Part

Sole Props General Partnership Limited Partnership Limited Liability Partnership
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Structural Single owner General parties who are owners. §6/7: 6(1): A limited partnership must have at least one all states have also adopted LLP statutes. Each
& business. partnership is association of 2+ persons who are general partner and one limited partner. The LLP statute
Organizatio Sole/only in business for profit. Joint ownership. general partner can have three individual LLP is Gen Partnership, not a limited
n proprietor. general partners/promoters (the ones who partnership.
Maybe other All states have adopted a version of UPA 1914 or come up with the business idea, go into All of the partners have the right to
employees the more recent 1997 RUPA, and business, and then sell it to make the money) participate in the management of the venture
within the Profit sharing arrangement creates presumption within it. They get different people (natural without risking a loss of their limited liability.
company. of a GP even if the parties do not intend to be persons or businesses) to be investors (these UPA controlling
Maybe parties. UPA §7; RUPA §202(c)(3) are the limited partners). More often than
lender+, not businesses will look for all different
supplier+, A GP without a definite term (at-will partnership) kinds of financing from different places.
clients+ dissolves on the withdrawal of any partner. UPA They borrow from the bank they take capital
based on §31; RUPA §801(a). Absent any agreement, the from investors, etc. General partners strike a
contractual withdrawing partner may demand tht the business deal with the investors--the limited partners
relationships. be liquidated and the net proceeds be distributed and the bank will provide capital and both
Only one to the partners in cash. UPA §38(1); RUPA expect to be paid back.
owner. §807;
Under RUPA §701, when a partner dies:

surviving partners may continue the GP and
bu out deceased partner s interest, ithout
liquidation.
Liability: SP is liable Important to know what you have, and make the What does RULPA have to say about the There is one basic exception to an LLP - if the
whether or for debts and decision to have a partnership and structure your liability issue for the limited partners? = partner, him/herself screwed up. Limited
not the ind obligations of business accordingly. Know the characteristics of §303. liability does not trump illegal actions of an
standing the business. it. §303(a) = makes it clear that limited individual who normally would be liable. If you
behind the What if 3 Joint and several liability. partners have limited liability as long as have a partner who helps structure and negotiate
business party car got they are not general partners and do not fraudulent tax shelters, for example, you can go
liable for the run into by GP can obtain limited liability by filing a "participate in the control of the after that particular partner without going after
debts and the company statement of qualification or registation with business." General partners want the the other partners in the partnership or the
obligations who is state officials as a LLP and adopt a name that limited partners' money but not their partnership itself. So, one point here is the
of the liable? and identifies its LLP status. Rupa §1001. LLP: advice. notion that if one person did something violating
business for SP: agency statutes protect the personal assets of partners §303(b) = But what does "participate in the law, well, that is violating the law and even
losses. law. from risk of negligence or malpractice by others the control of the business" entail? What if you theoretically had limited liability, all bets
Respondeat in firms. happens if the limited partner wants to are off. Tax shelters can be legal and acceptable
superior: participate in the control of the business or fraudulent.
owner of GP have unlimited liabitly for partnership (especially if the business is losing money LLP statutes graft Limited Liability onto the GP
business is obligations. Their personal assets are at risk for and the limited partner is scared of losing statutes. LLP partners avoid personal liability
liable for torts partnership obligations, whether contractual or his investment)? §303(b) lists activities for partnership obligations unless the partner s
of employee from misconduct (torts) of the partners or the limited partner can participate in own conduct makes him personally liable or the
if employee partnership employees. UPA §15, RUPA §306. without giving up his limited liability. It partner super ised the rongful conduct of
was acting in concerns certain types of formal relations another partner or associate. RUPA §306(c).
scope of GP: characterized by: that over the years began to come up. Partners remain personally liable for their
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employment. structural flexibility (the partners can §303(b) tried to create a safe harbor personal misconduct.
Owner is in contractually arrange to run the business largely whereby certain activities done by a
position to as they see fit. limited partner were not considered §306(c): provision that lays out the liability
ensure that participating in the control of the scheme for the limited liability partnership
employees Restricted transferability of ownerships business. The list is from the real world
acting interest ( a transferee of partnership interest can and the cases. No such provisions were Ederer v. Gursky
accordingly. only become a partner with the unanimous ever included in earlier versions of this LLP liability shield does not protect partners
Responsibilit consent of the other partners) statute. from claims by other partners. Partner
y. Pass-through taxation (partnership income is §303(c) = just specifies that if a limited creditors are better off than non-partner
only taxed at the partner level, rather than partner did an activity not enumerated creditors.
doubl ta ed at both the parnerhsip and the within §303(b), it doesn't automatically Courts could presumably impose personal
partner levels mean that the partner participated in the liabili on LLP par ners nder a piercing
control of the business. he eil heor .
§303(d) = But then there is the question:
who can actually sue a limited partner Wikipedia:
successfully and recover? §303(d) says One partner is not responsible or liable for
that if a limited partner permits another partner s misconduct or negligence.
him/herself to be known as a general Some partners ha e form of limited liabilit
partner to creditors, then the creditors similar to that of shareholders of a corp.
(and only the creditors) have the right to
sue that person as a general partner.
What does RULPA have to say about the

liability issue for the general partners? =
§403. §403 makes it clear that a general
partner in a limited partnership has the exact
same liability (unlimited joint and several
liability) that would a general partner in a
general partnership.
A limited partnership with a Corporate GP

But with the formation of the limited
partnership with a corporate general partner,
A, B, and C could set up a corporation as the
general partner of the limited partnership and
the corporation, not A, B, or C, would be
liable if anything happened. A, B, and C
could be shareholders, officers, and board
members without having joint and several,
unlimited liability
Control&M Partners control and manage. GP have authority to bind the LP as to
anagement: Each partner is an agent of all other partners and ordinary matters. RULPA §403.
efficiency in can bind the GP, either by transacting business as
the control. agreed by the partners (actual authority) or by LP have voting authority over specified
Contemplate appearing in the eyes of third parties to carry on matters but cannot bind LP. RULPA §302.
certain ways partnership business Apparent authority UPA
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of §9, RUPA §301; Unless otherwise agreed, a Fiduciary Duties: GP have FD akin to those
controlling. majority vote of the partners decides ordinary of partners in a GP
partnership matters, but anything that is
extraordinary or contravenes the agreement
requires unanimity. UPA §18(h); RUPA §401(j).
Fiduciary Duty:
Partners have FD to each other to act in good
faith with due care and loyalty. RUPA §404.
-Partners must inform co-parterns of material
information affecting the GP and share in any
benefits from transactions connected to GP. UPA
§§20, 21; RUPA §404(b). Breaches of FD are
actionable in court. UPA §22, RUPA §405(b).
Profit Partners can choose proportion from their Limited and general partners share profits, Profits of LLP are allocated among the partners
investment? They can choose.. losses, and distributions according to their for tax purposes. Avoiding the porblem
capital contributions, absent a contrary
Partners share equally in profits and losses, unless agreement. RULPA §§503-504; Pre-
agreed otherwise. UPA§18a, RUPA §401(b). A dissolution distributions are by agreement, as
partner may enforce the right to profits in an is compensation of the general partner.
action for accounting.UPA §22, RUPA RULPA §601
§406(b):Partners have no right to compensation
for their services, unless provided by agreement.
UPA §18(f); RUPA §401(h); On dissolution,
after discharging partnership obligations, profits
and losses are divided among the partners. UPA
§40, RUPA §807
Taxation Federal tax 1065: partnership and entities have to fill out. Paying Taxes on a Limited Partnership
purposes: set Partnership does not owe taxes, the partners pay All partnerships have pass-through status.
up that allows taxes on their proportion of their income. The limited partnership will have to fill out
the SP to form 1065: since the partnership does not pay form 1065, but it won't pay a separate tax.
include tax taxes, that form 1065 is a reporting form. Reports The profits/losses will pass to both the
calculations to the IRS, we have a partnership in existence, limited partner(s) and the general partner(s),
and tax-owed certain income, certain expenses, and law allows who will claim it on their individual 1040s.
on SP us to deduct or deduce by sales by the amount of
individual tax the expenses and net. Remaining number: taxable Paying taxes on a Limited Partnership
forms. Form income- basis for the payment of taxes, but the with a Corporate General Partner
1040: Line partners, not the partnership that has to pay the All partnerships have pass-through status.
12: Schedule taxes, some payment based on their proportion of As mentioned above, the limited partnership
C: Business obligation. Flowing through of the obligation. will fill out form 1065 but it does not have to
income or Form 1065: Form 1040: line 17: each individual pay a tax. Rather, the general partner(s) and
losses for SP. partner reports her/his portion of income tax, the limited partner(s) will fill out their
Your because that partner individually owes. individual 1040's showing the profits/losses
Income, of the limited partnership. If the general
Expenses A+B: partnership makes money as a business: no partner is a corporation, the corporation will
3
(allow you to tax. Positive for the partnership, other entities have to pay its own corporate tax because the
deduct) because there is only one level of taxation. Small corporation is taxed on this level. Then,
business: practical response when the dividends are issued to the
HYPO = partnership has $3 million in taxable shareholders/investors/limited partners, the
income. Who pays? Individual partners. And limited partners will pay the tax on the
they will pay their own portions, agreed to earlier. dividends extended to them from the
This is contrasted to the corporation which has to corporation.
pay a corporate tax. There is NO partnership tax.
Although a partnership has to report its taxable
income on Form 1065, at the end of the day (line
22 on form 1065) does not ask you to calculate
your partnership tax. Rather, there is pass
through/flow through to the individual partners.
Let's say each partner's share adds up to $1
million. Partner A doesn't have to actually take
that $1 million. He may leave it in the firm to
support and finance future firm endeavors. But
Partner A will still have to declare that $1 million
on line 17 on Form 1040, regardless
Formalities Simplest Does not require legal documentation. An LP arises when a Certificate is filed Article 10 of UPA = Limited Liability
form of UPA §6; RUPA §202(a). with a state official. RULPA §201. An LP Partnership
business : no filing. Potentially dangerous part, esp if you lasts as long as the parties agree or, absent §1001(a) = allows a partnership to become
associations. don t kno that ou ha e a partnership. Simple agreement, until a general partner withdraws. an LLP
No state form to set up and operate. Easy simple. RULPA §801. §1001(c) = deals with the practical
statute. Unlimited joint liability is the ugly part. requirements of how to form a limited
Doesn t e ist, liability partnership. It requires one to
statutory file a document with the state and pay a
structure and fee claiming to be an LLP. The filing
regime, basic process incorporates another requirement
rules of = notice. Notice. The notice requirement
rights, duties creates knowledge on the part of the
and liabilities. public even if it usually does not actually
notify the public that this partnership has
limited liability. So, there is a notice
requirement but there is no guarantee
that there actually is knowledge. No one
really reads the newspapers for notice on
which firms became/changed to become
an LLP. Law firms and accounting firms
particularly have made use of this
business form.
Partnership statutes typically provide that LLP is

a Partnership RUPA §101(5). LLP must fall
within the statutory definition of a partnership
ie- an association of two or more persons to
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carry on as co-owners a business for profit.
Beyond meeting the partnership definition, an
LLP must satisfy certain statutory
formalities.
I. LLP is required to file a document
(generally called an application,
registration, or certificate) with the sec
of state or other designated official.
II. Jdx require an LLP to provide a
specified amount of liability insurance
or, alternatively, a pool of funds
designated and segregated for the
satisfaction of judgments against the
partnership.
Vote of partners is needed to approve LLP
registration: Depending on the statute,
unanimous, majorit in interest or majorit
appro al ma be required .
Most LLP statutes provide that limited liability
begins as soon as the registration statement is
filed.
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Limited Liability Company Corporation S-Corporation Non-Profit Tax-Exempt Corporation
Structural & Hybrid entity between corp The board of directors is on topTheinS- quail Non-Profit Tax Exemption:
Organization and partnership. control/management; the board of Corporation is just like a regular corporation
answering
except that question: must be
directors passes that control/management that it enjoys a special tax treatment. Thesignificant
S stands for that businesses have
GP: members of LLC provide to the officers. These officers are more a Subchapter S of the internal Revenue Code.raisedThe
hellidea
with lawmakers that many
capital and manage the often than not the ones that make the big was to take the regular characteristics of anon=profits
corporationengage in activities that
business according to their decisions. Then the shareholders own the including limited liability and yet not haveare
to just
pay as
a just as the ones with
agreement; their interests corporation. Profits come in the form of corporate tax. Instead, the S-corporation allows
businesses
the and qualif and don t
generally are not freely dividends. The corporation is a business; pass-through status of a partnership. But not
havejust
to pay
everytaxes, giving them a
transferable. it is in the business of making money. If corporation can be a S-Corporation, there competitive
are certain advantage that is unfair.
the net profits are a plus, then the As a choice to operate an
All states have LLC statutes, corporation has made money. But this Must be eligible entity: Domestic corp ororganization.
LLC which
ULLCA was approved in doesn't mean that the shareholders will has elected ot be taxed as a corp Non Profit: no one earns a salary?
2006, but few states have make money. The Board has to decide Must be only one class of stock Fundamental questions for exam. Cannot
adopted it. that. The declaration and payment of Most not have more than 100 be divided up to shareholders or
dividends is a decision made by the Shareholders. members, People in the organization
Board. Shareholders US citizens manage or general audience of members.
The organization can make a profit, and
A corp arises when the articles of many successful ones do. The business
incorporation are filed with a state profit, pays out a certain amount, and
official. MBCA §2.03. Corporate brings in a certain amount if it is paying
existence is perpetual, regardless of what out.
happens to shareholders, directors or -officers directors fiduciary principals
officers, MBCA §3.02 apply. You have an inducement to engage
in activities that are profitable in the
human sense to society. business, making
significant profits over the years, not
interested in NP tax exempt
But I fyou have a qualifying tax activity
and would be satisfied with a decent
salary.
Grants/chartiable contributions, not for
profit ta org. ou re image to the public,
automatic sense of being more trusted
because ou aren t tr ing to take people.
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Liability Only liable for the amount that Shareholders have limited liability for
you invest into the business. If corporate obligations MBCA §6.22.
the business takes on huge True for directors/officers acting on
debts, you are not behalf of corporation. Corproate
automatically liable. participants can lose only what they
invested unless there is fraud or an
Members are not personally inequity that justifies piercing the
liable for debts of the LLC corporate veil. Often, large creditors of
entity. small corps will demand that corporate
ULLCA §303(a): debts, participants personally guarantee the
obligations, and liabilities corps obligations, thus reducing the
of a limited liability significance of corporate limited liability.
company, whether arising
in contract, tort, or
otherwise, are solely the
debts, obligations, and
liabilities of the compan .
a member or manager is
not personally liable for a
debt, obligation, or liability
of the company solely by
reason of being or acting
as a member or manager.
RULLCA§304(a):
substantially the same.
Limited liability, however,
has its limits
LLC members: both in

capacity as capital contributors
and managers are not liable for
LLC obligations. ULLCA
§303.
Some LLC statutes suggest that

member can become
individually liable if equity or
justice so requires: Veil-
Piercing.
Control& LLCs can be member-managed When deciding where to incorporate, the So, an S-corporation allows us to
Management or manager-managed. ULLCA likely question to ask is whether to have a vehicle that is:
§203: manager-member must incorporate in DE (where many other 1. simple to form and maintain -
be specified). business have chosen to incorporate due it doesn't require anyone to file
Under most statutes, members to DE's reputation) or in the state where anything to create it
in member-managed LLC: the business has its principle place of 2. associated with limited liability
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broad authority to bind the business (if it is not DE). Remember and pass through tax status -
LLC in much same way as though, that even if the the rule is don't check the box
partners. ULLCA §301(a). directors/officers/shareholders decide to unless you want to be taxed as
incorporate the business in DE, (and, of a corporation; otherwise, all
Members have no authority to course, if the principle place of business you have to do is form the S-
bind the LLC in manager- is another state besides DE), they still corporation and make money
managed LLC. have to file in the state of the principle and file tax forms at the federal
place of business to get permission to do level each year; and
Generally voting in a business as a foreign business in that 3. flexible so that we can choose
member-managed LLC: is in state. to have a Board (or not).
proportion to members capital So, to sum up: who incorporates in DE?
contributions, though some Publicly held companies where most
statutes specify equal shareholders are citizens without any
management rights. ULLCA connection to the control of the company
§404. all want to incorporate in DE because of
these reasons. After all, public
Members and Managers of companies get sued a lot! They will want
LLC have Fiduciary Duties of courts that favor their interests. Smaller,
Care and loyalty, which vary more sophisticated, closely (privately)
depending on mondel. held companies may also choose to
incorporate or reincorporate in DE as well
Member-Managed: FD because maybe it has 30 shareholders but
parallel those in GP. only 5 are officers. The answer to the
question of who incorporates in DE
Manager-Managed: only depends on the business animal that
managers have fD; a member produces a bunch of different players that
who is not a manger is said not do not all have interests in common.
to owe FD as a member. When the different players' interests are
not exactly the same, the business will
want to incorporate or reincorporate in
DE.
Corp has centralized management

structure. Business and affairds are under
management and supervision of Board of
Directors. MBCA §8.01.
Officers: carry out policies formulated by

board. MBCA §8.41.
Shareholders elect the board. MBCA

§8.03 and decide specified fundamental
matters, they cannot bind the board.
Corporate Directors and Officers owe

