,,,
Current .9: +",,,,,,&
<ividend paid + 5,,,,,&
Accumulated .9:, end of the year 2+%5,,,,,&
The deficit e=uals the deficit in current .9: that arose after the dividend
payment 6+2",,,,,,& x $!%'8.
,7. [LO% Gla)*ha'* Co"pan# reports )urrent 69: o( negati+e ;,001000. 0ts a))u"ulated
69: at the beginning o( the #ear 'as a negati+e ;%001000. Gla)*ha'* distributed
;-001000 to its sole shareholder1 4elanie Bush"ore1 on >une ,0 o( this #ear. 4elanie<s
tax basis in her Gla)*ha'* sto)* is ;7/1000.
a. &o' "u)h o( the ;-001000 distribution is treated as a di+idend to 4elanie$
2,. ?o part of the distribution is treated as a dividend because both current and
accumulated .9: are negative.
b. !hat is 4elanie<s tax basis in her Gla)*ha'* sto)* a(ter the distribution$
Celanie)s tax basis in her Flac*haw* stoc* is 2,, which is her beginning tax basis
less the lesser of the distribution in excess of accumulated .9: +2>,,,,,,& or her
basis in the Flac*haw* stoc* +2E5,,,,&. The remaining 2"'5,,,, is treated as gain
from sale of the Flac*haw* stoc* +capital gain&.
). !hat is Gla)*ha'*<s balan)e in a))u"ulated 69: on the (irst da# o( next #ear$
?egative 25,,,,,,, the combined deficit in the beginning balance in accumulated
.9: and the deficit in current .9:.
7-?
,=. [LO% This #ear >olt 0n). reported ;-01000 o( taxable in)o"e be(ore an# )haritable
)ontribution dedu)tion. >olt )ontributed ;101000 this #ear to 5ood'ill 0ndustries1 a publi)
)harit#. Co"pute the )o"pan#<s )urrent 69:.
Taxable income before charitable contribution deduction 2>,,,,,
Charitable contribution limited to %,D of taxable income >,,,,
Taxable 4ncome 2"$,,,,
1ederal income taxes 25,>,,
Taxable income 2"$,,,,
Hess Charitable contribution carryover +$,,,,&
Hess 1ederal income taxes +5,>,,&
Current .9: 2'>,$,,
,?. [LO% Goiler"a*er1 0n). reported taxable in)o"e o( ;/001000 this #ear and paid (ederal
in)o"e taxes o( ;1701000. Not in)luded in the )o"pan#<s )o"putation o( taxable in)o"e
is tax-exe"pt in)o"e o( ;%010001 disallo'ed "eals and entertain"ent expenses o(
;,010001 and disallo'ed expenses related to the tax-exe"pt in)o"e o( ;11000.
Goiler"a*er dedu)ted depre)iation o( ;1001000 on its tax return. Ander the alternati+e
E69:F depre)iation "ethod1 the dedu)tion 'ould ha+e been ;201000. Co"pute the
)o"pan#<s )urrent 69:.
Taxable income 25,,,,,,
Add;
Tax(exempt interest ',,,,,
.xcess of regular tax deprecation over .9: depreciation >,,,,,
Subtract;
1ederal income taxes +%E,,,,,&
<isallowed portion of meals and entertainment +",,,,,&
<isallowed expenses related to tax(exempt income + %,,,,&
Current .9: 2"5#,,,,
-0. [LO% 5ator1 0n). reported taxable in)o"e o( ;110001000 this #ear and paid (ederal
in)o"e taxes o( ;,-01000. 0n)luded in the )o"pan#<s )o"putation o( taxable in)o"e is
gain (ro" sale o( a depre)iable asset o( ;/01000. The in)o"e tax basis o( the asset 'as
;1001000. The 69: basis o( the asset using the alternati+e depre)iation s#ste" 'as
;17/1000. Co"pute the )o"pan#<s )urrent 69:.
7-10
Taxable income 2%,,,,,,,,
Subtract;
1ederal income taxes +">,,,,,&
Begular tax gain from sale of asset +2%5,,,,, ( 2%,,,,,,& + 5,,,,,&
.9: loss from sale of asset +2%5,,,,, ( 2%E5,,,,& + '5,,,,&
Current .9: 2575,,,,
-1. [LO% :aladin1 0n). reported taxable in)o"e o( ;110001000 this #ear and paid (ederal
in)o"e taxes o( ;,-01000. The )o"pan# reported a )apital gain (ro" sale o( in+est"ents
o( ;1/010001 'hi)h 'as partiall# o((set b# a ;1001000 net )apital loss )arr#o+er (ro" last
#ear1 resulting in a net )apital gain o( ;/01000 in)luded in taxable in)o"e. Co"pute the
)o"pan#<s )urrent 69:.
Taxable income 2%,,,,,,,,
Add;
?CH carryover %,,,,,,
Subtract;
1ederal income taxes +">,,,,,&
Current .9: 2E$,,,,,
-%. [LO% Kolunteer Corporation reported taxable in)o"e o( ;/001000 (ro" operations (or
this #ear. The )o"pan# paid (ederal in)o"e taxes o( ;1701000 on this taxable in)o"e.
During the #ear1 the )o"pan# "ade a distribution o( land to its sole shareholder1 Bo)*#
Topp. The land<s (air "ar*et +alue 'as ;7/1000 and its tax and 69: basis to Kolunteer
'as ;%/1000. Bo)*# assu"ed a "ortgage atta)hed to the land o( ;1/1000. .n# gain (ro"
the distribution 'ill be taxed at ,- per)ent. The )o"pan# had a))u"ulated 69: o(
;7/01000 at the beginning o( the #ear.
a. Co"pute Kolunteer<s total taxable in)o"e and (ederal in)o"e tax.
Taxable income from operations 25,,,,,,
Aain on distribution of land +2E5,,,, ( 2'5,,,,& 5,,,,,
Total taxable income 255,,,,,
1ederal income tax +255,,,,, x ">D& %7E,,,,
b. Co"pute Kolunteer<s )urrent 69: be(ore the distribution.
Taxable income 255,,,,,
Subtract;
1ederal income tax +%7E,,,,&
Adustment for .9: gain on distribution of land + ,&
Current .9: 2"$",,,,
7-11
). Co"pute Kolunteer<s a))u"ulated 69: at the beginning o( next #ear.
Current .9: 2"$",,,,
Subtract;
1air mar*et value of land distributed this year +E5,,,,&
Add;
Cortgage assumed by Boc*y %5,,,,
C.9: after distribution 2",",,,,
Accumulated .9:, beginning of this year E5,,,,,
Accumulated .9:, beginning of next year 2%,,5",,,,
d. !hat a"ount o( di+idend in)o"e does Bo)*# report as a result o( the distribution$
Boc*y reports dividend income of 2$,,,,,, computed as the fair mar*et value of the
land received +2E5,,,,& less the liability he assumes +2%5,,,,&.
e. !hat is Bo)*#<s in)o"e tax basis in the land re)ei+ed (ro" Kolunteer$
2E5,,,,. Boc*y)s income tax basis in the land e=uals its fair mar*et value.