8
FD to the corp and in some circumstances
to shareholders.
Controlling shareholders: have more

limited Fid Duties, principally in
e ercising their control hen the corp s
business is sold. Shareholders may seek
relief on behlf of the corp in a deriviate
suit for breaches of corp fid duties.
Profit Most LLC statutes allocate Financial rights are allocated according to Profit and losses must be
financial rights according to shares. MBCA §6.01. Distributions, from allocated to shareholders
member contributions, though surplus or earnings, must be approved by proportionatel to each one s
some provide for equal shares. the Board of Directors. MBCA §6.40; interest in the business.
ULLCA §405(a)( equal Directors and officers have no right
shares). Under many statutes, remuneration, except as fixed by contract.
member can take share
certificates to reflect their
relative financial interests.
Distributions must be approved
by all the members. ULLCA
§404(c). Absent agreement,
members generally have no
right to remuneration ULLCA
§403(d).
Taxation provides the limited liability of Corporation: double taxation: two levels Form 1120S. At the very end, Tax Exempt: in general, the entity does
a corprorations but the pass of corporate taxation: separate legal you'll see a "Tax due" line and an not have to pay taxes. The Entity has
through tax features of person under the law. Separate legal "overpayment" line. These are exemption from Taxation because the
partnership. Provides entity, under tax laws, when it has lines that an S-Corporation will kind of purpose (public service) many
advantageous approach to income, it has to pay a corporate tax. have to fill out when they didn't times activities that sometimes that
organization Income. Pays out salary and profit to get it right. S-Corporations have government would have to perform,
A+B: assume that they are individuals, pass-through status, like Activities where it might not be profitable
individual tax: two levels of taxation, at partnerships (which explains line for business to do. Encourage this kind of
the level of the entity and taxation by the 17, where the amount of pension, provision of services to society, that
individual. Two levels. profit sharing, etc. plans will be would have to do with essential matters.
passed down to shareholders).
But the S-Corporation - even
though it is not taxed on a
corporate level - will still have to
pay taxes on certain types of
activities that it engages in.
These activities are not activities
that arise in the ordinary course of
making income. So, these
activities are not in the category
of income that includes sales,
9
services, etc. Rather, they are
certain technical activities that
include screw-ups in the way the
officers operated the S
corporation. The S-Corporation
will have to account for these
screw-ups. This is what lines 25
and 26 are for
Formalities An LLC arises with the filing As to formation/formalities, the
of a certificate or corporation has the largest number of
AoOrganization with a state formalities. The corporation must file
official. ULLCA §202. Many articles of incorporation, submit
LLC statutes require there to documents, hold meetings and record
be at least two members, minutes, host an annual meeting of
though increasingly one- shareholders, etc.
membet LLCs are possible.
More recent statutes do not
limit the duration of LLCs.
ULLCA §203.
Limited Liability Partnerships LLP LP ( LLC) on the test look out for Wallace trying to trick me between LLPs and LPs.
(mostly law firms and accounting firms)
Frequent question on exam = distinguish a limited partnership from a limited liability partnership. Sometimes the question is "a limited liability
partnership is " and hat follo s is the definition of the limited partnership. Ob iousl the ans er is FALSE.
Ano her freq en q es ion on he e am is: " he ULLPA pro ides ha " NO! The correc ans er is ha " he UPA pro ides ha " There is
no ULLPA. The idea is that a lawyer practicing law should know what statute creates the basis for the business forms he is dealing with.
Distinguishing the LLP from the LP:

We have the UPA and the UPA (1997) which yield two possibilities:
1. A General Partnership = where there is joint and several liability of the partners
2. A Limited Liability Partnership = new form of business association = where there is a partnership but the partners have limited liability. It has
all features of a general partnership with just one exception - limited liability. However, if a particular partner is committing fraudulent or illegal
acts, that partner can be held liable for his/her actions. This is why the crooked partner will be liable but the other partners and the partnership
itself will still have limited liability.
Then we have the RULPA and the ULPA(2001) which yield only one possibility:
1. A Limited Partnership = the general partners who run the business are held jointly and severally liable but the limited partners (investors) have
limited liability (provided they do not participate in the control of the business and are not "held out" as general partners).
10
Distinguishing the LLP from the LLC
What is the difference between an LLP and an LLC? Why choose one form over another? Business forms have evolved over time. It may be that an
LLP and an LLC in a particular state are two different forms of the exact same thing. The answer will all depend on the statutes for that particular state.
The Formation of a Closely Held Corporation

Chapter 6. Pg. 208. We are dealing with the closely held corporation here i.e. not the big, publicly held corporation. Thus, we are not bringing federal
law into the discussion here. If we learn how to form a closely held corporation, then it won't be as difficult for us to learn how to form a publicly held
corporation.
DEFECTIVE INCORPORATION
De Jure Corporation = A corporation formed correctly and legally recognized as a corporation. You have prepared the articles the way you are
supposed to, included all info required, filed them with the proper government offices, and then went on to do business.
De Facto Corporation = you may/may not have prepared the articles or incorporation the way you were supposed to. Somehow, you didn't get
everything right (even though you did try to do something). There is no recognized corporation. But then (even though you knew you didn't have a
properly formed corporation) you went out to do business and generated a liability which the company cannot afford to pay. Now the injured party
wants their money.
Corporation by Estoppel = you have done even less or nothing to correctly form the corporation, yet you went out and did business and generated a
liability. As a matter of equity, you are estopped to deny the existence of a corporation even though there was never one formed. The court is making
you liable as a notion of fairness.
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My outline for Corporate Tax
1) § 351: formation
a) non-recognition of property, stock,
assumed liabilities, and boot
1) Birth and formation of corporations: when b) contributions of capital
people put money in exchange for control 2) debt v. equity characteristics
a) § 3511 allows 1) one or more person to 2) 3) non-liquidating distributions
a) dividend v. return of capital or basis
put property (not services) in 3) solely for b) redemptions v. partial liquidation
stock and 4) be in control i) constructive ownership which
i) definitions makes a redemption not a
(1) one or more persons (for purposes redemption
of § 351) ii) brother-sister and parent subsidiary
acquisitions
(a) can be corporations 4) stock distributions and tainted 306 stock
(2) property (for purposes of § 351) 5) complete liquidations
(a) If more than 20% of any class
of stock is issued to service
provider, the entire transaction will not qualify under § 351 because transferors of
property do not have immediate control after the exchange
(b) stock issued for services (past or present) are not included 351(d)(1); 1.351-1(a)(1)(i)
(i) but if a service creates an intangible right it may be treated as property
(ii) one who transfers only services will not be included in the test for control
(iii)cannot be for services, however, the services allows a mixed transfers of property
and services to count, so long as the amount of serves is not under the de minimis
amount of 10%
(c) debt assumption and issues
(i) issue: When a corporation exchanges its stock for a note, future payments are
recognized, but current principal paid is not -- check this
no responsibility for any errors.
Since these are my personal notes, I take
Please do not claim that you wrote this.
This does not constitute legal advice.
http://Case.tm
You got this offf
(ii) Cancellation: of corporate indebtedness: does not fall under § 351, and is
recognized because of § 61(a)(12) (income includes Income from discharge of
indebtedness)
(iii)Assumption: If the corporation assumes liability in exchange for stock: not gain
to shareholder, but treated as boot for purposes of determining basis in the stock
(Sec. 357(A)-(C))
1. Defining assumption
a. if a shareholder remains personally liable, he must still recognize the gain.
Owen
2. Encumbrances can be reduced by the transfer of a note from by the taxpayer
to the corporation, and the corporation gets a basis in the note equal to its, fmv,
and the negative basis in the property transferred is reduced
a. 9th cir Peracchi: must look to subjective character of loan, to see if it is
true, and the greater the risk of the corporation going bankrupt, and the
shareholder losing control over it, the greater the chance that it should
1
351 No gain or loss shall be recognized if property is transferred to a corporation by one or more
persons solely in exchange for stock in such corporation and immediately after the exchange such
person or persons are in control (as defined in section 368(c)) of the corporation.
Page 1 of 29
count ("if bankruptcy is so remote that there is no realistic possible it will
ever occur, we can ignore the potential economic effect of the note, and
You got this offf
treat it merely as an unenforceable promice to contribute capital in the
future)
i. if bankruptcy not a real risk, can't use note
b. Lessinger (2d cir): taxpayer who transfers an enforceable note has a basis
equal to the face value. Logic: 100% shareholder transferred note to his
corporation, corporation need not issues additional shares for 351 to apply,
corporation was deemed to have issued additional shares, corporation
therefore assumes the liabilities provided that the note is genuine,
corporation recognizes gain when the shareholder repays, therefore
this must be the shareholder's basis): a note transferred by the
corporation does count to reduce the basis because
c. Alderman (Tax court): service is correct. These notes are not for real, and
the taxpayer cannot avoid the bite of 357(c)
3. Exception for Liabilities that are assumed, but have not been taken into account
by the transferor for tax purposes (e. g. because he is a cash basis payer) are
not considered to be gain § 357(c)(3)
4. Contingent liabilities (such as brownfields Rev. Rule 95-74) are not taken into
account either 358(d)(2)
(3) Transfers
(a) non-exclusive rights is not a transfer
(b) must transfer all rights in the property (not a limited license) – this will be considered
royalty income
(c) Du Pont: perpetual nonexclusive license will satisfy test
(4) stock v. boot (for purposes of § 351)
(a) boot: solely in exchange for stock of the transferee corporation (b)if a someone
(transferor) who gets something other than stock, he must recapture any depreciation
in that boot. 351(a)
(b) transferor immediately recognizes any value of boot received § 351(b)(2)
(i) even if a transferor receives boot, he may not recognize a loss § 351(b)(2)
1. but the shareholders basis in the stock will be increased
2. it seems you can't recognize more than the basis in the property
(ii) realized gain on a transferred asset is recognized to the extent of the boot allocable
to the asset. 351(b)
(iii)However, the boot allocated to a loss asset will not cause recognition of gain or
loss Rev. Rul 68.55
(5) control (for purposes of § 351)
(a) two criteria that must both be satisfied as per Rev. Rul 59-259
(i) own at least 80% of the total combined voting power of all classes of stock entitled
to vote 368(c) 2
2
(c) Control defined.--For purposes of part I (other than section 304), part II, this part, and part V,
368(c) the term "control" means the ownership of stock possessing at least 80 percent of the total
combined voting power of all classes of stock entitled to vote and at least 80 percent of the total
number of shares of all other classes of stock of the corporation.
Page 2 of 29
You got this offf
1. voting stock is defined as stock that can vote for the directors at the time of
issuance or at the relevant testing date
(ii) and 80% of each nonvoting class of stock 368(c)
1. can issue new classes of stock
(iii)To determine whether the group is in control of the corporation, but look at the
entire group of non- de minimis parties
1. IRS defines de minimis in rev procedures as less than 10% of the stock already
owned or in excess of 10% -- this prevents someone from asserting the non-
recognition rule based on a small contribution from someone whose additional
contribution would give them the required amount of control3
(b) must be ownership (equity) interest in a corporation 1.351-1(a)(1)
(i) old definition was “securities”
(ii) non-qualified preferred stock is preferred stock is 1) limited in dividends 2) has
other debt-like features 3) features that give the corporation or the holder the right
to dispose of stock back to the corporation within a set amount of time (this is a
feature of debt)
(iii)Can’t be warrants or stock rights4 – and “debt-like stock” is treated as boot
(iv) Note: taxpayers can reognize a loss if only nonqualified preferred stock is received
in an exchange
(c) note: it doesn't matter that some transferors receive voting stock, while others receive
nonvoting stock
(d) one who transfers only services may not be included in the test for control 351(d)(1)
1.351-1(a)(1)(i), and the service-providing shareholder recognizes ordinary § 61
income
(i) timing of gain on stock received for services
1. if the stock is subject to a risk of forfeiture or is simply not transferrable: at the
time any restrictions on the dispositions of the stock lapse, the service provider
is taxed § 83
a. no additional income is recognized when the restriction lapse – only when
any stock is disposed of 1.83-2(a)(1) (check this)
3
Rev. When a person transfers property to a corporation in exchange for stock or securities of such
Proc. corporation and the primary purpose of the transfer is to qualify under section 351 of the Code the
77-37 exchanges of property by other persons transferring property, the property transferred will not be
considered to be of relatively small value, within the meaning of section 1.351- 1(a)(1)(ii) of the
regulations, if the fair market value of the property transferred is equal to, or in excess of, 10
percent of the fair market value of the stock and securities already owned (or to be received for
services) by such person.
4
In general.--The term "nonqualified preferred stock" means preferred stock if—
351(g)(2)(A) (i) the holder of such stock has the right to require the issuer or a related person to redeem or
purchase the stock,
(ii) the issuer or a related person is required to redeem or purchase such stock,
(iii) the issuer or a related person has the right to redeem or purchase the stock and, as of the
issue date, it is more likely than not that such right will be exercised, or
(iv) the dividend rate on such stock varies in whole or in part (directly or indirectly) with
reference to interest rates, commodity prices, or other similar indices.
Page 3 of 29
2. election by service provider but, a service provider can elect under § 83(b) to
be taxed on the fmv of the stock at the time of the transfer, and no additional
income is recognized when the restriction lapse 1.83-2(a)(1) (check this)
(ii) service providers basis in stock received for services: amount paid + amount
included in come. 1.83-4(b)(1)
1. forfeitures can be deducted as a long term capital loss of the cash paid for them
(iii)a corporation that issues stock in exchange for services can deduct whatever the
amount of ordinary income that was taxable to the service provider § 162(a) –
unless there the services provided are required to be amortized or capitalized
(b) mixed transfers of services and property: do, in general count for the 80% control
requirement
(i) if the property represents more than 10% of the value of the transfer, it will count
in the test
(ii) if the property represents less than 10% of the value of the transfer (diminimus), it
will not count in the test
(e) debt does not count (it used to, however)
(6) Simultaneousness: only have to be part of a pre-defined agreement5 (should be legally
binding)
(7) immediately after the exchange
(c) the test for control is done immediately after the exchange, but it does no matter how
long the stock is held for
(i) only if there is a binding agreement to transfer shares aware and divest someone of
control will someone be deemed not to be in control Intermountain Lumber
(d) there is no requirement for simultaneous transfer, so long as the rights of the parties
were "previously defined" and it followed some order 1.351-1(a)(1)
(e) but a required disposition of stock pursuant to a binding agreement means that there
was no control to start with, and that stock is not included in the 80% test.
International Lumber
(f) a later gift of the stock will not change the character of the transaction (because gifts
are not binding) Wilgard realty
(g) corporations that transfer stock can all or part of their stock to their shareholders
351(c)
(h) there are three versions of the step transaction doctrine6 that can be applied
(i) end result test: IRS and the courts can look @ the end result and recharacterize that
transaction to reach that result
(ii) mutual interdependence test: two more transactions will be stepped together
5
…The phrase "immediately after the exchange" does not necessarily require simultaneous
1.315- exchanges by two or more persons, but comprehends a situation where the rights of the parties
1(a) have been previously defined and the execution of the agreement proceeds with an expedition
consistent with orderly procedure…
6
A business transaction often has no clearly defined beginning or end, but it may be necessary in practice to divide it, usually
chronologically, into segments for tax purposes. If the segment is too thin, however, the tax results may be unfair to the
taxpayer or the government or both. In viewing a dynamic whole, the courts often say that an integrated transaction must not
be broken into independent steps or conversely that the separate steps must be taken together in attaching tax consequences.
The so-called step transaction doctrine is encountered most often in the taxation of corporations and shareholders, but its scope
is much broader.
Page 4 of 29
(iii)actually has to be a binding commitment b3 u enter into the first step, if you want
to piece the two transactions together
ii) results of a § 351 exchange
(1) Basis
(a) In general, the corporation takes the cost basis of the property a.k.a., its basis is the
cost basis of the stock that it is giving up7
(i) To Determine character of 357(c) "gain" (when new basis is less than zero),
allocate gain amount the transferred pro rata assets among the fair market value
(b) Tax free transfers: if the exchange were tax free (to the transferor) then the corporation
takes with the original basis
(c) Shareholder receives a basis that is reduced by the value of the indebtedness assumed
(i) Must allocate the character of the gain to the transferred assets (based on their
gross value) 1.357-2
(ii) No negative bases: If the assumed liabilities are greater than the shareholder's
basis, then the shareholder's bais in the stock is zero, because they really have debt
relief.
1. 357(C) catchall If the new basis is less than zero (liabilities greater than
original basis of stock), however, 357(c) applies, and the difference between
the negative is treated as currently realized boot
a. If § 357(c) applies, the corporation's (transferee's) basis is always zero
b. To Determine character of § 357(c) "gain" (when new basis is less than
zero), allocate gain amount the transferred pro ratta assets among the fair
market value
2. § 357(c) does not apply if the transferor has not taken into account these
liabilities for tax purposes. Rev. Rul 95-74 (property subject to liabilities that
have not been taken into account, do not increase their basis subject to §
357(c))
3. because values of assets are aggregated, bases can be increased to zero by
transferring cash (since bases are aggregated)
a. In the case of multiple assets transferred to the corporation that are subject
to liability, (cross-collateralized) , the non-recourse liability will be
reduced by the lesser of "the amount of such liability which an owner of
other assets no transferred to the transferee and also subject to the liability
has agreed with the transfer to, and is expected to, satisfy"
b. e. g. must be reduced by whatever portion was not transferred
4. criticisms of 357(c)
a. bit self executing – only comes up in audit
b. overly broad – it is all or nothing
(d) If the corporation assumes liability in exchange for stock: not gain to shareholder, but
treated as boot for purposes of determining basis in the stock (§ 357(A)-(C))
(iv) Assumption of debt is not treated as boot, but is added to basis of transferor
7
1032(b) For basis of property acquired by a corporation in certain exchanges for its stock, see § 362
362(a)(2) as paid-in surplus or as a contribution to capital, then the basis shall be the same as it would be in
the hands of the transferor, increased in the amount of gain recognized to the transferor on such
transfer.
Page 5 of 29
You got this offf
1. If the assumed liabilities are greater than the shareholder's basis, then the
shareholder's basis in the stock is zero, because they really have debt relief.
(v) Shareholder receives a basis in the stock that is reduced by the value of the
indebtedness assumed
(2) Must allocate the character of the gain to the transferred assets (based on their gross value)
1.357-2
(a) tax avoidance or not a bona fide corporation business purpose § 357(b)8 in this case,
all of the relieved liabilities are treated as boot. Reg. 1.357-1(c)
(i) Taxpayer has burden of proving by preponderance that this is so. 357(b)(2)
(ii) Examples might include deliberately encumbering property shortly before a
transfer
(3) From the transferee's perspective: §§ 351 and 1032 prevent the shareholder form being
forced to recognize ordinary income
iii) Strategy: ways to avoid § 351, and recognize gain at transfer
(1) Transfer property not for stock
(2) Avoid control requirement (e.g. transfer for services)
(3) Binding contract to reduce control after the transfer)
(a) Transfer things where the could be a radically different character
b) transactions by the corporation of its own stock§ 1032: no recognized gain to corporation when
selling (or buying its own shares), since it is merely a change in form. § 1032 allows corporations
to traffic in their own stock in exchange for property or services (for these purposes the IRS
deems transactions in services to be transactions in property )
ii) but 362: corporation's basis in property transferred in preserved. So-called transferred or
carryover basis
(1) a corporation that receives boot, will have a basis of the value of the property received
plus anything that the transferor realized 362(a)
(2) if there is an installment not resulting in a deferred gain to the transferor, the corporation
may only increase its basis when it pays that note (e. g. when the gain is recognized).
Proposed Regulation1.453-1(f)(3)(ii).
(3) If there are several assets, there is no authority on how the basis should be attributed
(a) However, it probably should be the transferor's basis, increased by any gain
recognized
iii) holding period:
(1) 1231 or capital assets: carried over holding period
(2) everything else holding periods begin on date of exchange
iv) a corporation that issues stock in exchange for services can deduct whatever the amount of
ordinary income that was taxable to the service provider § 162(a) – unless there the services
provided are required to be amortized or capitalized
v) steps
(1) calculate amount transferor recognizes
8
351(b) RECEIPT OF PROPERTY.--
If subsection (a) would apply to an exchange but for the fact that there is received, in addition to the stock permitted to be
received under subsection (a), other property or money, then--
351(b)(1) gain (if any) to such recipient shall be recognized, but not in excess of--
351(b)(1)(A) the amount of money received, plus
351(b)(1)(B) the fair market value of such other property received; and
351(b)(2) no loss to such recipient shall be recognized.
Page 6 of 29
(a) current boot
(b) deferred installment not boot
(2) calculate transferor's basis in stock received
(a) basis in property transferred
(b) minus value of boot received
(c) plus total value which was realized by transferor (even if delayed recognition)
(3) initial basis in property received by corporation is
(a) tranferror's basis
(b) plus gain recognized by transferor in year one
(4) basis increases when note is paid off
(a) if they sell the property before the note is paid off must recognize gain, however when
the note is paid off, it can deduct that remaining basis as a capital loss Proposed
Regulation 1.453-1(f)(3)(iii)
c) shareholders don't have to so easy. They will only be able to will only be able to avoid
recognition of gain if they assume control of the corporation. This is considered to be a change
of form9 of their wealth, rather than an actual transaction resulting in gain or loss to any of the
parties. Afterwards the parties must actually be in control. 10
i) Can't be sham transaction
(1) Must be actual purchase, not as a disguised transaction between two parties11
ii) Elements of the § 351 exchange that will avoid recognition
(5) one or more persons (including individuals, corporations, partnerships)
(a) the people getting the stock need not get it in proportion to what the contributed
(i) they are treated as having received the stock in proportion to the value of the
transferred proper, and then having transferred the property amongst themselves.
1.351-1(b)(1),(b)(2), ex. 1
1. e. g. first treated as a sale, then the imbalances are treated as gifts resulting and
is taxed on the fmv of the stock received, and takes a later bais of that fmv.
The ones transferors who are treated as giving up the stock are treated as
realizing a gain in satisfying an obligation
(b) Transfers to "investment companies" do not count. 351(e)
iii) Results of an actual exchange
(1) No gain or loss recognized to the person or the shareholder under 1031, and 1032
(2) Shareholders take the stock received in exchange for a carryover basis, so he has the same
basis as the transferred assets (35812’s deferred gain) this is called exchange basis
property13
10
General rule.--No gain or loss shall be recognized if property is transferred to a corporation by
351(a) one or more persons solely in exchange for stock in such corporation and immediately after the
exchange such person or persons are in control (as defined in section 368(c)) of the corporation.
11
… Accordingly, if the transferor sells his stock as part of the same transaction, the transaction is
Intermountain taxable because there has been more than a mere change in form.
Lumber
12
Nonrecognition property.--The basis of the property permitted to be received under such section
358(a)(1) without the recognition of gain or loss shall be the same as that of the property exchanged
Page 7 of 29
(3) Calculation of holding period
(a) tacking:
(i) capital assets: holding period for stock received for stock in exchange for stock or
a § 1231 (check this) asset is the holding period of the transferred property plus the
holding period of the stock § 1223(1).
(ii) Ordinary income assets: begins on immediately date of exchange
(iii)Capital and ordinary assets: if property is transferred for a combination of capital
and ordinary assets, each share takes a split holding period, in proportion to the
fmv of the transffered assets. Rev. Rule 85-164
1. However, dividing up holding periods upon shares (e.g. if one share of stock
was later sold) can be quite difficult, as individual shares of stock now have
multiple holding periods
(b) Character of gain received is determined by the character of the assets transferred
(c) Installment sales as a means of realization
(i) § 453: gain can be recognized as the note is paid off (though there is a provision to
opt out)
(ii) all payments of interest on such a note are gain
(d) determining when gain will be recognized under 1.453-1(c)(f)(1)(iii)
(i) boot: transferor recognizes immediately on receipt on boot
(ii) cash: transferor recognizes immediately on receipt on boot
(iii)Installment sales as a means of realization
1. § 453: gain can be recognized as the note is paid off (though there is a
provision to opt out)
2. all payments of interest on such a note are gain
3. in proposed regulations, a transferor can immediately increase the basis in any
non-recognition property (e.g. stock) by the transferor’s total potential
recognized gain, but they delay the corporations corresponding § 362(a) basis
increase in its assets until the transferor actually recognizes gain on the
You got this offf
installment method proposed Reg. § 1.453-1(f)(3)(ii)