-,. [LO% Tiger Corporation reported taxable in)o"e o( ;/001000 (ro" operations (or this
#ear. The )o"pan# paid (ederal in)o"e taxes o( ;1701000 on this taxable in)o"e.
During the #ear1 the )o"pan# "ade a distribution o( land to its sole shareholder1 4i*e
!oods. The land<s (air "ar*et +alue 'as ;7/1000 and its tax and 69: basis to Tiger 'as
;1%/1000. 4i*e assu"ed a "ortgage atta)hed to the land o( ;1/1000. .n# gain (ro" the
distribution 'ill be taxed at ,- per)ent. The )o"pan# had a))u"ulated 69: o( ;7/01000
at the beginning o( the #ear.
a. Co"pute Tiger<s total taxable in)o"e and (ederal in)o"e tax.
Hoss on distribution of land +2E5,,,, ( 2%'5,,,,&I ,
Total taxable income 25,,,,,,
1ederal income tax +25,,,,,, x ">D& %E,,,,,
I Hoss on a distribution of property is not recognized.
b. Co"pute Tiger<s )urrent 69: be(ore the distribution.
Subtract;
1ederal income tax +%E,,,,,&
Adustment for .9: loss on distribution of land + ,&
Current .9: 2"",,,,,
7-1%
). Co"pute Tiger<s a))u"ulated 69: at the beginning o( next #ear.
Current .9: 2"",,,,,
Subtract;
.9: basis of land distributed this year +%'5,,,,&
Add;
Cortgage assumed by Ci*e %5,,,,
C.9: after distribution 2'',,,,,
Accumulated .9:, beginning of this year E5,,,,,
Accumulated .9:, beginning of next year 2#E,,,,,
d. !hat a"ount o( di+idend in)o"e does 4i*e report as a result o( the distribution$
Ci*e reports dividend income of 2$,,,,,, computed as the fair mar*et value of the
land received +2E5,,,,& less the liability he assumes +2%5,,,,&.
e. !hat is 4i*e<s tax basis in the land he re)ei+ed (ro" Tiger$
2E5,,,,. Ci*e)s income tax basis in the land e=uals its fair mar*et value.
--. [LO% 0llini Corporation reported taxable in)o"e o( ;/001000 (ro" operations (or this
During the #ear1 the )o"pan# "ade a distribution o( an auto"obile to its sole shareholder1
Carl# Arbana. The auto<s (air "ar*et +alue 'as ;,01000 and its tax basis to 0llini 'as ;0.
The auto<s 69: basis 'as ;1/1000. .n# gain (ro" the distribution 'ill be taxed at ,-
per)ent. 0llini had a))u"ulated 69: o( ;11/001000.
a. Co"pute 0llini<s total taxable in)o"e and (ederal in)o"e tax.
Aain on distribution of auto +2",,,,, ( 2,& ",,,,,
Total taxable income 25",,,,,
1ederal income tax +25",,,,, x ">D& %7,,',,
b. Co"pute 0llini<s )urrent 69: be(ore the distribution.
Taxable income 25",,,,,
Subtract;
1ederal income tax +%7,,',,&
Adustment for .9: gain on distribution of autoI + %5,,,,&
Current .9: 2"">,7,,
I 2",,,,, tax gain J 2%5,,,, .9: gain +2",,,,, ( 2%5,,,,&
7-1,
). Co"pute 0llini<s a))u"ulated 69: at the beginning o( next #ear.
Current .9: 2"">,7,,
Subtract;
1air mar*et value of auto distributed this year + ",,,,,&
C.9: after distribution 2",>,7,,
Accumulated .9:, beginning of this year %,5,,,,,,
Accumulated .9:, beginning of next year 2%,7,>,7,,
d. !hat a"ount o( di+idend in)o"e does Carl# report as a result o( the distribution$
Carly reports dividend income of 2",,,,,, computed as the fair mar*et value of the
auto received +2",,,,,&. 4llini has sufficient current earnings and profits to support
dividend treatment.
e. !hat is Carl#<s tax basis in the auto she re)ei+ed (ro" 0llini$
2",,,,,. Carly)s income tax basis in the auto e=uals its fair mar*et value.
-/. [LO% Gea+er Corporation reported taxable in)o"e o( ;/001000 (ro" operations this
During the #ear1 the )o"pan# "ade a distribution o( land to its sole shareholder1 6ugenia
KanDa". The land<s (air "ar*et +alue 'as ;%01000 and its tax and 69: basis to Gea+er
'as ;/01000. 6ugenia assu"ed a "ortgage on the land o( ;%/1000. .n# gain (ro" the
distribution 'ill be taxed at ,- per)ent. Gea+er had a))u"ulated 69: o( ;11/001000.
a. Co"pute Gea+er<s total taxable in)o"e and (ederal in)o"e tax.
Hoss on distribution of land +2'5,,,, ( 25,,,,,&I ,
Total taxable income 25,,,,,,
1ederal income tax +25,,,,,, x ">D& 2%E,,,,,
I Hoss on a distribution of property is not recognized. Fecause the mortgage
assumed exceeds the property)s fair mar*et value, the land)s fair mar*et value for
purposes of computing gain would e=ual the mortgage assumed.
7-1-
b. Co"pute Gea+er<s )urrent 69: be(ore the distribution.
Hess; 1ederal income tax +%E,,,,,&
Hess; Adustment for .9: loss on distribution of land + ,&
Current .9: 2"",,,,,
). Co"pute Gea+er<s a))u"ulated 69: at the beginning o( next #ear.
Current .9: 2"",,,,,
Subtract; .9: basis of land distributed +5,,,,,&
Add; Cortgage assumed by .ugenia '5,,,,
C.9: after distribution 2",5,,,,
Accumulated .9:, beginning of this year %,5,,,,,,
Accumulated .9:, beginning of next year 2%,7,5,,,,
d. !hat a"ount o( di+idend in)o"e does 6ugenia report as a result o( the distribution$
.ugenia reports dividend income of 2,, computed as the fair mar*et value of the
land received +2',,,,,& less the liability she assumes +2'5,,,,&.
e. !hat is 6ugenia<s in)o"e tax basis in the land re)ei+ed (ro" Gea+er$
2',,,,,. .ugenia)s income tax basis in the land e=uals its fair mar*et value.
-2. [LO% Lresearch formM Tin# and Ti" ea)h o'n hal( o( the 100 outstanding shares o(
8lo'er Corporation. This #ear 8lo'er reported taxable in)o"e o( ;21000 and 'as sub@e)t
to a %/ per)ent tax rate. 0n addition1 8lo'er re)ei+ed ;%01000 o( li(e insuran)e pro)eeds
due to the death o( an e"plo#ee E8lo'er paid ;/00 in li(e insuran)e pre"iu"s this #earF.
8lo'er had ;/1000 o( a))u"ulated 69: at the beginning o( the #ear.
a. !hat is 8lo'er<s )urrent 69:$
Taxable income 2 $,,,,
Hess; Tax at '5D ( %,5,,
:lus; tax exempt income K ',,,,,
Hess; expenses associated with exempt income ( 5,,
Current .9: 2 '>,,,,
b. 8lo'er distributed ;21000 on 8ebruar# 1/ and ;,01000 on .ugust 1. !hat total
a"ount o( di+idends 'ill Tin# and Ti" report$
7-1/
Amount <istributed 2$,,,, 2 ",,,,,
proportion of total distribution %!$ 5!$
Current .9: +2'>,,,, divided %!$, 5!$& 2 >,,,, 2 ',,,,,
Accumulated .9: +chronological& ',,,, ",,,,
Total dividend 2 $,,,, 2 '",,,,
). !hat a"ount o( )apital gain Ei( an#F 'ould Tin# and Ti" report on the distributions
in part b i( their sto)* basis is ;%1000 and ;1010001 respe)ti+el#$
The 2$,,,, distribution in 1ebruary would have no impact on stoc* basis since this
entire amount is treated as a dividend. Lnly 2'",,,, of the August distribution was
dividend income and so the remaining 2E,,,, would be treated as a return of
capital. Thus, 2%%,5,, of the 2%5,,,, received by each shareholder in August
would be treated as dividend and the remaining 2",5,, would be a return of capital.
The 2",5,, return of capital would reduce the basis of Tiny)s stoc* to zero and
generate a 2%,5,, capital gain +2",5,, ( 2',,,,&. The 2",5,, return of capital
would only reduce Tim)s basis to 2$,5,, +2%,,,,, less 2",5,,&.
d. !hat (or" 'ould 8lo'er use to report non-di+idend distributions$
1orm 5>5' is used to report non(dividend distributions.
e. On 'hat (or" ElineF 'ould Tin# and Ti" report these distributions$
<ividend distributions are reported on line 5 of :art 44 of Schedule F +or line # of
form %,>,& while non(dividend distributions in excess of basis are reported initially
on 1orm 7#>#. The totals from 1orm 7#># are then transferred to either :art 4 or
:art 44 +depending on holding period& of Schedule <.
-7. [LO, Nittan# Co"pan# pa#s its sole shareholder1 >oe :apa1 a salar# o( ;1001000. .t the
end o( ea)h #ear1 the )o"pan# pa#s >oe a CbonusD equal to the di((eren)e bet'een the
)orporation<s taxable in)o"e (or the #ear Ebe(ore the bonusF and ;7/1000. 0n this 'a#1 the
)o"pan# hopes to *eep its taxable in)o"e at a"ounts that are taxed at either 1/ per)ent or
%/ per)ent. This #ear Nittan# reported pre-bonus taxable in)o"e o( ;27/1000 and paid
>oe a bonus o( ;2001000. On audit1 the 0BH deter"ined that indi+iduals 'or*ing in >oe<s
position earned on a+erage ;,001000 per #ear. The )o"pan# had no (or"al )o"pensation
poli)# and ne+er paid a di+idend.
a. &o' "u)h o( >oe<s bonus "ight the 0BH re)hara)teri7e as a di+idend$
7-12
The 4BS could treat 3oe as receiving a constructive dividend to the extent the
/bonus0 is considered unreasonable compensation. The 4BS could argue that the
total /compensation0 in excess of what an individual in 3oe)s position typically
receives as compensation should be recharacterized as a dividend. 3oe)s excess
compensation would be 2>,,,,,, +2%,,,,,, K 2$,,,,,, ( 2",,,,,,&.
b. !hat argu"ents "ight >oe "a*e to )ounter this assertion$
3oe could argue that his value to the company exceeds what a person in his position
receives on average. Ge would have to convince the 4BS or the court that his role
in the company has uni=ue features. 1actors that would wor* against 3oe are the
company)s lac* of a formal compensation policy and not paying dividends.
). .ssu"ing the 0BH re)hara)teri7es ;%001000 o( >oe<s bonus as a di+idend1 'hat
additional in)o"e tax liabilit# does Nittan# Co"pan# (a)e$
?ittany would be denied a deduction for the 2',,,,,,, increasing the company)s
taxable income from 2E5,,,, to 2'E5,,,,. The additional 2',,,,,, increases the
company)s tax liability by 2E$,E5,.
-=. [LO- &oosier Corporation de)lared a %-(or-1 sto)* split to all shareholders o( re)ord on
4ar)h %/ o( this #ear. &oosier reported )urrent 69: o( ;2001000 and a))u"ulated 69:
o( ;,10001000. The total (air "ar*et +alue o( the sto)* distributed 'as ;11/001000.
Garbara Gloo"ington o'ned 11000 shares o( &oosier sto)* 'ith a tax basis o( ;100 per
share.
a. !hat a"ount o( taxable di+idend in)o"e1 i( an#1 does Garbara re)ogni7e this #ear$
.ssu"e the (air "ar*et +alue o( the sto)* 'as ;1/0 per share on 4ar)h %/ o( this
#ear.
The stoc* dividend is not taxable because it is pro rata to all the shareholders.
b. !hat is Garbara<s in)o"e tax basis in the ne' and existing sto)* she o'ns in
&oosier Corporation1 assu"ing the distribution is tax-(ree$
The new stoc* is allocated part of the tax basis of the old stoc* based on relative
fair mar*et value. 4n a ' for % stoc* split, Farbara would allocate half of the basis
of the old stoc* +2%,,& to the new stoc*, ma*ing her tax basis in the old and new
stoc* 25, per share.
). &o' does the sto)* di+idend a((e)t &oosier<s a))u"ulated 69: at the beginning o(
next #ear$
Goosier does not adust its .9: for the stoc* dividend because it is not taxable to
the shareholders.
7-17
-?. [LO- Gadger Corporation de)lared a sto)* di+idend to all shareholders o( re)ord on
4ar)h %/o( this #ear. Hhareholders 'ill re)ei+e one share o( Gadger sto)* (or ea)h ten
shares o( sto)* the# alread# o'n. 4adison Cheese"an o'ns 11000 shares o( Gadger
sto)* 'ith a tax basis o( ;100 per share. The (air "ar*et +alue o( the Gadger sto)* 'as
;110 per share on 4ar)h %/ o( this #ear.
a. !hat a"ount o( taxable di+idend in)o"e1 i( an#1 does 4adison re)ogni7e this #ear$
The stoc* dividend is not taxable because it is pro rata to all the shareholders.
b. !hat is 4adison<s in)o"e tax basis in her ne' and existing sto)* in Gadger
Corporation1 assu"ing the distribution is non-taxable$
The new stoc* is allocated part of the tax basis of the old stoc* based on relative
fair mar*et value. After the stoc* dividend, Cadison will own %,%,, shares of
Fadger stoc* +%,,,, K %,,,,!%,&, each with the same fair mar*et value. Ger basis
in each share of stoc* will be 2#%, computed as +%,,,, shares x 2%,, basis& ! %,%,,.
). &o' 'ould #ou ans'er questions a and b i( 4adison 'as o((ered the )hoi)e
bet'een 1 share o( sto)* in Gadger (or ea)h 10 shares she o'ned or ;100 )ash (or
ea)h 10 shares she o'ned in Gadger$
4f Cadison choose the stoc*, she would have a taxable dividend e=ual to 2%%,,,,,
computed as %,,,,!%, x 2%%,, because the distribution has the potential to be non
pro rata to the shareholders. Cadison)s tax basis in the stoc* she receives will
e=ual its fair mar*et value of 2%%,,,, +%,, x 2%%,&. 4f Cadison choose the cash,
she would be taxed on the amount of cash received, 2%,,,,.