a. transferee realizes gain
i. proposed regs divided it into a 351(a) nonrecognition transaction with
respect to the stock receive
ii. and a installment sale with regard to the boot
iii. basis is allocated first to the boot received
iv. if the transferor’s basis exceeds the fair market value of the non-
recognition property received the excess basis is allocated to the
installment portion of he transaction (p. 71 of book)
v. the “selling price” (fair market value of boot plus face value of
installment obligation) is then allocated to the installment portion of the
transaction, based on the ratio of (difference between fair market value
and selling price/selling price)
13
Exchanged basis property.--The term "exchanged basis property" means property having a basis
7701(a)(44) determined under any provision of subtitle A (or under any corresponding provision of prior
income tax law) providing that the basis shall be determined in whole or in part by reference to
other property held at any time by the person for whom the basis is to be determined.
Page 8 of 29
b. corporation’s basis is the same as the transferor’s basis increased by the
gain recognized only if, the gain is actually recognized.
(4) Corporation has a carryover basis in the property received. This creates double taxation,
but it could have been avoided if the transferor had sold his property and used it to buy the
original stock14
(5) but 358: shareholder's basis in property transferred is preserved
(a) stock received will have the same basis as the stock received immediately prior to the
exchange § 358(a)(1) -- this is exchanged or substituted basis
(b) if a transferor receives more than one class the aggregated basis is allocated among all
classes of stock received in proportion to the fmv of each class. Reg. 1.358-2(a)(2)
(c) example equation to determine shareholder's basis in property
(i) transferor's basis in property transferred equals (this applies even if there is an
installment sale 1.453-1(f)(3)(ii)
1. basis in stock equal basis in transferred property
2. minus amount of cash
3. minus amount of boot (debt, assumption of liability and other property)
a. usually fmv 358(a)(2)
b. but if debt, it is face value minus the amount of income that will be taxable
if the obligation is satisfied in full 453B(b)
4. plus gain immediately recognized by transferor
(ii) allocate basis among differing classes of stock received 1.358-2(a)(2)
(6) recognition of boot
(a) However, the boot allocated to a loss asset will not cause recognition of gain or loss.
Instead, the IRS says one must look at the property bit by bit and allocate the property
on a pro rata basis based on these assets Rev. Rul 68-55.15 – e.g. boot must be
allocated to other assets, and their basis can be increased
(b) Steps for determining allocation of basis when boot is received
(i) Determine proportion of fair market value of assets transferred
14
Boot (property other than stock)
Shareholder Corporation
Gain boot Property. Gain realized to the extent of fair If the corporation recognizes gain because of
market value of boot. If several assets are boot, the corporation’s basis is the
transferred, the value of the boot is allocated transferor’s basis plus any gain recognized.
among the transferred assets and realized
gain is recognized to the extent of the boot If transferor recognizes gain when assets are
allocable to that asset/ transferred for a combination of stock and
boot the there is a basis increase which is to
Stock received: So, it is transferror’s basis be allocated among the assets.
in the property minus amount of cash plus
gain recognized.
Loss boot No loss may be recognized. § 351(b)(2)
15
In determining the amount of gain recognized under section 351(b) of the Internal Revenue Code of 1954 where several
assets were transferred to a corporation, each asset must be considered transferred separately in exchange for a portion of
each category of consideration received. The fair market value of each category of consideration received is separately
allocated to the transferred assets in proportion to the relative fair market values of the transferred assets. Where as a result
of such allocation there is a realized loss with respect to any asset, such loss is not recognized under section 351(b)(2) of the
Code.
Page 9 of 29
(ii) Allocate boot received between those assets in proportion to the value of the assets
transferred
(iii)Each of these is the amount if gain (of whatever type of asset) – there cannot be a
loss realized
1. only a value up to the fair market value of boot received must be immediately
recognized § 351(b)
2. obviously, subtract the basis in the property transferred from the amount of
gain recognized
(7) installment obligations (such as notes transferred to the taxpayer)
(a) divide stock into 1) boot immediately received and 2) taxable installment instrument
sale
(i) basis of transferred property is allocated to the fair market value of extent of stock
received
(ii) § 453 provides for installment sale reporting, the shareholder recognizes the gain
as the installments come due (regs., not statutes) Proposed regulations 1.453-
1(f)(1),(3)(ii). Use the gross profit percentage to determine how much of the
remaining value must be allocated
(b) steps
(i) determine realized gain: (value of property received minus fmv of what was given
up)
(ii) limit recognized gain to whatever the fmv of whatever was transferred + its
basis
1. (e. g. can't recognize more than the total amount of what was given up)
(iii)if depreciable property is transferred everything must be realized up font
(iv) allocate basis in property given up (minus boot) to the first property received
(v) allocate "excess basis" (whatever is left) to the value of the second property
received (could be total value of monies to be received from a note) on the basis of
gross profit percentage
1. gross profit is the total value of the note minus the basis (or money paid for it)
2. gross profit percentage is the percentage of the profit percentage
3. in the first installment (or cash received) recognition is gpp * cash (or other
boot) received
(c) in other installments recognition is gpp * when other boot is received
d) Corporations can also buy assets, or somehow issue debt
2) Contributions to capital
a) Shareholder may increase their basis in other shares
b) Corporation take zero basis but is not taxed
i) If cash received, must reduce other bases
3) Taxation of debt v. equity (differentiation between the two will not be on the test, but the criteria is
found in Fin Hay)
a) Equity
i) Dividends are includible in shareholders income but are not deductible to corporation
ii) No gain or loss when corps repurchase stock
iii) Note: corps that receive dividends from other corporations pay tax at a lower rate
Page 10 of 29
iv) Bad stock16: 165(g) (note: no distinction between business and non-business)
(1) Can take a deduction when the stock becomes “worthless” or when sold
(a) Limitations
(i) Can only take worthless stock deduction once
(ii) Must take in the year that it is worthless (alternative is to sell it)
(2) Regulations define “worthless” but most people would rather just sell the stock to realize
the loss and not take the litigation risk17
(a) This is a question of fact where the burden is on the taxpayer
(b) A decline in market value is not a loss
(3) Timing
(a) Short term less than a year
(b) Long term more than a year
(c) But if you are a deduction under 165(g)(1), taxpayer is deemed to have disposed the
stock on the last day of the taxable year
v) Special provision for small business: § 1244 for individuals: can treat certain losses from sale
or exchange of stock as ordinary (as opposed to capital) loss
(1) Must be an individual (or partnership
(2) Monetary limits
(a) 50,000 for singles
(b) 100,000 for married couples filing jointly
(3) criteria
(a) must be domestic corporation
(b) was a “small business corporation” is defined as if the aggregate amount of money and
other property received by the corporation for stock, as a contribution to capital, and as
paid-in surplus, does not exceed $1,000,000.
(c) stock was issued by such corporation for money or other property (not stock)
(i) Property. For purposes of this part, the term "property" means money, securities,
and any other property; except that such term does not include stock in the
corporation making the distribution (or rights to acquire such stock
(d) corporation must be engaged in active business : in the past 5 years, the corporation
derived more than 50 percent of its aggregate gross receipts from sources other than
royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or
securities
(e) must receive stock directly from corporation
16
(1) General rule.--If any security which is a capital asset becomes worthless during the taxable year, the loss resulting
therefrom shall, for purposes of this subtitle, be treated as a loss from the sale or exchange, on the last day of the taxable year,
of a capital asset.
…
In computing gross receipts for purposes of the preceding sentence, gross receipts from sales or exchanges of stocks
and securities shall be taken into account only to the extent of gains therefrom.
17
1.165-4(a): Deduction disallowed. No deduction shall be allowed under section 165(a) solely on account of a decline in the
value of stock owned by the taxpayer when the decline is due to a fluctuation in the market price of the stock or to other
similar cause. A mere shrinkage in the value of stock owned by the taxpayer, even though extensive, does not give rise to
a deduction under section 165(a) if the stock has any recognizable value on the date claimed as the date of loss. No loss for
a decline in the value of stock owned by the taxpayer shall be allowed as a deduction under section 165(a) except insofar as
the loss is recognized under §1.1002-1 upon the sale or exchange of the stock and except as otherwise provided in §1.165-5
with respect to stock which becomes worthless during the taxable year.
Page 11 of 29
vi) note: sale of 306-tainted stock will result in realization of ordinary income
b) debt
i) In repayment, creditors don’t recognize any gain or loss
ii) Premiums for early repayment of debt are deductible
iii) Bad debt: § 16618 – depends on whether business or personal debt, but taxpayer is entitled to
a deduction when a debt becomes worthless
(1) Defining worthless
(a) Worthlessness is a question of fact, and no particular legal action is required.
(b) Bankruptcy is an indicia of worthlessness
(c) Debts can become worthless before they come due
(2) Timing:: Must be taken in the year that the debt becomes worthless, unless the debt is
sold
(3) character
(a) Business debt: ordinary losses
(i) Can be written off when they become partially worthless, but must “charge off”
under GAAP
(ii) Any time a corporation lends money, and the debt goes bad, it is a business bad
debt19
(b) Personal debt (non-business): capital losses
(i) Can only be written off when they become wholly worthless
4) non-liquidating distributions (treated as sales, unless they are dividends): a distribution must be with
respect to stock to be treated as a dividend
a) definitions
i) a distribution is a dividend to the extent that it is made out the “earnings and profits” for the
current taxable year, and if they are insufficient to the accumulated earnings and profits since
1913regulations say that a distribution to a shareholder is only in his capacity as a
18
(a) General rule.--
(1) Wholly worthless debts.--There shall be allowed as a deduction any debt which becomes worthless within the taxable year.
(2) Partially worthless debts.--When satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an
amount not in excess of the part charged off within the taxable year, as a deduction.
(b) Amount of deduction.--For purposes of subsection (a), the basis for determining the amount of the deduction for any
bad debt shall be the adjusted basis provided in section 1011 for determining the loss from the sale or other disposition of
property.
…
(c) Nonbusiness debts.--
(1) General rule.--In the case of a taxpayer [non-corporation]
(d) (A) subsection (a) shall not apply to any nonbusiness debt; and (B) where any nonbusiness debt becomes worthless
within the taxable year, the loss resulting therefrom shall be considered a loss from the sale or exchange, during the taxable
year, of a capital asset held for not more than 1 year.
(2) Nonbusiness debt defined.--For purposes of paragraph (1), the term "nonbusiness debt" means a debt other than--
(A) a debt created or acquired (as the case may be) in connection with a trade or business of the taxpayer; or
(B) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.
…
19
166(d)(2) Nonbusiness debt defined. For purposes of paragraph (1), the term "nonbusiness debt" means a debt other than--
(A) a debt created or acquired (as the case may be) in connection with a trade or business of the taxpayer; or
(B) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.
Page 12 of 29
shareholder20 -- because each shareholder has a different bases, each shareholder is
individually analyzed
(1) elements
(a) distribution
(b) of property (as defined in section 317(a)
(c) money or other tangible property
(i) does not include stock or rights to acquire stock
(ii) made by a corporation
(c) to a shareholder
(d) in his capacity as a shareholder
(2) amount of distribution is the amount of cash received by shareholder plus the fair market
value of any property received
(3) does not apply to distributions of rights to stock or distributions of stock (stock dividends)
(4) accounting rules
(a) each shareholder individually analyzed
(b) anti-evasion rules: a series of distributions will be treated as one
(5) defining earnings and profits: do not determine to the end of the taxable year!
(a) start with taxable income
(b) add back in excludible items
(i) tax exempt municipal bond interest
(ii) life insurance proceeds
(iii)federal tax refunds 1.312-6(b)
(iv) do not add in: contributions to capital and realized gains that are not recognized for
tax purposes
(c) add in tax-deductible items that do not represent actual “economic outlay”
(i) dividends received deduction (note: there is no deduction for
(ii) NOL deductions (since it is taken care of in year incurred)
(iii)Capital losses
(d) subtract non-deductible items
(i) subtract federal income taxes
(ii) expenses related to tax-exempt income
(iii)losses between related taxpayers
(iv) charitable contributions in excess of limitions
(e) timing adjustments: to override timing rules in rest of code
(i) add back in depreciation
(ii) change basis in property sold so as not to reflect depreciation
(iii)§ 312(k)(3)(B): corporation must amortize expenses that were “expensesd” ratably
(iv) installment sale: realized gains that were deferred under installment sales have to
be added back in for the year of the sale 312(n)(5)
(v) anything reported on LIFO, must be reported under FIFO 312(h)(4)
(vi) account method (cash v. accrual) remains the same
(d) steps examples from Rev. Rule 74-16421
20
1.301-1c
21
Distribution earnings Results

Source of dividends
Page 13 of 29
(i) determine current earnings and profits, as of the end of the taxable year w/o
reducing it by the other distributions made during the year 1.316-2(a)
(ii) where a corporation has common and preferred stock, distributions to preferred
stock holders absorb earnings and profits before distributions to holders of
common stock
(iii)when there are insufficient earnings and profits, determined as of the end of the
year, the current earnings must be pro-rated amount all of the distributions 1.316-
2(b)(c), example
(iv) use this formula: deduction from current e&p = amount of each distribution *
(current e & p / total current distributions)
(v) accumulated earnings are allocated chronologically to each distribution
(vi) if there is a current loss, but accumulated earnings:
1. in usual case, corp. cannot prove at what point the loss came from: must
determine the amount of accumulated e&p at the time of the distribution (gets
reduced at every further distribution)
(vii) if the corp. can name the point that the loss occurred, then the earnings and
profits will be applied to that date
(4) two categories
(a) earnings and profits from the current year
(b) earnings and profits since 1913
iv) other ways corporations can give money to shareholders that are not dividends
(1) employ them (deductible as compensation)
(2) Redemption of stock. For purposes of this part, stock shall be treated as redeemed by a
corporation if the corporation acquires its stock from a shareholder in exchange for
property, whether or not the stock so acquired is cancelled, retired, or held as treasury
stock. Redemptions could be tainted
c) treatment of dividends (broken into three pieces) by § 301(c) (must be analyzed in order)
i) portion will be treated as a dividend that will be included in gross income as ordinary income
(taxable)
Distributed 7/1 Accumulated As of distribution Current year current accumulated