/0. [LO/ !ild)at Co"pan# is o'ned equall# b# 6+an Htone and his sister Hara1 ea)h o(
'ho" held 11000 shares in the )o"pan#. Hara 'ants to redu)e her o'nership in the
)o"pan#1 and it 'as de)ided that the )o"pan# 'ill redee" /00 o( her shares (or ;%/1000
per share on De)e"ber ,1 o( this #ear. Hara<s in)o"e tax basis in ea)h share is ;/1000.
!ild)at has )urrent 69: o( ;1010001000 and a))u"ulated 69: o( ;/010001000.
a. !hat is the a"ount and )hara)ter E)apital gain or di+idendF re)ogni7ed b# Hara as a
result o( the sto)* rede"ption$
Sara reduces her ownership in @ildcat Company from 5,D to "".""D +5,,!%,5,,&.
Sara meets the substantially disproportionate test to treat the redemption as an
exchange. Under this test, she reduces her ownership below 5,D, and her
ownership percentage after the redemption is less than 7,D of her ownership
before the redemption +7,D x 5,D M >,D&. As a result, Sara recognizes a capital
gain of 2',,,,, per share +2'5,,,, ( 25,,,,&.
7-1=
b. !hat is Hara<s in)o"e tax basis in the re"aining /00 shares she o'ns in the
)o"pan#$
Sara)s income tax basis in the remaining shares remains 25,,,, per share.
). .ssu"ing the )o"pan# did not "a*e an# di+idend distributions during this #ear1 b#
'hat a"ount does !ild)at redu)e its 69: as a result o( the rede"ption$
2%',5,,,,,,. @ildcat reduces its accumulated .9: by the lesser of the cash
distributed +2%',5,,,,,, N5,, I 2'5,,,,O& or the percentage of stoc* redeemed
times accumulated .9: after reduction by any dividends paid during the year
+5,,!',,,, x 2$,,,,,,,,, M 2%5,,,,,,,,&.
/1. [LO/ 8lintstone Co"pan# is o'ned equall# b# 8red Htone and his sister !il"a1 ea)h o(
'ho" hold 11000 shares in the )o"pan#. !il"a 'ants to redu)e her o'nership in the
)o"pan#1 and it 'as de)ided that the )o"pan# 'ill redee" %/0 o( her shares (or ;%/1000
per share on De)e"ber ,1 o( this #ear. !il"a<s in)o"e tax basis in ea)h share is ;/1000.
8lintstone has )urrent 69: o( ;1010001000 and a))u"ulated 69: o( ;/010001000.
a. !hat is the a"ount and )hara)ter E)apital gain or di+idendF re)ogni7ed b# !il"a as
a result o( the sto)* rede"ption1 assu"ing onl# the Csubstantiall# disproportionate
'ith respe)t to the shareholderD test is applied$
@ilma reduces her ownership in 1lintstone Company from 5,D to >'.#D
+E5,!%,E5,&. @ilma fails the /substantially disproportionate0 test to treat the
redemption as an exchange. Although she reduces her ownership below 5,D, her
ownership percentage after the redemption is not less than 7,D of her ownership
before the redemption +7,D x 5,D M >,D&. As a result, @ilma recognizes a
dividend of 2$,'5,,,,, +2'5,,,, x '5, shares&.
b. 5i+en #our ans'er to question a1 'hat is !il"a<s in)o"e tax basis in the re"aining
7/0 shares she o'ns in the )o"pan#$
@ilma)s income tax basis in the remaining shares of stoc* is 25,,,,,,,,. @ilma
adds bac* the /unused0 tax basis of the '5, shares redeemed +2%,'5,,,,,& to the
basis of her remaining E5, shares +2",E5,,,,,&.
). .ssu"ing the )o"pan# did not "a*e an# di+idend distributions this #ear1 b# 'hat
a"ount does 8lintstone redu)e its 69: as a result o( the rede"ption$
1lintstone reduces its .9: by 2$,'5,,,,,, the amount of dividend income reported
by @ilma.
7-1?
d. !hat other argu"ent "ight !il"a "a*e to treat the rede"ption as an ex)hange$
@ilma could argue that the distribution is not /essentially e=uivalent to a dividend0
+section ",%+b&+%&& because she reduced her ownership below 5, percent. This is a
subective test that re=uires 4BS approval.
/%. [LO/ .)"e Corporation has 11000 shares outstanding. >oan and Gill are "arried1 and
the# ea)h o'n %0 shares o( .)"e. >oan<s daughter1 Hhirle# also o'ns %0 shares o( .)"e.
>oan is an equal partner 'ith >eri in the >9> partnership1 and this partnership o'ns 20
shares o( .)"e. >eri is not related to >oan or Gill. &o' "an# shares o( .)"e is Hhirle#
dee"ed to o'n under the sto)* attribution rules$
Shirley is deemed to own #, shares of Acme. She owns ', shares directly and is
attributed ', shares from Fill +family attribution&. She is also attributed 5, shares from
3oan +family attribution&. 3oan owns ', shares directly and another ", shares is
attributed to 3oan from 393 +5,D of $, shares through entity attribution&. The ", shares
attributed to 3oan are reattributed to Shirley through family attribution.
/,. [LO/ Gedro)*1 0n). is o'ned equall# b# Garne# Bubble and his 'i(e Gett#1 ea)h o(
'ho" held 11000 shares in the )o"pan#. Gett# 'ants to redu)e her o'nership in the
)o"pan#1 and it 'as de)ided that the )o"pan# 'ill redee" /00 o( her shares (or ;%/1000
per share on De)e"ber ,1 o( this #ear. Gett#<s in)o"e tax basis in ea)h share is ;/1000.
Gedro)* has )urrent 69: o( ;1010001000 and a))u"ulated 69: o( ;/010001000.
a. !hat is the a"ount and )hara)ter E)apital gain or di+idendF re)ogni7ed b# Gett# as
a result o( the sto)* rede"ption1 assu"ing onl# the Csubstantiall# disproportionate
'ith respe)t to the shareholderD test is applied$
Fetty reduces her direct ownership in Fedroc*, 4nc. from 5,D to ""."D
+5,,!%,5,,&. Gowever, under the family attribution rules, she is deemed to own the
%,,,, shares owned by her husband, Farney. Ger stoc* ownership before the
exchange is %,,D, and her ownership after the exchange is still %,,D
+%,5,,!%,5,,&. Fetty fails the substantially disproportionate test to treat the
redemption as an exchange. As a result, Fetty recognizes a dividend of 2%',5,,,,,,
+2'5,,,, x 5,, shares&.
b. 5i+en #our ans'er to question a1 'hat is Gett#<s in)o"e tax basis in the re"aining
/00 shares she o'ns in the )o"pan#$
Fetty)s income tax basis in her remaining shares is 25,,,,,,,,. Fetty adds bac* the
/unused0 tax basis of the 5,, shares redeemed +2',5,,,,,,& to the basis of her
remaining 5,, shares +2',5,,,,,,&.