15,000 40,000 (50,000) 5,000 5,000 10,000
(all 316 (all 316
dividend) dividend)
15,000 -60,000 75,000 5,000 5,000 is
dividend
15,000 -60,000 75,000 -5,000 15,000 is
dividend
You got this offf
because the
75,000 is pro-
rated to ½ of
the year
15,000 -60,000 75,000 -55,000 12,500 is
dividend
because the
75,000 is pro-
rated to ½ of
the year
Page 14 of 29
ii) portion will be treated as a return of basis (not taxable, but will result in a reduction of basis)
(e.g. the portions that are not accumulated or in current taxable year) (non-taxable)
(1) where there are insufficient current earnings and profits available to cover cash
distributions during the year, earnings and profits must be allocated to the distribution in
order to determine dividend status under the following rules
(2) must prorate earnings and profits among distributions using this formula: Currents
earnings and profits allocated to each distribution = amount of distribution * (total
current earnings and profits / total distributions) Reg. 1.316-2(b),(c) Example
(3) but, accumulated earnings are allocated chromatically to distributions (first come, first
served)
(a) if the corporation has a current loss but has accumulated earnings and profits from
prior years, it will be necessary to determine the amount of accumulated earnings and
profits available on the date of distribution – unless the loss can be earmarked to a
particular period, the current deficit is prorated to the date of the distribution Reg.
1.317-2(b)
Current > distribution Each distribution is a dividend out of current earnings and profits. 1.316-2(b)
earnings and
profits
Current < distribution Portion of each distribution treated as coming from current e&p
earnings and
profits
= amount of each distribution * current e&p/total current
distribiutions
Accumulated accumulated EP as of the beginning the year is reduced by portion of the current
e&p and current deficit allocable to the period prior to distribution. Current EP is then po-rated on a
deficit daily basis to the date of distribution. Rev1.316-2(b)
Note: if the corporation can trace the deficit to a particular time of year, they are
welcome to try.
iii) shareholders basis has been applied against them or reduced to zero, and shall be treated as
gain from the sale or stock or cap. gain. (gain from sale)
iv) dividend received deduction: when corporations
receive a dividend they are eligible for a deduction Steps to DRD
(1) general limits 1) Determine whether the DRD to a
(a) 70%: general rule corporation is 70, 80, 100% of the
dividend to the corporation
(b) 80%: (from 242(c)): where the parent
2) If it is 70, 80, it is limited to that
corporation holds more than 20% amount, or 70 or 80% of the
(c) 100%: where they are affiliated under corporations taxable income
243(a)(3) 3) But, if the corporation has a net
(i) a 100% dividend will never be treated operating loss, there is no step #2
limit (e.g. when the full DRD would
as extraordinary dividends
produce a loss, the limit doesn’t
1059(e)(3)(C)(i) kick in)1
(2) options and DRD: Immediate gain if a
redemption is treated as a dividend when the
Page 15 of 29
nontaxed portion of the dividend exceeds the basis of the shares surrendered if the
redemption is treated as a dividend because of the holding of options that are really
constructive ownership § 318
(3) qualitative limits ( no limits if corporation has NOL)
(a) anti-short-term holding provisions: no deduction if (anti-short term holdings
provisions)
(i) common stock: the holding period is under 45 days… during the 90 day ex-
dividend period (the time which one is entitled to receive a dividend)
(ii) preferred stock: 90 days during the beginning on the day which is 180 day before
the ex-dividend date
(b) tolling of restrictions: period is tolled if there is a call or put option on the stock:
purpose is to force the shareholders to take genuine market risk b/c preferred stock is
more stable
(i) no deduction if something is debt-financed portfolio stock owned during a “base
period” under 246A: i.e. deduction only to the extent that one gets an interest in
the stock
(ii) defining debt-financed portfolio
1. debt financed: any indebtedness attributed directly to the investment in the
portfolio stock
2. either purchased w/ borrowed funds or traceable to the borrowed funds
(iii)portfolio stock: any stock of the corporation unless the corporate shareholder
owns either 50% of voting power and value –or- at least 20% of the voting power
and value and five or fewer corporate shareholder own at least 50% of the voting
power and value § 246A(d)(3)(A)
(iv) base period: calculated debt over average date over each day during the period
(c) rules
(i) no deduction if stock purchase is entirely debt financed (DRD=DRD*(100-
average indebtedness%)
1. point of this is to keep a corp from getting DRD and interst deduction
(ii) if it is partially debt-financed, the deduction must be reduced by that portion
246A(e)22
(4) extraordinary dividend limitations (dividend stripping of extraordinary dividends (1059):
if a corporate shareholder holds a share of stock for less than two years, the corporation
must reduce its basis in the stock of the dividend below (but not below zero) by the
amount of the dividend received deduction (1059(b)))
(a) an extraordinary dividend is
(i) preferred: 5% of adjusted basis
(ii) non-preferred: 10% of adjusted basis
(iii)or if it is non-pro-rata, or part of a partial liquidation 302(e) (see later)
(iv) one which is not a qualified preferred divided
1. a qualified preferred divided is not treated as an extraordinary dividend if the
dividends do not exceed a rate of 15% of the lesser of the shareholders adjusted
22
256A(e): Under regulations prescribed by the Secretary, any reduction under this section in the amount allowable as a
deduction under section 243 , 244 , or 245 with respect to any dividend shall not exceed the amount of any interest deduction
(including any deductible short sale expense) allocable to such dividend.
Page 16 of 29
basis or the liquidation preference of the stock 2) and the stock is owned by the
shareholder for over 5 years
(b) all dividends within 85 days are treated as one dividend
ii) If the nontaxed amount exceeds a portion of the adjusted basis, any excess is treated as gain
from the sale of stock
b) distributions that don’t qualify as dividends because of statutory exclusions: Things that
don’t qualify as a dividend because of the Safe harbors in § 302 (which defines when one is
actually giving up stock and control in a corporation) – and if none of the § 301 tests apply, §
302(d) says that it must be treated as a 301 distribution
i) (or) Not “essentially the same” as a dividend (defined by common law) (not "essentially the
same", substantially disproportionate, complete termination, or partial liquidation)
ii) (or) “substantially disproportionate”:
(1) Immediately after the redemption, shareholder must own less than 50% of the total
combined voting power of the stock (attribution rules apply)
(2) Percentage owned by the shareholder immediately after the redemption must be less than
80% of the voting stock owned before the redemption (attribution rules apply)
(3) The percentage of common stock (voting or non-voting) owned after the redemption must
be 80% of what was owned before the redemption
(4) Doesn’t apply where there is series of redemptions
(5) 302(b)(2)(d)(2): Substantially disproportionate redemption of stock
(a) defining “substantially disproportaionate”
(i) After the redemption the shareholder must own less than 50% of the shares entitled
to vote (e.g. if after the redemption he is still a majority shareholder, it does not
apply)
(ii) What voting stock shareholder owns after the exchange must be less than 80% of
what voting stock was owned before aka (voting shares after redemption/total
voting shares outstanding after redemption) must be less than .8*(voting shares
owned before redemption/total voting shares outstanding before redemption) (this
really means that it must suffer a more than 20% decrease in voting power)
1. Stock with contingent rights is not considered to be voting, unless that
contingent event occurs 1.302-3(a)
2. a redemption of solely nonvoting stock can’t be an exchange, because there
won’t be a reduction in the shareholders interest in voting stock
(iii)What total common stock shareholder owns after the exchange must be less than
80% of what common total stock was owned before aka (total shares after
redemption/total total shares outstanding after redemption) must be less than
.8*(total shares owned before redemption/total total shares outstanding before
redemption)
1. If there is more than one class of common stock, the 80% test is based on fair
market value
2. a redemption of solely nonvoting stock can’t be an exchange, because there
won’t be a reduction in the shareholders interst in voting stock
(b) fatal provision: if a shareholder has one type of stock but not anotjer
Page 17 of 29
You got this offf
(i) if shareholder doesn’t any any voting stock, 302(b) doesn’t apply according to
1.302-3(a)23
(c) safe harbors
(i) if the shareholder owns no common stock either directly or constructively, a
redemption of voting preferred stock without a reduction in a 'shareholder's
ownership of the common stock' may qualify as a substantially disproportionate
redemption under section 302(b)(2) of the Code Rev. Rul 81-41
(ii) §1.302-3(a): if the shareholder makes a reduction of voting and nonvoting
stock, it qualifies24
(iii)exception: if there a a substantial redemption, a simultaneous redemption of non-
voting stock will be treated as an exchange Rev. Rul 81-41
(d) Mechanics
(i) Sec. 318 attribution rules are applicable (and to be applied in the way that
attributes the most shares)
1. timing: causal relationship (though not contractual relationship) deems two
redemptions to be as one.
2. Treat a series of redemption in the aggregate. 302(b)(2)(d)25
3. However, a planned retirement and redemption of shares does count. Rev.
Rul. 77-293
iii) (or) 302(b)(2)(d)(3): Termination of shareholder's interest combined with election by the
shareholder (To completely terminate a family (usually) members interest in a closely held
corporation, a shareholder can elect to waive attribution)
(1) Limits:
(a) entity and option rules still apply
(b) Three initial restrictions
(i) “ten year” look forward rule – apply to any interest other than as a creditor
302(c)(2) (this might be a bit more relaxed)
23
1.302-3(a) The fact that a redemption fails to meet the requirements of paragraph (2), (3) or (4) of section 302(b) shall not
be taken into account in determining whether the redemption is not essentially equivalent to a dividend under section
302(b)(1). See, however, paragraph (b) of this section. For example, if a shareholder owns only nonvoting stock of
a corporation which is not section 306 stock and which is limited and preferred as to dividends and in
liquidation, and one-half of such stock is redeemed, the distribution will ordinarily meet the requirements of
paragraph (1) of section 302(b) but will not meet the requirements of paragraph (2), (3) or (4) of such section.
The determination of whether or not a distribution is within the phrase "essentially equivalent to a dividend" (that is,
having the same effect as a distribution without any redemption of stock) shall be made without regard to the earnings
and profits of the corporation at the time of the distribution. For example, if A owns all the stock of a corporation and
the corporation redeems part of his stock at a time when it has no earnings and profits, the distribution shall be treated
as a distribution under section 301 pursuant to section 302(d).
24
(a) Section 302(b)(2) provides for the treatment of an amount received in redemption of stock as an amount received in
exchange for such stock if--
(1) Immediately after the redemption the shareholder owns less than 50 percent of the total combined voting power of
all classes of stock as provided in section 302(b)(2)(B),
(2) The redemption is a substantially disproportionate redemption within the meaning of section 302(b)(2)(C), and
(3) The redemption is not pursuant to a plan described in section 302(b)(2)(D).
25
302(b)(2)(D) SERIES OF REDEMPTIONS.--This paragraph shall not apply to any redemption made pursuant to a plan the
purpose or effect of which is a series of redemptions resulting in a distribution which (in the aggregate) is not substantially
disproportionate with respect to the shareholder.
Page 18 of 29
You got this offf
(ii) if the stock was not transferred for stock avoidance, two additional limiations
apply 302(c)(2)(B)
(iii)additional restriction #1: 10 year look back rule:26 if they bought the stock within
the past ten years from someone who would normally have their ownership
attributed to them, then they cannot make the election
(iv) additional restriction #2: at the time of the distribution, no person may own stock
which is attributable to the distribute under the family attribution rules if that
related family member acquired any stock in the corporation within the 10
year lookback period 27
(c) examples of legitimate transactions
(i) a planned retirement and redemption of shares. Rev. Rul. 77-29328
(d) examples of tax avoidance transactions
(i) transfers stock of a corporation to a spouse in contemplation of the redemption of
the remaining stock of the corporation and terminates all direct interest in the
corporation in compliance with
1. the transfer by a taxpayer of part of the stock of a corporation to a spouse in
contemplation of the subsequent redemption of the transferred stock from the
spouse
(2) Mechanics
(a) Analyze immediately after the distribution
(b) Note: if there is more than one way to attribute shares, the way that attributes the
highest number of shares should be used
(c) “ten year” look forward rule – apply to any interest other than as a creditor 302(c)(2)
(this might be a bit more relaxed)
(d) redeemed shareholder must do three things
(i) must give notice to the service
(ii) must agree to notify service if they obtain a prohibited interest
(iii)must waive statute of limitations
(3) Examples of “prohibited interest”
(a) providing post redemption services may disqualify Lynch v. Commissioner
(b) an agreement between the taxpayer (shareholder) and the remaining shareholders of
the corporation calling for a member of the taxpayer's law firm to be appointed to the
board of directors to protect the interest of the taxpayer as a creditor of the corporation
26
302(c)(2)(B)(i) any portion of the stock redeemed was acquired, directly or indirectly, within the 10-year period ending on
the date of the distribution by the distributee from a person the ownership of whose stock would (at the time of distribution) be
attributable to the distributee under section 318(a) , or
27
302(c)(2)(B)(ii) any person owns (at the time of the distribution) stock the ownership of which is attributable to the
distributee under section 318(a) and such person acquired any stock in the corporation, directly or indirectly, from the
distributee within the 10-year period ending on the date of the distribution, unless such stock so acquired from the distributee
is redeemed in the same transaction.
28
77-293: The structure and legislative history of section 302 of the Code make it clear that the purpose of section
302(c)(2)(B) is not to prevent the reduction of capital gains through gifts of appreciated stock prior to the redemption of the
remaining stock of the transferor, but to prevent the withdrawal of earnings at capital gains rates by a shareholder of a family
controlled corporation who seeks continued control and/or economic interest in the corporation through the stock given to a
related person or the stock he retains. Application of this provision thus prevents a taxpayer from bailing out earnings by
transferring part of the taxpayer's stock to such a related person and then qualifying the redemption of either the taxpayer's
stock or the transferee's stock as a complete termination of interest by virtue of the division of ownership thus created and the
availability of the attribution waiver provisions.
Page 19 of 29
will be in violation of section 302(c)(2)(A)(i) of the Code, the redemption shall be
treated as a distribution of property to which section 301 of the Code applies Rev.
Rul. 59-119
(i) difficult issue where there is a delayed payment of stock.
(ii) Courts hold that mere postponement does not cause a classification as equity
(iii)Leases, on an arms-length basis, a redeemed shareholder can lease property to a
corporation Rev. Rul 77-467
(b) If someone becomes a custodian under the UGTMA Rev. Rul 81-233
(c) Trustee of corporate voting stock Rev. Rul 71-426
(2) Safe harbors or not “prohibited interest
(a) Maintaining a creditor relationship with the corporation
(b) As an executor, but virtue of stock held by inheritance. 302(c)(2)(A)(ii)
(3) Entities waiving attribution when 100% of the interest is terminated
(a) Person who causes the attribution has to waive… and
i) Requires that the entity (usually a trust) and the beneficiary agree to be jointly and severally
liable29
c) 302(b)(2)(d)(4): Redemption from noncorporate shareholder in partial liquidation (this creates
parity with complete liquidaitions). Partial liquidations are treated as exchanges (not dividends)
ii) defining partial liquidations (302(e)(1))
(1) must be a plan
(2) must execute the plan in the current tax year or next
(3) must not essentially equivalent to a dividend
(4) must be the termination of one line of business (qualified trade or biz) (but the business
must live on)30
(a) raw land is not an active trade or business
(b) 5 year rule: must have been engaged in the trade or business for more than 5 years, so
as to avoid acquisition of a dummy corporation and than immediate liquidation for sale
or exchange treatment
(c) corporation must live on (ie engaged in another trade or biz)
(5) does not apply to subsidiaries. The terminated business must be run directly from the
corporation
(6) does not apply to corporate-owned shares
iii) even a partial distribution to a shareholder will be treated as a sale or exchange
iv) there is no need for any surrender of stock
v) Partial liquidations, which under 302(b)(4) are treated as exchanges. Unlike the other
requirements for exchange treatment, partial liquidations are measured at the corporate level
(1) Requirements for exchange treatment of partial liquidations
(a) Only distributions to non-corporate shareholders count
29
302(c)(2)(C)(II) each related person agrees to be jointly and severally liable for any deficiency (including interest and
additions to tax) resulting from an acquisition described in clause (ii) of subparagraph (A).
30
302(e)(2) TERMINATION OF BUSINESS.--The distributions which meet the requirements of paragraph
(1)(A) shall include (but shall not be limited to) a distribution which meets the requirements of subparagraphs (A)
and (B) of this paragraph:
302(e)(2)(A) The distribution is attributable to the distributing corporation's ceasing to conduct, or consists of the
assets of, a qualified trade or business.
302(e)(2)(B) Immediately after the distribution, the distributing corporation is actively engaged in the conduct of a
qualified trade or business.
Page 20 of 29
(i) Corporate shareholders may not only get a divident, but might have to reduce the
basis in their stock
(ii) Dealing with subsidiaries
(iii)Distribution of liquidated shares of wholly owned subsidiaries to a parent
corporation's shareholders do not qualify of exchange treatment 79-184
1. However, a liquidation of a child corporation which owns stock in a grandchild
corporation pass, resulting in a partial liquidation (if a subsidiary is liquidated,
its assets can be deemed to be liquidated).
(b) Pursuant to a plan
(c) Must be some contraction of a business
(i) could be any contraction of the business, including proceeds from a fire
1. can be a sale of one line of business
2. safe harbor
(ii) must be assets
(iii)of an active trade or business
(iv) that has been in use for five years
1. cannot have been acquired in the past five years in a taxable transaction
(v) no need to surrender stock
(d) Occurs within the taxable year in which the distribution was adopted or the next one
(e) "not essentially equivalent to a dividend" (but this requirement is based on whether it
is equivalent at the corporate level
(2) pro rata distributions, can qualify as partial liquidations so long as they are actually
contracting a business
(3) when a corporation distributes appreciated property in a redemption (311)
(a) corporations recognize gain on distribution of appreciated property in a redemption as
if the property had been sold for its fair market value (this applies to all distributions,
even those which could be termed a partial liquidation)
(b) effect on earnings and profits 312(n)(7)
(i) look to shareholder level
1. If it is treated as an exchange: 312(n)(7): a ratable share of the corporation’s
earnings based on the redeemed stock
2. if it is treated as an ordinary distribution under § 301: the distributing
corporation adjusts its EP in the same matter that other non-liquidating
corporations would: They are reduced by the amount of cash and the principal
value of any obligation, and by the greater of the adjusted basis and fair market
value of any property distributed.
d) The ordinary distributions take priority in determining earnings and profits Rev. Rul 74-339
5) brother-sister stopgaps Stopgaps on controlling corporations in § 304 which prevents controlling
shareholders from triggering distributions to claim a basis recover and capital gain treatment of
transactions, unless there is a significant reduction in corporate control
a) Unless they have significantly reduced their interest in the corporation, it does not matter
i) Terms
(1) Property is defined as money, securities, etc. but not stock
(2) Acquiring corporation is defined as one that acquires stock frin a shareholder of another
related corporation in return for property. In a parent subsidiary acquision, the acuquiring
corporation is the subsidiary
Page 21 of 29
(3) Issuing corporation is defined as whose stock has been transferred. In a parent-subsidiary
corporation, it is always the parent.
(4) Control is defined owning 50% of the combined voting power or 50% of the total vooe of
all shares of all classes of stock 304(c)(1)\
(a) 318 attribution rules apply, but stock is attributed between a corporation and a 5%
(rather than 50% shareholder)
ii) analysis
(1) to see if 304 applies, see if the sale is "brother-sister" or "parent-subsidiary" redemption
(a) bother-sister acquisitions: where persons in control of two corporations transfer stock
between one corporation (issuing) and the other (acquiring)
(i) this would fail to satisfy any of 302(b)'s test for exchange treatment
(ii) 304 requires that the transaction be treated as a dividend to the extent of the
acquiring corporation's EP, then to the extent of the issuing corporation's EP
You got this offf
(iii)consequences
1. if treated as a dividend
a. acquiring corporation takes a transferred basis controlling party
b. controlling party's stock's basis in acquiring corporation is increased by the
basis of aquired stock that is treated as having been transffered
c. then reduce the earnings and profits as per 304(b)(2): first the acquiring
corporation's earnings, by the amount of the vidident, then the issuing
corporation's EP
d. acquiring corporation is treated as having acquired the stock by purchase
and takes a cost basis under the normal? 1012
2. if as an exchange
a. Sec. 312(n)(7) limits it to an amount not in excess of the redeemed stock's
ratable share of earnings and profits
b. but the code and regulations don’t say which corporation matters
(b) parent-subsidiary acquisitions: when a controlled corporation acquires stock of its
parent in return for property
(i) Control is defined owning 50% of the combined voting power or 50% of the total
vote of all shares of all classes of stock 304(c)(1)
(ii) If a transaction is both a brother-sister and a parent sub-sidiary the parent
subsidiary rules take precedence 304(a)(1) – but if the attribution rules do this (as
they inevitably will), the brother sister rules will apply 1.304-2(c) ex. 1
b) 302(b)(2)(d)(1): Redemptions not [essentially] equivalent to dividends.--Subsection (a) shall
apply if the redemption is not essentially equivalent to a dividend. (this was the original
provision, and it is explained by common law
i) Davis: must be some meaningful reduction, and if a shareholder really holds the same amount
before and after (even if he contributes capital), it is not a dividend
ii) A redemption of non-voting preferred stock is not essentially equivalent to a dividend when
there is no reduction in the percentage of voting and noting stock, and when the redeemed
shareholder remains in the control group Rev. Rul 85-106
iii) Determination of what is “meaningful” reduction is based on
(1) Right to vote and exercise control
(a) A reduction from 57 to 50% is meaningful, since this takes away a shareholders right
to act unilaterally Rev. Rul. 75-502 (different if charter uses a 66% test)
Page 22 of 29
(b) Where a trust loses its rights to the trust experienced a reduction of its voting rights, its
right to participate in current earnings and accumulated surplus, and its right to (a)
share in net assets on liquidation, it is essentially equivalent to a dividend. Rev.
Rul. 75-512. Where a shareholder has some voting interest, a redemption of non-
voting shares won’t be meaningful
(2) Right to participate in current earnings and accumulated surply
(3) Right to share in net assets on liquidation
iv) (or) Partial liquidation
b) When corporations redeem stock, there are two possible consequences
i) Sale or exchange, which results in capital gain or loss (unless is a dividend)
6) Realizations by corporation and shareholder of a non-liquidating distribution
a) Realization by corporation: realize gain equal to the amount fair market value of the property
minus the basis. 311(b) (this means that there must be some corporate level tax on the property)
i) Limited to avoid a negative basis: if the shareholder assumes a liability, the maximum fair
market value of the property can be the liability
b) Effect of a non-liquidating distribution on the shareholder's basis
i) effect on EP: gain recognized increases or decreases current EP by the adjusted basis of the
distributed property. but won a distribution of appreciated property, earnings and profits is
reduced by its fair market value. 312(a)(3). – net result: same as if the corporation had sold
the property and than distributed the cash to the shareholders
ii) exceptions that reducing a distribution corporations EP in determining tax consequences of
distributions to large shareholders
(1) 312(k): depreciation deduction – do not apply to a 20% corporate shareholders 301(e)
(a) 20% corporate shareholders 301(e) is anyone entitled to a dividends received
deduction either directly or indirectly and under 318 received either 1) stock in
distributing corporation possessing at least 20% of the total combined power or 20%
of the total value of all the distribution corporations stock, except non-preferred stock
(2) 312(n): other timing deductions – do not apply to a 20% corporate shareholders 301(e)
(a) 20% corporate shareholders 301(e) is anyone entitled to a divdents received deduction
either directly or indirectly and under 318 received either 1) stock in distributing
corporation possessing at leat 20% of the total combined power or 20% of the total
value of all the distribution corporations stock, except non-preferred stock
c) realization by sh: shareholder basis is the fair market value at the date of the distribution, reduced
by any encumbered liabilities 301(c)
7) stock dividends (splits): In general, a stock split cannot be taxed since it is really creating more
pieces of paper. Eisner v. Macumber (common) Koshland (preferred); Towne (if they are given
something they did not have before, it is more); Gowran (preferred stock to common shareholders
counts as more). In other worse a stock dividend does not result in a realization event
a) But, if there is a change in the shareholder's interests, it DOES result in a stock dividend.
i) When stock distributions are includible in gross income (because the shareholders interests
have either changed, or have the possibility of changing) , it is treated as per § 301 (dividend
to the extent of earnings and profit (but not below zero), return of basis, than capitol gain)
(1) Right to purchase additional stock count as an increase
(2) Rights of others to purchase stock count as an increase
Page 23 of 29
ii) There is a hair-trigger upon which shareholder has a disproportionate effect. Shareholder, for
these purposes includes one with 1) someone who holds stock 2) someone who has the right
to acquire stock; 3) someone who has the right to convert a note to stock
(1) Any election of any shareholder to acquire stock or property will trigger taxable treatment
(2) Shareholders who participate in reinvestment plans are taxed. Rev. Rul 78-375
(3) Anything that ends up giving some shareholders an increased share and others more
property will be taxed (this means that if some shareholders have the option of doing
something, some will have a disproporate effect)
(4) Doesn't matter if they are not pursuant to a plan
(a) But, if distributions are more than 36 months apart, a safe harbor is created wherein
they are presumed to not be part of a plan. Reg. 1.305-3(b)(2)
(5) If some shareholders receive common and others receive preferred stock, then they are
deemed to have a disproportionate effect
(a) Preferred stock is defined as stock that does not participate in corporate growth
(6) Preferred stock is generally taxable – unless it is increased to take account of a dividend or
stock split under § 205(b)(4)
(a) A change in conversion ratio is deemed to be a stock distribution, unless it can be
established that it is to take into account a split
(7) A distribution of covertible preferred stock is presumed to have a disproporationate effect,
and therefore taxable unless the taxpayer can establish under 1.305-6(a)(2) that it is not
predictable
(8) Imputed dividends: preferred stock that is issued at a discount, but no dividends are paid
until distribution
i) Distribution of taxable rights
b) Effect of nontaxable stock dividends (e. g. where there is no increase in voting power, just more
paper)
i) In a nontaxable distribution there is no change in earnings and profits
ii) Shareholders basis in stock distributed: will be allocated between old shares and new shares
based on their fmv on the date of distribution. § 307(a)
iii) Shareholders holding period of the new stock is tacked on to the holding period of the old tock
(this means that stock can get the 306 taint)
c) Characterization of taxable stock dividends
i) Effect on corporation
(1) Corporation recognizes no gain or loss
(2) Corporation can reduce its EP by the fmv of what is distributed. 1.312-1(d) (this might be
very lower)
ii) Effect on shareholders of stock distribution
(1) Shareholders basis in stock distributed: will be allocated between old shares and new
shares based on their fmv on the date of distribution. § 307(a)
(2) Shareholders holding period of the new stock is tacked on to the holding period of the old
tock
(3) Rights
(b) Distribution of rights does not get included in gross income, unless some shareholders
get cash, and others get rights in that distribution
Page 24 of 29
(c) Usually there is an allocation of basis between the underlying stock and the and the
rights in proportion to their relative fair market values on the date of distribution.
(unless de minimus rule). 1.307-1(a). If the rights lapse, no loss.
d) Rights have a zero basis if their fair market value is less than 15% of the stock with to which they
are distributed, unless the shareholder elect to allocate between the underlying stock and the rights
in proportion to their fmv
8) Redemptions of stock
a) Differentiating between a redemption and a distribution (a.k.a. a dividend to the extend of
earnings and profits)
i) A distribution must satisfy these five criteria to be a distribution as opposed to a redemption
(1) distribution
(2) of property (as defined in section 317(a)
(3) money or other tangible property
(a) does not include stock or rights to acquire stock
(5) made by a corporation
(6) to a shareholder
(7) in his capacity as a shareholder
ii) Amount of distribution: Calculation: amount is amount of cash received by shareholder plus
the fair market value of any property received
iii) does not include distributions of rights to stock or distributions of stock (stock dividends)
b) bifurcation possible for distributions without fmv: To the extent that a corporation distributes
property to its shareholders and doesn’t receive fair market value for it, that is a dividend, and
under Sec. 316, the transaction will be bifurcated into the transaction and the dividend
9) transfers of shares between parties
c) Selling stock to a related party does not result in a realization of gain or loss Sec. 26731
d) Corporations that make distribution, under 301, the entire amount is taxable.
10) corporation's redemption of stock
a) Redemptions: a buyback of the shares from the corporation. This means that the shareholders
share in the corporation does not change (this is treated like dividend, as opposed to a buyback, in
which the actual control changes), .
b) When redemptions will be treated as an exchange
i) When it is an exchange: so that the shareholder will recognize a capital gain or loss between
the amount of distribution and the shareholders basis. (non-corporate shareholders prefer,
corporate shareholders prefer b/c they get the drd)
ii) When it is not under 302 (an exchange), it falls under 301, which will be treated as a
distribution (possibly a dividend) dividend.
e) Test to determine whether or not it is an exchange (four statutory tests in 301(b)(1)-(4), they focus
how the shareholders interest has changed, and whether there has been a meaningful reduction in
interest (must analyze under constructive ownership rules)
i) Each shareholder is analyzed individually, but ownership can be attributed to them
ii) Constructive ownership: attribution to determine whether or not there has actually be a
change in proportion of ownership -- with the exception of families, must reattribute each
31
267(a)(1) DEDUCTION FOR LOSSES DISALLOWED.--No deduction shall be allowed in respect of any loss from the
sale or exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection
(b). The preceding sentence shall not apply to any loss of the distributing corporation (or the distributee) in the case
of a distribution in complete liquidation.
Page 25 of 29
person’s interest in what they have to the succeeding generation. (if there is more than one
way to attribute shares, attribute them in the way that gives them the most shares).
(1) All individuals own stock that is owned by spouses, children, grandchildren and parents.
Siblings are not considered to be “family” for these purposes
(c) No double family attribution (since this would mean that everyone is related)32
(2) Option attribution: people are deemed to own shares that they have options in. If both
option and family attribution applies, than option attribution applies (so family attribution
can be used later)33
(3) Entity to owner attribution (no sideways attribution – co-partners do not have interests in
what their partners own, except as a member of the partnership)
(a) From Partnerships to their members: all individual who have an interested in a
partnership are considered to own stock that the partnership owns in proportion to their
beneficial interest
(b) From trusts to beneficiaries: Trusts: all individual who have an interested in a trusts
are considered to own stock that the partnership owns in proportion to their beneficial
interest
(i) Doesn’t matter how small or remote, it is considered owned to the extent of their
interest in the trust
(ii) Must have present, not contingent interest
(c) From corporations to individuals: : individuals are considered own the stock of
corporations that they own more than 50% of
(4) From individuals to entities (no sideways attribution – co-partners do not have interests in
what their partners own, except as a member of the partnership)
(a) To partnerships: all stock owned or constructively owned by partners is considered
owned by a partnership or the estate
(b) To estates: all stock owned or constructively owned by partners is considered owned
by a partnership or the estate
(c) To trusts: if an individual has more than a 5% interest in the trust it is considered to be
contingent
(d) To corporations: if the corp is more than 50% owned by the individual, it is deemed to
be an owner
c) Options: individuals who own an option are considered to be owning that sock
11) 306 taints: the anti-bailout provisions. Distributions of stock may be treated as ordinary income when
sold if it would have been treated as a divided
a) defining § 306-tainted stock
i) preferred stock distributed to a shareholder as a tax free stock dividend under § 305.
(common stock, since it participates in corporate growth, doesn't count.)
(2) If the stock has a limited right to dividends it is preferred
(3) If the corporation has a right of first refusal it is common. 76-386
(4) In general, any dividend other than common on common
32
318(A)(5)(B) Members of family.--Stock constructively owned by an individual by reason of the application of paragraph
(1) shall not be considered as owned by him for purposes of again applying paragraph (1) in order to make another
the constructive owner of such stock.
33
318(A)(5)(D)Option rule in lieu of family rule.--For purposes of this paragraph, if stock may be considered as owned by
an individual under paragraph (1)(family) or (4)(options, it shall be considered as owned by him under paragraph (4).
Page 26 of 29
(5) Does not include stock with no current or accumulated EP (e. g. would no part of the
stock been a tax free dividend for the year in question)
iii) Any stock whose basis is determined with reference to the 306 stock is considered to be 306
stock
(1) 306 stock is removed on the death of the shareholder, since it takes a date-of-death basis
under 1014
(2) any stock which is received in a reorganization or division is 306 stock if the effect is the
same as a receipt of a stock dividend, or if the stock was received in exchange for 306
stock
iv) stock received in a reorganization
v) preferred stock received in a 351 exchange is covered under § 306(c)(3). If the receipt of
money instead of any part of the stock would have been treated as a dividend, then it will be §
306 stock. In this case, one must apply the rules in § 304 (brother-sister acquisitions)
b) exceptions to section Sec. 306
(1) exemptions:
(a) 306(b)(1): total withdrawal from the corporation (since the shareholder is not taking
bailing out earnings)
(b) complete liquidation
(c) contributions to capital
(d) tax free 351 transfers
(e) if the IRS thinks that it was not tax avoidance
(i) Fireoved: maintaining effective control is not grounds for relief
ii) exception: stock sold in a taxable transfer erases the taint
iii) selling entire interest in corporation
(1) must not even have effective control
iv) redemption in complete liquidation
v) disposition that are treated as non-recognized under 351
vi) distribution that is coupled with a later disposition or redemption that is not part of a plan
c) the power of § 306: 306 taint (avoiding a preferred stock bailout wherein a corporation would
distribute preferred stock to shareholders, would would sell the stock and report a long term
capital gain (since a portion of the shareholders basis was allocated to the preferred stock) and
corporation would redeem the preferred stock from the 3rd party. 306 labels stock with bailout
potential, and 306 tainted stock will be treated, upon its disposition not as ordinary income but as
a capital gain.
i) if sold: treated as ordinary income to the extent of its ratable share of the amount that would
have been a dividend if the corporation distributed cash instead. The rest is treated as gain
from the sale or exchange of stock
(1) sh must look back to the time of the distribution and determine what would have come out
of earnings and profits
(2) the ordinary income is not eligible for a dividends received deduction, and a corporation
can't reduce its earnings and profits when its 306 stock is sold
d) Effect of 306 stock
i) If it is sold: Ordinary income, not capital gain when stock is sold to the extent of the stock’s
“ratable share” of the amount that would have been a dividend if the corporation distributed
cash in an amount equal to the fair market value of the stock at the time of the distribution.
Page 27 of 29
The balance is treated as a reduction of basis of the 305 stock, and anything else is treated as
gain from an exchange.
(1) Must look back to the original time of the distribution
(a) in determining the date that the distribution was made, the date that the shares are
surrendered is irrelevant, the date of distribution is what matters. Rev. Rul. 68-348:
(2) No Dividends received deduction available
(3) No reduction of Earnings and Profits by the corporation allowed
ii) if redeemed: treated as a distribution taxable to the extent of current or accumulated earnings
and profits in the year of the redemption
(1) If it is redeemed (really a two-step process to withdraw cash): treated as a 301 distribution
(2) 1.331-e: if a shareholder has acquired stock at different times, gain or loss is determined
separately. This is important for holding period purposes. The actual amount of gain or
loss should be the same, whether you aggregate or do it on a block-by-block approach.
(Doesn't usually matter since LT and ST CGs can offset each other)
b) purging 306 taint
i) sale
ii) death
12) liquidations of a subsidiary
a) liquidations of one corporation into another should be a tax free event (e. g. c2 liquidates
distributing its assets into Corporation)
i) two reasons why it should be nontaxable event
(1) dividend received deduction
(2) we were taxing, in the first case, something where the assets didn't remain in corporate
form
ii) there is no need to tax if any gain remains there, and the way we do this is under a carryover
basis, under a 332 liquidation
(1) in order to qualify for a liquidation under 332, the liquidation must meet two requirements
under § 332(b).
(a) the corporation receiving the property, was, on the date of liquidation was the owner
of stock as per 1504(a)(2) (as long as you own 80% of the vote, and 80% of the value
you can file a consolidated return)
(i) the first requirement is that Corporation own that much of the property (80%)
(b) second requirement: liquidation take place within 1 taxable year or take place within
three years of when the first distribution was made (does not need to be the same year
in which the plan was adopted).
(i) If they want to do it within the three year period, they have to waive the statute of
limitations, and might be required to post a bond
(c) Failure to meet these requirements will result in the liquidation being retroactively
disqualified
(i) Also, will be disqualified if the corporation loses control
(ii) There actually is a formal plan of liquidation under § 332 (§ 332(b)(1)
(2) 332: no gain or loss is recognized by a corporation on receipt of property distributed by
another corporation (assets are not leaving corporation form, and we have another chance
to impose the corporation tax)
(a) 334(b): basis of the property in the hands of the distribute shall be the same as if it is in
the hands of the transferor (and a carryover basis and a carryover holding period)
Page 28 of 29
(i) 381 (there are other carryover attributes, not applicable here such as NOL that
would carry over to the corporation)
(3) 1.332-5: minority shareholders are taxed under 331
(4) consequences to the liquidating corporation.
(a) § 337: no gain or loss shall be recognized to an 80% distributee.
(5) 336(d)(3) prevents any loss from being recognized only any distribution, on any
distribution in such liquidation – in distribution property that it had a gain on
(a) can't manipulate the property by dividing up the losses (§ 337)
(6) exception: 337(b)(2) and 337(d)(2): a gain is recognized where the property is transferred
to either a tax exempt or a foreign parent (because this loses the chance to tax it any layer).
You got this offf
Page 29 of 29
Retirement Plan Comparison Chart
Safe Harbor
Feature 401(k) Solo 401(k) SIMPLE 401(k) Profit Sharing SEP IRA SIMPLE IRA
401(k)
Basic plan type Defined Defined Defined Defined Defined Defined Defined
Contribution Contribution Contribution Contribution Contribution Contribution Contribution
Who generally Corporations, Sole Sole Sole Sole Sole Sole