7-%0
). .ssu"ing the )o"pan# did not "a*e an# di+idend distributions this #ear1 b# 'hat
a"ount does Gedro)* redu)e its 69: as a result o( the rede"ption$
Fedroc* reduces its accumulated .9: by the cash distributed +2%',5,,,,,,&.
d. Can Gett# argue that the rede"ption is Cnot essentiall# equi+alent to a di+idendD
and should be treated as an ex)hange$
?o. The attribution rules apply to this test as well as the other stoc* ownership
tests. As a result, Fetty is treated as owning %,,D of the Fedroc* stoc* before and
after the reduction.
/-. [LO/ LresearchM .ssu"e in proble" /, that Gett# and Garne# are not getting along and
ha+e separated due to "arital dis)ord Ealthough the# are not legall# separatedF. 0n (a)t1
the# )annot e+en stand to tal* to ea)h other an#"ore and )o""uni)ate onl# through their
a))ountant. Gett# 'ants to argue that she should not be treated as o'ning an# o( Garne#<s
sto)* in Gedro)* be)ause o( their hostilit# to'ards ea)h other. Can (a"il# hostilit# be
used as an argu"ent to +oid the (a"il# attribution rules$ Consult Be+. Bul. =0-%21 1?=0-1
C.G. 221 Bobin Gaft Trust v. Comm.1 /10 8.%d -, EC.-1 1?7/F1 Cetzger Trust v. Comm.1
2?, 8.%d -/? EC.-/ 1?=%1 and Cerone v. Comm.1 =7 TC 1 E1?=2F.
:robably not. The 4BS held that family hostility cannot be used to ignore the family
attribution rules in Bev. Bul. 7,('$, %#7,(% C.F. $$. 4n Bobin Gaft Trust v. Comm., 5%,
1.'d >" +CA(% %#E5&, the %st Circuit reversed the Tax Court +$' T.C. %>5 +%#E>&& and held
that family hostility might /negate the presumption0 of the family attribution rules. The
5th Circuit +Cetzger Trust v. Comm., $#" 1.'d >5# +CA(5 %#7'&& and the Tax Court
+Cerone v. Comm., 7E TC % +%#7$&& have held that family hostility should not affect the
application of the attribution rules. 4n Cetzger, the 5th Circuit explained its decision as
follows;
The courts of appeal have been given the authority to review Tax Court decisions at least
in part because it was thought that a generalist)s perspective would be helpful- that we
are less li*ely to succumb to the arcane. Pet the avoidance of the arcane must include
recognition of the limits of tax law. 4t is not a tas* measured by the chancellor)s foot. As
understandable as it may be, yielding to the temptation to /do e=uity0 in a specific tax
case by loo*ing past plain language to udicially perceived purpose will not do. @e do
not.
The Tax Court noted in Cerone that family hostility might have a limited role in testing for
dividend e=uivalence under Q",'+b&+%&.
7-%1
//. [LO/ Goots1 0n). is o'ned equall# b# 8ran* .lbert and his daughter Nan)#1 ea)h o(
'ho" held 11000 shares in the )o"pan#. 8ran* 'ants to retire (ro" the )o"pan#1 and it
'as de)ided that the )o"pan# 'ill redee" all 11000 o( his shares (or ;%/1000 per share on
De)e"ber ,1 o( this #ear. 8ran*<s in)o"e tax basis in ea)h share is ;/00. Goots1 0n). has
)urrent 69: o( ;110001000 and a))u"ulated 69: o( ;/10001000.
a. !hat "ust 8ran* do to ensure that the rede"ption 'ill be treated as an ex)hange$
1ran* must file a triple i agreement with the 4BS, in which he agrees he will not
ac=uire a prohibited interest in the next %, years. Fy filing such an agreement,
1ran* can waive the family attribution rules and be treated as having a complete
termination of his interest in Foots, 4nc.
b. 0( 8ran* re"ained as the Chair"an o( the Goard a(ter the rede"ption1 'hat is the
a"ount and )hara)ter E)apital gain or di+idendF o( in)o"e that 8ran* 'ill re)ogni7e
this #ear$
1ran* will have retained a prohibited interest in the company, which will cause the
family attribution rules to apply to the distribution. 1ran* will be deemed to own
%,,D of the company before and after the distribution. As a result, the distribution
will be treated as a property distribution under section ",%. 1ran*)s distribution
totals 2'5,,,,,,,, +2'5,,,, x %,,,, shares&. The distribution will be a dividend to
the extent of the company)s .9: of 2$,,,,,,,,. The remaining 2%#,,,,,,,, will be
a tax(free return of capital to the extent of 1ran*)s basis in his shares of stoc*
+25,,,,,,& and a capital gain for the remaining amount +2%7,5,,,,,,&.
). 0( 8ran* treats the rede"ption as a di+idend1 'hat happens to his sto)* basis in the
11000 shares redee"ed$
1ran* will have a basis of 2, in his stoc* after the transaction. Gis unused basis
otherwise would transfer to ?ancy, the person who attributed stoc* to him that
caused him to fail the exchange test.
/2. [LO/ LresearchM 0n the pre+ious proble"1 Nan)# 'ould li*e to ha+e 8ran* sta# on as a
)onsultant a(ter all o( his shares are redee"ed. Hhe 'ould pa# hi" a "odest a"ount o(
;/00 per "onth. Nan)# 'ants to *no' i( there is an# de "ini"is rule su)h that 8ran*
'ould not be treated as ha+ing retained a prohibited interest in the )o"pan# be)ause he is
re)ei+ing su)h a s"all a"ount o( "one#. Consult Hynch v. Comm.1 =01 8.%d 1172 EC.-?
1?=2F1 reversing =, T.C. /?7 E1?=-F1 Seda1 =% T.C. -=- E1?=-F1 and Cerone1 =7 T.C. 1
E1?=2F.
7-%%
The courts generally have held that there is no de minimis rule in determining if a
shareholder has ac=uired a prohibited interest in a corporation for purposes of waiving
the family attribution rules in a complete termination of the shareholder)s stoc* interest in
a corporation. 4n Hynch, 7" T.C. 5#E +%#7>&, the Tax Court held that a salary of 25,, per
month was not substantial enough to treat the family member as having a prohibited
interest. The #th Circuit reversed the Tax Court)s decision in Hynch, 7,% 1.'d %%E$ +CA(#
%#7$&, and held that the Tax Court had no authority to read into the legislative history of
Q",'+c& a de minimis rule. 4n Seda, 7' T.C. >7> +%#7>&, the Tax Court held that a
monthly salary of 2%,,,, was substantial enough to treat the family member as having a
prohibited interest. 4n Cerone, 7E T.C. % +%#7$&, the Tax Court ruled that a salary of
2%>,>,, per year was substantial enough to treat the family member as having a
prohibited interest +it was in excess of the 2%',,,, received by the taxpayer in Seda&.
/7. [LO/ LplanningM Li"ited Grands re)entl# repur)hased 2=1?2/1000 o( its shares1 pa#ing
;%? per share. The total nu"ber o( shares outstanding be(ore the rede"ption 'as
-7,1%%,1022. The total nu"ber o( shares outstanding a(ter the rede"ption 'as
-0-1%/=1022. .ssu"e #our )lient o'ned %01000 shares o( sto)* in The Li"ited. !hat is
the "ini"u" nu"ber o( shares she "ust tender to re)ei+e ex)hange treat"ent under the
Csubstantiall# disproportionate 'ith respe)t to the shareholderD )hange-in-o'nership
rules$
Fefore the redemption, your client owned ,.,,>''$"D of the stoc* +',,,,, !