adopts partnerships, proprietorships, proprietorships, proprietorships, proprietorships, proprietorships, proprietorships,
limited liability partnerships, partnerships, partnerships, partnerships, partnerships, and partnerships,
companies limited liability limited liability limited liability limited liability small businesses limited liability
companies and companies and companies and companies and companies and
corporations with corporations corporations with corporations corporations with
no common law 100 or fewer 100 or fewer
employees employees employees
Can employer Yes Yes Yes No Yes No No

sponsor other
qualified
retirement plans
Who can Employee; Employee; Employee and Employee and Employer Employer Employee and
contribute employer employer employer employer employer
contributions are contributions are
optional optional
Cost index Low to High Low to Medium Low to Medium Low to Medium Low to High Low Low
depending upon depending upon
design complexity, design complexity,
service model service model
adopted and other adopted and other
factors factors
Maximum The lesser of The lesser of The lesser of The lesser of None None. The lesser of
employee deferral $13,000 for 2004 $13,000 for 2004 $13,000 for 2004 $9,000 for 2004 Contributions are $9,000 for 2003
contribution (indexed for (indexed for (indexed for (indexed for generally by (indexed for
inflation each inflation each year) inflation each inflation each Employer only inflation each
year) or 100% of or 100% of year) or 100% of year) or 100% of year) or 100% of
compensation compensation compensation compensation compensation
Copyright © 2003 - 2004 by 401khelpcenter.com, LLC. All rights reserved. (Revised January 2, 2004)
This chart is provided as general guidance on the subject covered and is
not intend to be authoritative or to provided legal, tax, or investment advice.
Safe Harbor
401(k)
Employer Optional; matching Discretionary up to Required match of Required match of Discretionary up to Discretionary up to Required match of
contributions contributions and 25% of an 100% on the first 100% on the first 100% of 25% of an 100% on the first
profit sharing employee's eligible 3% of employee 3% of employee compensation or employee's eligible 3% of employee
contributions compensation or deferral plus 50% deferral $41,000, compensation or deferral (may be
allowed -- plan $41,000, whichever on the next 2% of whichever is less $41,000, reduced to 1% in 2
document will is less (excluding employee deferral whichever is less of any 5 years)
OR
state formulas catch-up
contribution) OR
OR
2% of
3% of compensation to
compensation to all eligible 2% of
all eligible employees compensation to
employees all eligible
employees
Catch-up $3,000 for 2004 $3,000 for 2004 $3,000 for 2004 $1,500 for 2004 N/A N/A $1,500 for 2004
contributions for (indexed for (indexed for (indexed for (indexed for (indexed for
those age 50 and inflation each inflation each year) inflation each inflation each inflation each
older year) year) year) year)
Employee eligibility Age requirement Age requirements Age requirement Age requirement Age requirement Age requirement All employees
cannot exceed 21; cannot exceed 21; cannot exceed 21; cannot exceed 21; cannot exceed 21; cannot exceed 21; earning $5,000 for
service service service service service Have earned $450 any past two years
requirement can’t requirements can’t requirement can’t requirement can’t requirement can’t in three of past and is expected to
exceed one year; exceed one year exceed one year exceed one year exceed one year; five years do so in current
may exclude union two years if 100% year; no age limit
employees vested permitted
Who directs Employer/Trustee Individual Employer/Trustee Individual Employer/Trustee Individual Individual

investments or plan may or plan may or plan may
allow individual allow individual allow individual
direction direction direction
IRS reporting by Form 5500 Form 5500-EZ Form 5500 Form 5500 Form 5500 None None
employer when plan assets
reach $100,000
Safe Harbor
401(k)
Establishment By the last day of Establish in the tax Any date between On or before By the last day of Established by the On or before
deadline the plan year for year January 1 and October 1st for the plan year for time the corporate October 1st for
which the plan is October 1; may existing which the plan is tax return (with existing
effective not have an businesses; effective extensions) is filed businesses;
effective date that as soon as for the tax year in as soon as
is before the date administratively which the administratively
plan actually feasible for deduction is being feasible for
adopted businesses taken businesses
established established
after October 1st after October 1st
Funding deadline Employee Unincorporated Employee Employee Contributions must Funded by the Employee
contributions must businesses -- contributions must contributions must be deposited by time the corporate contributions must
be deposited as employer/employee be deposited as be deposited as the time the tax return (with be deposited
soon as contributions: by soon as soon as corporate tax extensions) is filed within 30 days
administratively the time the administratively administratively return (with for the tax year in after the end of
possible, but no corporate tax possible, but no possible, but no extensions) is filed which the the month in which
later than 15 return (with later than 15 later than 15 for the tax year in deduction is being the amounts would
business days after extensions) is filed business days after business days after which the taken otherwise have
the month in which for the tax year in the month in which the month in which deduction is being been payable to
the deferrals were which the the deferrals were the deferrals were taken the employee in
made; employer deduction is being made; employer made; employer cash; employer
contributions must taken; incorporated contributions must contributions must contributions must
be deposited by businesses -- be deposited by be deposited by be deposited by
the time the employer the time the the time the the time the
corporate tax contributions: by corporate tax corporate tax corporate tax
return (with tax-filing date plus return (with return (with return (with
extensions) is filed extensions and extensions) is filed extensions) is filed extensions) is filed
for the tax year in employee for the tax year in for the tax year in for the tax year in
which the contributions must which the which the which the
deduction is being be deposited as deduction is being deduction is being deduction is being
taken soon as taken taken taken
administratively
possible, but no
later than 15
business days after
the month in which
the deferrals were
made
Safe Harbor
401(k)
Can rollover to:
IRA Yes Yes Yes Yes Yes Yes Yes

SIMPLE IRA Yes2 Yes2 Yes2 No Yes2 No Yes
Roth IRA No No No No No Yes Yes
SEP Yes Yes Yes Yes Yes Yes Yes
SIMPLE 401(k) Yes3 Yes3 Yes3 No Yes3 No No
Safe Harbor Yes Yes Yes Yes Yes Yes Yes
401(k)
403(b) 1 Yes Yes Yes Yes Yes Yes Yes
4571 Yes Yes Yes Yes Yes Yes Yes
401(k)1 Yes Yes Yes Yes Yes Yes Yes
Minimum vesting Immediate on Immediate Immediate Immediate Employer Immediate Immediate

Employee contributions can
Contributions; be subject to
Employer vesting schedule
contributions can
be subject to
vesting schedule
Loans Employer option Employer option Employer option Yes Employer option No No
Safe Harbor
401(k)
When can Withdrawals can Withdrawals can Withdrawals can Withdrawals can Withdrawals can Withdrawals can Withdrawals can
withdrawals be generally be made generally be made generally be made generally be made generally be made be taken at any be taken at any
taken for the following for the following for the following for the following for the following time; withdrawals time; withdrawals
reasons: reasons: reasons: reasons: reasons: taken prior to an taken prior to an
employee reaching employee reaching
termination of termination of termination of termination of termination of age 59½ may be age 59½ and
employment employment employment employment employment subject to IRS within the first 2
disability disability disability disability disability penalties; years of
withdrawals are participation, may
death death death death death generally be subject to a
retirement retirement retirement retirement retirement considered taxable 25% early
hardship hardship hardship hardship hardship income withdrawal
penalty; after 2
If taken prior to an If taken prior to an If taken prior to an Withdrawals taken If taken prior to an years, a 10% early
employee reaching employee reaching employee reaching prior to an employee reaching withdrawal penalty
age 59½ may be age 59½ may be age 59½ may be employee reaching age 59½ may be would apply;
subject to a 10% subject to a 10% subject to a 10% age 59½ and subject to a 10% withdrawals are
penalty;4 penalty;4 penalty;4 within the first 2 penalty; generally
withdrawals are withdrawals are withdrawals are years of withdrawals are considered taxable
generally generally generally participation, may generally income
considered taxable considered taxable considered taxable be subject to a considered taxable
income income income 25% early income
withdrawal
penalty; after 2
years, a 10% early
withdrawal penalty
would apply;
withdrawals are
generally
considered taxable
income
1. Even though a plan may accept rollovers, they are not required to do so. Hardship distributions cannot be rolled over.
2. Only after the individual has participated in the SIMPLE IRA for two years.
3. Some retirement professionals do not believe that the IRS Code permits such a rollover.
4. There is an exception to this rule which allows an employee who retires during the calendar year in which they turn 55, or later, to withdraw without penalty.
IMPORTANT NOTE: This chart is not intended as a comprehensive or detailed review of each plan type. It is intended to be general in nature. As a result, exceptions to each
plan feature can exist. Be sure to consult with a professional retirement planner or consultant before you act on any information contained in this chart.
Corporation Partnership
Entity
Formation Basis of Property transferred Basis of Property contributed
Plus: FMV of Services rendered Plus: FMV of Services rendered
Minus: Liability Assumed by Corporation Minus: Liability Assumed by Partnership
Initial
Basis: Plus: Gain Recognized by S/H Plus: Gain Recognized, b/c of Investment Co. rules
1. Boot recv'd:
S/H & Partner a. Gain = Lesser of: Plus: Share of Partnership Liabilities assumed
b. Realized Gain or Boot recv'd
2. Liability Assumed by Corp:

[Gain Recognition, 2 Exceptions]
a. Tax Avoidance or No Bona-Fide Business
Purpose
b. Debt relief, Exceeds, Basis of Property
transferred.
Minus: Boot rec d: Cash & FMV of Non-Money Boot
Note:
1. S/H Debt assumed by Corp, only affects Basis
when Debit Relief, Exceeds, Basis of Property
transferred, b/c it triggers recognition of
Gain.
Non- 1. Distribution Amount (DA) equals: 1. Non-Liquidating distribution to a Partner is Non-

Liquidating Money recv'd Taxable event.
Distributions Plus: Greater of: FMV or NBV of non-money aka: Current Distribution
Property recv'd
Minus: Liability assumed by Shareholder 2. Partner's Outside Basis is Reduced by
Minus: Money recv'd
Tax
2. DA is Dividend to extent of Corp's E&P (Current Minus: NBV of non-money Property recv'd
Consequences:
and Accumulated) o ** Cannot reduce Partner Basis below
DA in Excess of E&P treated as = Return Zero
S/H & Partner
of Capital o NBV of non-money Property recv'd from
o Also reduces S/H Stock Basis, but distribution is Limited to Partner
not below zero. Outside Basis.
Additional Excess is treated as = Capital
Gain 3. Gain Recognized on Excess Cash.
Partner recognizes Gain to extent that:
3. S/H Basis in Property recv'd = FMV o Money recv'd, + Plus, PSHIP Debt
** Note, Debt assumed by S/H does not assumed by Partner
reduce Basis in Property. o Exceeds
o Partner Outside Basis
4. S/H Holding Period begins = Day after
Distribution 4. Gain is Capital Gain, on Partner Individual Tax
Rtn.
5. Note: Distributions of non-money Property

Does not trigger Gain or Loss recognition to
Partner.
Complete 1. Recognized Gain or Loss to S/H 1. Complete Withdrawal (Liquidation)

Liquidation Treated like S/H sold Stock to an Outside
Party. 2. Partner Basis in non-money Property recv'd from
Liquidating distribution recv'd by S/H, Liquidation:
treated as receiving Full Payment in Partner Outside Basis
Tax exchange for their Stock. Minus: Money recv'd
Consequences:
Minus: Inventory recv'd, Basis to PSHIP
2. Amount Realized calculated as follows: Minus: Unrealized Receivables, Basis to
S/H & Partner
FMV of Property recv'd PSHIP
Minus: Debt assumed by S/H ** Must "Zero-Out" Account, meaning Partner
Outside Basis
3. S/H recognizes Gain/Loss as follows:
Amount Realized 3. Gain recognized when
Minus: S/H Basis in Stock Surrendered Money recv'd, Exceeds, Partner Outside Basis
= Gain or <Loss>
4. Loss recognized when
Gain = Amount Realized > S/H Basis in Basis of Assets recv'd, Less Than, Partner
Stock surrendered Outside Basis
Loss = Amount Realized < S/H Basis in Basis of Assets recv'd includes the
Stock surrendered following:
o Money, Inventory, or Unrealized
S/H Basis in Property recv'd = FMV Receivables
5. Becker Pass Key: Must understand the difference

in Basis rules for Non-Liquidating and Liquidating
Distributions:
Withdrawal Basis Used Stopping
Point
Non- NBV Asset Taken Stop at Zero

Liquidating
Liquidating Partnership Must "Zero-

Interest Out" Account
(Partner Outside
Basis)
Stock 1. Redemption is Proportional = Dividend treatment

Redemption Follow rules of Non-Liquidating
distribution
2. Redemption is Substantially Disproportionate =

SALE treatment
Follow rules of Complete Liquidation
Corporate Tax Outline
Business Taxation Overview 1
Tax Imposed - § 11 1
Deductions for “Reasonable” Salaries - § 162(a)(1) 1
Corporation Defined - § 7701(a)(3) 1
Publicly Traded Partnerships - § 7704 2
Social Security and Medicare Taxes 2
Corporations vs. Trusts 3
Separate Corporations with Same Owners - § 1561 3
Subsidiary Dividend to Parent Corporation - § 243 3
Consolidated Filing § 1501 4
Corporate Agent (Commissioner v. Bollinger) 4
Alternative Minimum Tax § 56 4
Net Investment Income Tax and Pass-through Income 4
Formation of a Corporation 5
Section 351 Exchanges 5
Corporation’s Tax Effect (§ 1032) and Basis (§ 362) 5
Depreciation Recapture (§ 1245) 5
Installment Notes and § 453B5
Effect of a Good § 351 Exchange 6
Requirements of a Good § 351 6
“Boot” in a § 351 7
Assumption of Liabilities § 357 8
Incorporation of a Going Business 9
Contributions to Capital § 118 9
Avoiding § 351 9
Organizational and Start-Up Expenses 10
Capital Structure 11
Debt vs. Equity § 385 11
Character of Gain or Loss on Corporate Investment 11
Nonliquidating Distributions 12
Distributions in General § 301 12
Dividends and Earnings and Profit § 316 13
Distributions of Non-Cash Property 14
Constructive Distributions 14
Redemptions and Partial Liquidations 15
Redemptions Generally §302 15
Complete Termination § 302(b)(3) 15
Constructive Ownership of Stock § 302(c) 15
Substantially disproportionate Redemptions § 302(b)(2) 17
Redemptions Not Essentially Equivalent to a Dividend § 302(b)(1) 17
Partial Liquidations § 302(b)(4) 18
Consequences to the Distributing Corporation 18
Redemptions through Related Corporations § 304 19
Redemptions to Pay Death Taxes §303 19
Stock Dividends and Section 306 Stock 19
Stock Dividends and Splits 19
Taxation of Stock Distributions § 305 20
§ 306 Stock 21
Complete Liquidations 21
Complete Liquidations under § 331 21
Liquidation of a Subsidiary § 332 (Parent) and § 337 (Subsidiary) 22
Taxable Corporate Acquisitions 23
Stock Acquisition 23
Asset Acquisition 23
Reorganizations 24
Reorganizations (Ch 9-12) 24
§ 361 - Corporations in a Reorganization 24
§ 354 - Shareholders in a Reorganization 25
In order to be a Reorganization: 25
§ 368(a)(2)(E) Triangular Mergers 26
Anti-Avoidance Rules 26
Economic Substance Doctrine 26
Accumulated Earnings Tax (§ 531) 26
Personal Holding Company Tax 26
S Corporations 27
Generally 27
S Corporation Not Taxed § 1363 27
Shareholder of S Corporation Pass-Thru Tax § 1366 27
Eligibility Requirements § 1361 28
"Small Business Corporation" under IRC § 1361(b) 28
Election: IRC § 1362 29
Terminating S Status 29
S Corporation Operations 29
Example 30
S-Corporation Operations 30
C-Corps To S-Corps 30
Example 30
Former c-corps. - Appreciated Property 31
Former C-Corps. - Dividends 31
Former C-Corps with E&P And Passive Investment Income 31
Business Taxation Overview