>E",''",,$$&. To meet the /substantially disproportionate with respect to the
shareholder0 change(in(ownership rules, your client must reduce her stoc* ownership
below .,,""7%%D +7,D&. The algebraic e=uation to solve for the number of shares to
be redeemed is +',,,,, J R& ! >,>,'57,,$$ S .,,,,""7%%. Solving for R, the number of
shares to have redeemed e=uals $,""' shares. After the redemption, your client will own
%",$$7 shares. Ger percentage ownership will now be .,,""7%,D, which is below the
7,D threshold. @ith an ownership percentage this small, it is li*ely that any redemption
that reduces the shareholder)s percentage stoc* ownership will be treated as an
exchange under the /not essentially e=ual to a dividend0 test.
/=. [LO/ Cougar Co"pan# is o'ned equall# b# Cat Hte+ens and a partnership that is o'ned
equall# b# his (ather and t'o unrelated indi+iduals. Cat and the partnership ea)h o'n
,1000 shares in the )o"pan#. Cat 'ants to redu)e his o'nership in the )o"pan#1 and it is
de)ided that the )o"pan# 'ill redee" 11/00 o( his shares (or ;%/1000 per share. Cat<s
in)o"e tax basis in ea)h share is ;/1000. !hat are the in)o"e tax )onsequen)es to Cat as
a result o( the sto)* rede"ption1 assu"ing the )o"pan# has earnings and pro(its o( ;10
"illion$
7-%,
Cat owns directly ",,,, shares in Cougar Company and owns %,,,, shares indirectly
through his father)s ownership in the partnership +%!" x ",,,,&. :rior to the redemption,
Cat owns >,,,, ! $,,,, shares M $$.$ED. After the redemption of %,5,, shares, Cat owns
',5,, ! >,5,, shares M 55.55D. Fecause Cat)s stoc* ownership remains above 5,D, he
will be treated as having received a dividend to the extent of the corporation)s .9:
+2%,,,,,,,,,&. Lf the remaining distribution of 2'E,5,,,,,,, 2%5,,,,,,,, will be treated
as a tax(free return of capital +%,5,, x 2%,,,,, J the basis in the redeemed stoc* is
allocated to the remaining shares& and 2%',5,,,,,, will be treated as gain from sale of
stoc* +capital gain&.
/?. [LO/ LplanningM Oriole Corporation1 a pri+atel#-held )o"pan#1 has one )lass o( +oting
)o""on sto)*1 o( 'hi)h 11000 shares are issued and outstanding. The shares are o'ned
as (ollo's:
Larr# G#rd -00
:aul G#rd ELarr#<s sonF %00
Lad# G#rd ELarr#<s daughterF %00
Cal Bi(*in EunrelatedF %00
Total 11000
Larr# is )onsidering retire"ent and 'ould li*e to ha+e the )orporation redee" all o( his
shares (or ;-001000.
a. !hat "ust Larr# do or )onsider i( he 'ants to guarantee that the rede"ption 'ill be
treated as an ex)hange$
Fecause this is a complete termination of his direct ownership interest in Lriole
Corporation, Harry can elect to waive the family attribution rules provided he does
not ac=uire a prohibited interest in Lriole over the next ten years. Harry must file a
/triple i agreement0 with the 4BS to waive the election and agree to alert the 4BS if
he ac=uires a prohibited interest within the next %, years.
b. Could Larr# still a)t as a )onsultant to the )o"pan# and still ha+e the rede"ption
treated as an ex)hange$
?o. A consultant is considered a prohibited interest in Lriole Corporation.
7-%-
20. [LO/ LresearchM Asing the (a)ts (ro" :roble" 201 Oriole Corporation proposes to pa#
Larr# ;1001000 and gi+e hi" an install"ent note that 'ill pa# hi" ;,01000 per #ear (or
the next 10 #ears plus a "ar*et rate o( interest. !ill this arrange"ent allo' Larr# to treat
the rede"ption as an ex)hange$ Consult N-/,E*FE%FE.F.
Pes. Q>5"+*&+'&+A& allows a corporation to issue an installment note to a shareholder in a
redemption if the corporation is privately(held. The installment note would not be
considered a prohibited interest +being a creditor of the company is allowed&.
21. [LO/ 65 Corporation redee"ed %00 shares o( sto)* (ro" one o( its shareholders in
ex)hange (or ;%001000. The rede"ption represented %0I o( the )orporation<s outstanding
sto)*. The rede"ption 'as treated as an ex)hange b# the shareholder. G# 'hat a"ount
does 65 redu)e its total 69: as a result o( the rede"ption under the (ollo'ing 69:
assu"ptions$
a. 65<s total 69: at the ti"e o( the distribution 'as ;%10001000.
4n a redemption treated as an exchange, .A reduces its .9: by the lesser of the
amount distributed +2',,,,,,& or the percentage of stoc* redeemed times .9: at
the time of the distribution +',D x 2',,,,,,,, M 2>,,,,,,&. 4n this case, .A
reduces its .9: by 2',,,,,,.
b. 65<s total 69: at the ti"e o( the distribution 'as ;/001000.
4n a redemption treated as an exchange, .A reduces its .9: by the lesser of the
amount distributed +2',,,,,,& or the percentage of stoc* redeemed times .9: at
the time of the distribution +',D x 25,,,,,, M 2%,,,,,,&. 4n this case, .A reduces
its .9: by 2%,,,,,,.
2%. [LO/ LresearchM Hpartan Corporation redee"ed %/I o( its shares (or ;%1000 on >ul# 1
o( this #ear1 in a transa)tion that quali(ied as an ex)hange under N,0%EaF. Hpartan<s
a))u"ulated 69: at the beginning o( the #ear 'as ;%1000. 0ts )urrent 69: is ;1%1000.
Hpartan "ade di+idend distributions o( ;11000 on >une 1 and ;-1000 on .ugust ,1.
Deter"ine the beginning balan)e in Hpartan<s a))u"ulated 69: at the beginning o( the
next #ear. Hee Be+. Bul. 7--,,=1 1?7--% C.G. 101 and Be+. Bul. 7--,,?1 1?7--% C.G. 10,
(or help in "a*ing this )al)ulation.
7-%/
Spartan first reduces its current .9: for dividend distributions made during the year.
Current .9: is 2E,,,, +2%',,,, ( 2%,,,, ( 2>,,,,& for purposes of computing the effect
of the redemption on accumulated .9:. Accumulated .9: on 3uly %, ',%", is 25,5,,
+2',,,, K +2E,,,, x $!%'&&. Spartan reduces accumulated .9: as a result of the
redemption by the lesser of the distribution +2',,,,& or +'5D x 25,5,, M 2%,"E5&.
Accumulated .9: at 3anuary %, ',%>, is 2E,$'5 +2',,,, K 2%',,,, ( 2%,,,, ( 2>,,,, (
2%,"E5&.
2,. [LO/ Gonnie and Cl#de are the onl# t'o shareholders in 5eta'a# Corporation. Gonnie
o'ns 20 shares 'ith a basis o( ;,10001 and Cl#de o'ns the re"aining -0 shares 'ith a
basis o( ;1%1000. .t #ear end1 5eta'a# is )onsidering di((erent alternati+es (or
redee"ing so"e shares o( sto)*. 6+aluate 'hether ea)h o( these sto)* rede"ption
transa)tions quali(# (or sale or ex)hange treat"ent.
a. 5eta'a# redee"s 10 o( Gonnie<s shares (or ;%1000. 5eta'a# has ;%01000 o( 69:
at #ear end and Gonnie is unrelated to Cl#de.
Fonnie owns $,D before the redemption and 5$D after the redemption +5,!#,&.
Thus, the redemption will fail the 5,D test in Q ",'+b&+'&. Fecause Fonnie still has
control of the corporation after the redemption +more than 5,D& the redemption
will li*ely fail the not essentially e=uivalent to a dividend test under Q",'+b&+%&.
b. 5eta'a# redee"s %/ o( Gonnie<s shares (or ;-1000. 5eta'a# has ;%01000 o( 69:
at #ear end and Gonnie is unrelated to Cl#de.
Fonnie owns $,D before the redemption and >$D after the redemption +"5!E5&. 4n
addition, Fonnie)s share of the outstanding stoc* after the redemption has dropped
by more than 7,D +7,D x $,DM >7D& of her percentage ownership before the
redemption +$,D before and >$D afterwards&. Thus, the redemption passes both
the 5,D test and the 7,D test in Q ",'+b&+'&. This means that Fonnie will treat her
redeemed shares as though she sold them for 2>,,,, resulting in a capital gain of
2',E5, +2>,,,, J 6+'5!$,& T 2",,,,&.
). 5eta'a# redee"s 10 o( Cl#de<s shares (or ;%1/00. 5eta'a# has ;%01000 o( 69: at
#ear end and Cl#de is unrelated to Gonnie.
Clyde owns >,D before the redemption and ""D after the redemption +",!#,&.
Gowever, Clyde)s share of the outstanding stoc* has not dropped by more than
7,D+7,D x >,DM "'D& since his ownership percentage would have to be below
"'D, and his ownership percentage is ""D. Thus, the redemption passes the 5,D
7-%2
test but fails the 7,D test in Q ",'+b&+'&. This redemption might still =ualify as a
redemption not essentially e=uivalent to a dividend under Q ",'+b&+%&. Clyde does
not have control of the corporation +Fonnie does&, and he has suffered a significant
reduction in his ownership.
2-. [LO2 Hpartan Corporation "ade a distribution o( ;/001000 to Bust# Cedar in partial
liquidation o( the )o"pan# on De)e"ber ,1 o( this #ear. Bust#1 an indi+idual1 o'ns
100I o( Hpartan Corporation. The distribution 'as in ex)hange (or /0I o( Bust#<s sto)*
in the )o"pan#. .t the ti"e o( the distribution1 the shares had a (air "ar*et +alue o( ;%00
per share. Bust#<s in)o"e tax basis in the shares 'as ;/0 per share. Hpartan had total
69: o( ;=10001000 at the ti"e o( the distribution.
a. !hat is the a"ount and )hara)ter E)apital gain or di+idendF o( an# in)o"e or gain
re)ogni7ed per share b# Bust# as a result o( the partial liquidation$
An individual receives exchange treatment on distributions in partial li=uidation of
stoc*. As a result, Busty reports capital gain of 2%5, per share of stoc* exchanged
+2',, ( 25,&.
b. .ssu"ing Hpartan "ade no other distributions to Bust# during the #ear1 b# 'hat
a"ount does Hpartan redu)e its total 69: as a result o( the partial liquidation$
Fecause the li=uidation is treated as an exchange, Spartan reduces its .9: by the
lesser of the amount distributed +25,,,,,,& or +5,D x 27,,,,,,,, M 2>,,,,,,,,&.
4n this case, Spartan reduces its .9: by 25,,,,,,.
2/. [LO2 !ol+erine Corporation "ade a distribution o( ;/001000 to Bi)h Bod1 0n). in partial
liquidation o( the )o"pan# on De)e"ber ,1 o( this #ear. Bi)h Bod1 0n). o'ns 100I o(
!ol+erine Corporation. The distribution 'as in ex)hange (or /0I o( Bi)h Bod1 0n).<s
sto)* in the )o"pan#. .t the ti"e o( the distribution1 the shares had a (air "ar*et +alue o(
;%00 per share. Bi)h Bod1 0n).<s in)o"e tax basis in the shares 'as ;/0 per share.
!ol+erine had total 69: o( ;=10001000 at the ti"e o( the distribution.
a. !hat is the total a"ount and )hara)ter E)apital gain or di+idendF o( an# in)o"e or
gain re)ogni7ed b# Bi)h Bod1 0n). as a result o( the partial liquidation$
A corporation receives dividend treatment on distributions in partial li=uidation of
stoc*. As a result, Bich Bod, 4nc. reports a dividend of 25,,,,,,, which is eligible
for a %,,D dividends received deduction.
b. .ssu"ing !ol+erine "ade no other distributions to Bi)h Bod1 0n). during the #ear1
b# 'hat a"ount does !ol+erine redu)e its total 69: as a result o( the partial
liquidation$
25,,,,,,, the amount treated by Bich Bod, 4nc. as a dividend.
7-%7
Comprehensive problems
27. :etos*e# Htone Ouarr#1 0n). E:HOF1 a )alendar #ear1 a))rual basis C Corporation1 pro+ides
lands)aping supplies to lo)al builders in northern 4i)higan. :HO has al'a#s been a
(a"il# o'ned business and has a single )lass o( +oting )o""on sto)* outstanding. The
/00 outstanding shares are o'ned as (ollo's:
Nu"ber o( shares
Ni)* .da"s 1/0
."# .da"s ENi)*<s 'i(eF 1/0
.bigail .da"s ENi)*<s daughterF /0
Charlie .da"s ENi)*<s sonF /0
Handler .da"s ENi)*<s (atherF 100
Total shares /00
7-%=
Ni)* .da"s ser+es as :resident o( :HO1 and his (ather Handler ser+es as Chair"an o( the
Goard. ."# is the )o"pan#<s C8O1 and .bigail and Charlie 'or* as e"plo#ees o( the
)o"pan#. Handler 'ould li*e to retire and sell his shares ba)* to the )o"pan#. The (air
"ar*et +alue o( the shares is ;/001000. Handler<s tax basis is ;101000.
The rede"ption is tentati+el# s)heduled to ta*e pla)e on De)e"ber ,1 o( this #ear. .t the
beginning o( the #ear :HO had a))u"ulated earnings and pro(its o( ;%1/001000. The
)o"pan# pro@e)ts )urrent 69: o( ;%001000. The )o"pan# intends to pa# pro rata )ash
di+idends o( ;,00 per share to its shareholders on De)e"ber 1 o( this #ear.
a. .ssu"e the rede"ption ta*es pla)e as planned on De)e"ber ,1 and no ele)tions are
"ade b# the shareholders.
1. !hat a"ount o( di+idend or )apital gain 'ill Handler re)ogni7e as a result o( the
sto)* rede"ption$
Sandler will have a dividend of 25,,,,,,. Under the family attribution rules, Sandler
is deemed to own the shares of stoc* of his son ?ic* +%5,& and his grandchildren
Abigail +5,& and Charlie +5,&. Ge is not deemed to own any of Amy)s stoc*. :rior to
the redemption, Sandler owns "5, ! 5,, shares M E,D. After the redemption,
assuming he does not waive the family attribution rules, Sandler is deemed to own '5,
! >,, M $'.5D of the company)s stoc*. The company has ample .9: to absorb the
distribution to Sandler on <ecember "% and the distribution of 2%5,,,,, +5,, x 2",,&
on <ecember %.
%. &o' 'ill the tax basis o( HandlerPs sto)* be allo)ated to the re"aining
shareholders$
Sandler)s unused tax basis in his stoc* of 2%,,,,, will be allocated to ?ic*, Abigail,
and Charlie on a pro rata basis because they caused him to fail the exchange test.
b. !hat "ust Handler and the other shareholders do to )hange the tax results #ou
)al)ulated in question a$
Sandler must file a triple i agreement with the 4BS to waive the family attribution
rules. Ge will then have a capital gain of 2>#,,,,, +25,,,,,, ( 2%,,,,,& because he
will be treated as having a complete termination of his interest in :SU.
). Co"pute :HO<s a))u"ulated earnings and pro(its on >anuar# 1 o( next #ear
assu"ing the rede"ption is treated as an ex)hange.
7-%?
Current .9: 2',,,,,,
Subtract;
Cash dividends on <ecember % +%5,,,,,&
Current .9: on <ecember "% after dividends 5,,,,,
Accumulated .9:, beginning of this year ',5,,,,,,
Accumulated .9: at <ecember "% 2',55,,,,,
Subtract;
Hesser of cash distributed M 25,,,,,, + 5,,,,,,&
or ',D x 2',55,,,,, M 25%,,,,,
Accumulated .9: at 3anuary % of next year 2',,5,,,,,
2=. [comprehensive Thriller Corporation has one )lass o( +oting )o""on sto)*1 o( 'hi)h
11000 shares are issued and outstanding. The shares are o'ned as (ollo's:
>oe >a)*son -00
4i*e >a)*son E>oe<s sonF %00
>ane >a)*son E>oe<s daughterF %00
Kinnie :ri)e EunrelatedF %00
Total 11000
Thriller Corporation has )urrent 69: o( ;,001000 (or this #ear and a))u"ulated 69: at
>anuar# 1 o( this #ear o( ;/001000.
During this #ear1 the )orporation "ade the (ollo'ing distributions to its shareholders:
0,Q,1: :aid a Cdi+idendD o( ;10Qshare to ea)h shareholder E;101000 in totalF.
02Q,0: Bedee"ed %00 shares o( >oe<s sto)* (or ;%001000. >oe<s basis in the %00
shares redee"ed 'as ;1001000.
0?Q,0: Bedee"ed 20 shares o( Kinnie<s sto)* (or ;201000. &is basis in the 20
shares 'as ;,21000.
1%Q,1: :aid a di+idend o( ;10Qshare to ea)h shareholder E;71-00 in totalF.
a. Deter"ine the tax status o( ea)h distribution "ade this #ear. E&int: 8irst1 )onsider
i( the rede"ptions are treated as di+idend distributions or ex)hanges.F
The 2%,,,,, distribution on Carch "% is a dividend because C.9: of 2",,,,,,
exceeds total dividends distributed during the year. The 2E,>,, distribution on
<ecember "% is a dividend because C.9: of 2",,,,,, exceeds total dividends
distributed during the year.
7-,0
3oe is deemed to own 7,, of the %,,,, +7,D& shares of Thriller Corporation +>,,
directly and ',, each from Ci*e and 3ane& before the redemption. After the
redemption 3oe is deemed to own $,, of the 7,, +E5D& remaining shares of Thriller
Corporation +',, directly and ',, each from Ci*e and 3ane&. 3oe fails the stoc*
ownership tests because he still owns more than 5,D of the stoc*. Therefore, the
entire 2',,,,,, received by 3oe is treated as a dividend.
Vinnie owns ',, of the remaining 7,, +'5D& shares of Thriller Corporation stoc*
before the redemption. After the redemption, Vinnie owns %>, of the E>, +%7.#D&
remaining shares of Thriller Corporation stoc*. Vinnie meets both the 5,D and 7,D
tests of Q",'+b&+'& +%7.#D is less than 5,D and is less than N7,D '5DO M ',D&.
Vinnie treats the redemption as an exchange and reports a capital gain of 2'>,,,,
+2$,,,,, ( 2"$,,,,&.
b. Co"pute the )orporation<s a))u"ulated 69: at >anuar# 1 o( next #ear.
Thriller Corporation first reduces its C.9: for the dividends paid during the current
year;
Current .9: 2",,,,,,
( <ividends paid +'%E,>,,&
Undistributed Current .9: 2 7',$,,
x #!%' ,.E5
Undistributed Current .9: at #!", 2$%,#5,
Current .9: in >th =uarter K ',,$5,
Accumulated .9: at %!,% K 5,,,,,,
Total Accumulated .9: at #!", 257',$,,
Beduce Accumulated .9: by the lesser of;
2$,,,,,, or
$,!7,, x 257',$,, M 2>",$#5 + >",$#5&
Accumulated .9: at ,%!,% of next year 25"7,#,5
). >oe is )onsidering retire"ent and 'ould li*e to ha+e the )orporation redee" all o(
his shares (or ;1001000 plus a 10-#ear note 'ith a (air "ar*et +alue o( ;,001000.
1. !hat "ust >oe do or )onsider i( he 'ants to ensure that the rede"ption 'ill be
treated as an ex)hange.
3oe must execute a family attribution waiver and a /triple i agreement0 with the 4BS
in which he agrees not to ac=uire a /prohibited interest0 within the next %, years. 4f
he does ac=uire such an interest, he must so inform the 4BS or the statute of limitations
on the tax return that reports the redemption will begin to run. A creditor is not a
prohibited interest.
7-,1
%. Could >oe still a)t as a )onsultant to the )o"pan#$
The 4BS and courts have held that serving as a consultant is considered to be a
prohibited interest. The Tax Court adopted a de minimis rule with respect to how
much the former shareholder is paid +25,,!mo. was o*ay but not 2%,,,,!mo.&. The
#th Circuit overruled the Tax Court in Hynch and held that no de minimis rule should
be applied.
d. Thriller Corporation "ust pa# attorne#<s (ees o( ;/1000 to (a)ilitate the sto)*
rede"ptions. 0s this (ee dedu)tible$
Aenerally, Q%$'+*& disallows a deduction for expenses incurred /in connection with0
a stoc* redemption. Gowever, Congress enacted Q%$'+*&+'&+A&+i& in %##$ to allow
deductions for expenses related to indebtedness incurred to repurchase stoc*. 4f the
payment was to facilitate a debt offering to repurchase the stoc*, the expense would be
deductible.
7-,%

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Chapter 07 - Corporate Taxation: Nonliquidating Distributions

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