Tax Imposed - § 11
• 15% on first $50,000
• 25% on next $25,000
• 34% on income from $75,000 to $10,000,000
• 35% on income over $10,000,000
• For corporations with substantial amounts of income, the tax benefits of the lower brackets are phased
out – over 18,333,333 flat 35% on all income
• For corporations earning over 100k, the amount of tax is increased by the lesser of 5% of such
excess or $11,750.
• If the corporation has more than $15M, the amount of tax is increased by an additional amount
equal to the less of 3% of such excess or $100k.
• Personal Service Corporation Exception §11(b)(2): Personal Service corporations do not get the lower
brackets. Instead, they are taxed at 35 percent.
• Defined § 448(d)(2): Two Requirements:
• 1) Substantially all of the activities of the corporation involve the performance of services
in health, law, engineering, architecture, accounting, actuarial science, performing arts, or
consulting, and
• 2) substantially all of the stock (by value) is held directly (or indirectly through
companies/partnerships) by employees, retired employees, estates of employees, or any
other person who had acquired the stock from such an employee.
• They can, however, use the cash-method of accounting under § 448.
Deductions for “Reasonable” Salaries - § 162(a)(1)
• A “reasonable” allowance for salaries and other compensation for personal services
• This is to prevent the corporation from paying dividends as salaries to escape paying corporate tax.
Corporation Defined - § 7701(a)(3)
• “corporation” includes associations, joint-stock companies, and insurance companies.
• Reg. § 301.7701-1: discusses whether a separate entity exists at all.
• Certain joint undertakings give rise to entities for federal tax purposes.
• A joint venture or contractual arrangement may create a separate entity if the participants:
• Carry on a trade, business, financial operation, or venture and divide the profits.
• Exception: This does not include a joint undertaking merely to share expenses.
• Exception: This also does not include mere co-ownership of property that is maintained
and rented or leased.
• Reg. § 301.7701-2: Defines what IS a corporation.
• A business entity is any entity recognized for federal tax purposes that is not a trust.
• A business entity with two or more members is either a corporation or a partnership
• A business entity with only one owner is classified as a corporation or disregarded.
• A business entity is a corporation if a federal or state statute describes it as a corporation. So, if
you’re a corporation under state law, you are a corporation for IRC.
• An association – as defined under 301-7701-3.
• A joint-stock company or association.
• Insurance company.
• State chartered business entity conducting banking activities
• Certain foreign entities.
• Reg. § 301-7701-3 (“Check the Box Regulation”)
• (a) A business not already classified as a corporation can elect to be classified as an association
(and thus corporation).
• (b) If you don’t make this election, then (b) defines your tax status. These are the default rules.
• If you have two or more members, you’re a partnership.
• Otherwise, you’re a disregarded entity.
• (c)(1)(iv) Limitation: Once you make an election, you cannot elect to change its classification in
the next 5 years.
• (g) Changing Tax Treatment:
• (1)(i) Partnership to Association: If an election is made, the following occurs: the
partnership contributes all of its assets and liabilities to the association in exchange for
the stock in the association and then the partnership liquidates by distributing the stock of
the association to its partners.
• (1)(ii) Association to Partnership: If an election is made, the following occurs: the
association distributes all of its assets and liabilities to its shareholders in liquidation of
the association and immediately thereafter, the shareholders contribute all of those assets
and liabilities to a newly formed partnership.
• This isn’t a big deal going from partnership to association, but the tax implications for
liquidating a corporation can be huge when going from association to partnership.
Publicly Traded Partnerships - § 7704
• (a) Generally, publicly traded partnerships are treated as a corporation.
• (c) provides a narrow exception for if 90% or more of the company’s gross income comes from qualified
income as defined by (d).
Social Security and Medicare Taxes
• Employer/Employee Situation:
• 6.2% Social Security tax for employer and employee
• 1.45% Medicare tax for employer and employee
• No Personal Exemption
• Social Security Wage Base for 2015: $118,500 – this is the capped social security wage tax
amount
• Self Employment
• 12.5% social security tax
• 2.9% medicare tax
• Tax base: 92.35% of net earnings from self-employment
• Filing threshold: $400 of net earnings from self-employment
• Social security base for 2015: $118,500 minus wages
• Medicare Surtax: After $200k ($250k for married, joint return) of wages, compensation, or self-
employment income, taxpayer pays an additional 0.9% in Medicare surtax.
• Medicare Taxes on Net Investment Income
• 3.8% of net investment income
• Applicable only to extent adjusted gross income is greater than $200,000 ($250,000 married)
• Applicable to investment income (dividends, interest, recognized gains on stocks, bonds) income
from financial trading business, and passive activity income
• Not applicable to income from non-rental, non-financial-trading business activities in which
taxpayer materially participates
• Not imposed on wages or self employment income
• This is § 1411.
• Choice of Entity Consideration:
• Partnerships and Wages: Wage tax is not applicable to partners in a partnership
• Partnerships and Self-Employment Tax: Self-employment tax is imposed on pass through income
from partnership business to general partners (NOT imposed to limited parters)
• S-Corporations Pass-Through Income: Self-employment tax is NOT imposed on pass-through
income from S corporations to shareholders
• S-Corporations Wages: Wage tax is imposed on S corporation shareholders only to the extent of
wages paid.
• If you don’t take out wages, you never have to pay SS/Medicare taxes – however, the IRS
will look at blatantly evasive actions – you’re supposed to take out a ‘reasonable’ wage.
Corporations vs. Trusts
• Trusts are not pass-through entities, but they are single-tax. When a trust earns income, that is taxed to
the trust if the trust accumulates it. If it distributes to the beneficiaries, just the beneficiaries pay the tax.
• Reg. § 301.7701-4:
• (a) Ordinary Trusts:
• (b) Business Trusts: Generally created by the beneficiaries simply as a device to carry on a profit-
making business which normally would have been carried on through business organizations.
These are classified as corporations or partnerships under the IRC. So, if the trustee is actively
carrying on a business, it cannot be a trust.
• This often arises in property rental. If the trustee is simply receiving a check, you’re
likely a trust, but if there’s a bunch of property management, that would be a business
trust.
Separate Corporations with Same Owners - § 1561
• IRC § 1561(a)(1): If you have a controlled group of corporation, their tax liability is combined. It will
essentially treat this group of corporations as one.
• § 1561(a)(2) Brother-Sister Controlled Group: Two or more corporations will aggregate their income if 5
or fewer persons possess more than 50% of the total combine voting power or more than 50% of the
total value of shares of each corporation.
• § 1561(e) Constructive Ownership: Shares held by family members are considered held by you for
determining this aggregate value.
Subsidiary Dividend to Parent Corporation - § 243
• The parent corporation must pay tax on this dividend, but it gets a deduction equal to most of or the
entire dividend.
• § 243(a)(2): 100 percent deduction in the case of dividends received by a small business
investment company.
• § 243(a)(3): 100 percent in the case of qualifying dividends defined in (b)(1)
• § 243(a)(1): 70 percent deduction in all other cases.
• § 243(b)(1) Qualifying Dividends: Any dividend received by a corporation if such corporation is a
member of the same affiliated group. (b)(2) says that “affiliated group” is defined by § 1504(a).
• § 1504(a) Affiliated Group: An affiliated group means 1 or more chains of includible corporations. The
ownership of stock of any corporation meets the requirement if (A) it possesses at least 80 percent of the
total voting power of the stock and (B) has a value of at least 80 percent of the total value of the stock.
• So, essentially, the parent company must own 80% of the voting power and total value of the
stock to get the 100% deduction. Otherwise, you’re stuck with the 70% deduction.
• 70% to 80% Bump: Further § 243(c) indicates that if you own at least 20% of the value and
voting power of the subsidiary, the 70% deduction can be bumped to 80%.
Consolidated Filing § 1501
• An “Affiliated Group” can file a consolidated tax return for the whole group in lieu of separate returns.
• Cannot contain foreign companies.
• Further, any transactions within the group are ignored.
Corporate Agent (Commissioner v. Bollinger)
• Agency relationship is established if:
• Written agency agreement
• Corporation functions as agent and never as principal
• Corporation is held out as agent in all dealings with third parties
• This is all you need to ignore the c-corporation.
• And, you CAN have a related party be your agent - you don't need the arm's length relationship.
• National Carbide Factors:
• Corporation operates in the name and for the account of the principal
• Corporation binds the principal
• Transmits money to the principal
• Income attributable to services of the employees of the principal
• Relations with the principal must not be dependent upon the fact that it is owned by the
principal; AND business purpose must be the carrying on of the normal duties of an agent.
Alternative Minimum Tax § 56
Net Investment Income Tax and Pass-through Income
• Net investment income tax is not imposed on tax-free distributions from s-corporations to shareholders,
or from partnerships to partners
• Net investment income tax is imposed on investment income passing through from s-corporations to
shareholders, and from partnerships to partners
Formation of a Corporation
Section 351 Exchanges
• General Rule: No gain or loss is recognized if property is transferred to a corporation solely in
exchange for stock in such corporation and immediately after the exchange, such persons are in control
of the corporation.
• In this case, property includes money.
• Control here is defined in § 368(c): ownership of stock possessing at least 80 percent of the total
combined voting power and at least 80 percent of the total number of shares.
• Shareholder’s Basis (§358): The shareholder’s basis in the shares received is generally equal to the
property exchanged for the shares. (§ 358)
• The Basis is decreased by:
• FMV of any other property (EXCEPT MONEY) received by the taxpayer
• The amount of any money received by the taxpayer, and
• The amount of loss to the taxpayer which was recognized on such exchange
• The Basis is increased by:
• The amount which was treated as a dividend, and
• The amount of gain to the taxpayer which was recognized on such exchange.
Corporation’s Tax Effect (§ 1032) and Basis (§ 362)
• General Rule §1032: The corporation never has income when it issues stock in exchange for property
(including money).
• Corporation’s Basis (§362): The corporation gets a carry-over basis from the shareholder.
• Basis Haircut: If the property exchanged has a lower FMV than basis, the property gets a basis
haircut in the property down to the FMV of the property at the time of the exchange. (§ 362(e)
(2)).
• Aggregate Transfer: This applies in aggregate to all of the transferred property. So, you
add up the aggregate FMV and the aggregate bases of the property exchanged.
• Shareholder Haircut Election: 362(e)(2)(C) allows the haircut to be taken on the
shareholder’s basis in the shares received rather than the corporation’s basis in the
property received.
• This election is not good for S-Corps. Don’t do this election if the company is to
become an S-Corp.
• Tacking the Holding Period (§ 1223): Also, the holding period tacks with the property whenever the
basis goes with the property.
Depreciation Recapture (§ 1245)
• Generally, any gain attributable to depreciation should be ordinary income rather than a capital gain.
1245(a)(1) says that if section 1245 property is disposed of, you only get to use the cost-basis rather than
the basis adjusted for depreciation, when calculating how much capital gains you have. The rest is
ordinary income. Essentially, this forces the depreciation you took to be ordinary income.
• 1245 Property: This is typically anything you use in your business other than real property.
• Application to § 351 Exchange: This doesn’t apply to a good § 351 exchange according to § 1245(b)
(3).
Installment Notes and § 453B
• Ordinary, when you exchange an installment note, you realize all of the gain.
• Gain/Loss Calculation: Difference between the basis and
• 1) the amount realized in the case of satisfaction at other than face value or a sale or exchange;
OR
• 2) The FMV of the obligation at the time of exchange.
• Application to §351 Exchange: Reg. § 1.453-9(c)(2) which makes an exception when the exchange is
a § 351 exchange.
• Death of Installment Holder: §453B(c) treats this gain as income in respect of decedent.
Effect of a Good § 351 Exchange
§ 351 Exch. A B C D E
Equipment worth
Installment note worth
Inventory worth Unimproved land worth $25,000 ($5,000 basis
Partner Gives $25,000 cash $20,000 ($2,000 basis
$10,000 ($5,000 basis) $20,000 ($25,000 basis) due to 20k depreciation
sold last year)
taken)
Partner Received 25 shares 10 shares 20 shares 25 shares 20 shares
Not a taxable event. No gain/loss recognized No gain/loss recognized No gain/loss recognized No gain/loss recognized
Tax Consequences?
Nothing even realized. (§ 351) (§ 351) (§ 351) (§ 351)
Basis in Stock $25,000 (Cost basis $5,000 (carry-over basis $25,000 (carry-over
$5,000 (§ 358) $2,000 (§ 358)
Received? §1012) § 358) basis § 358)
Holding period does not
Holding Period for Not a capital gains item tack because this is not Previous holding period Previous holding period Probably could tack the
Stock Received? (§1221) a capital gains item (§ (§ 1223(1)) is tacked (§ 1223) holding period (§ 1223)
1221)
§ 1032 - corporation never has income when it issues stock in exchange for
For the Corporation itself?
property(including money).
§ 362(e)(2) - Basis
Corporation Basis? $25,000 (§ 362) $5,000 (§ 362) Haircut Applies! $5,000 (§362) $2,000 (§362)
$20,000 basis
Stock Received? (§1221) a capital gains item (§ (§ 1223(1)) is tacked (§ 1223) holding period (§ 1223)
1221)
§ 1032 - corporation never has income when it issues stock in exchange for
For the Corporation itself?
property(including money).
§ 362(e)(2) - Basis
Corporation Basis? $25,000 (§ 362) $5,000 (§ 362) Haircut Applies! $5,000 (§362) $2,000 (§362)
$20,000 basis
$5,000 gain is realized
No gain OR LOSS is § 453B doesn't apply
Buying with cash isn’t a under §1001, but § 351 § 1245 doesn't apply
Notes recognized. § 351 is a because of Reg. §
taxable event. prevents this gain from because of 1245(b)(3).
two-way street. 1.453-9(c)(2)
being recognized
Requirements of a Good § 351

• Control (351(a)): Immediately after the exchange the transferors of property participating in the
exchange are in control of the corporation.
• Control Defined (§ 368(c)): Control requires:
• Ownership of 80% voting power; AND
• Ownership of 80% of the number of shares of the corporation.
• “Immediately after the exchange” (Reg. § 1.351-1(a)): Immediately after the exchange simply
means can be right after the exchange or after the end of an integrated plan.
• “The phrase “immediately after the exchange” does not necessarily require simultaneous
exchanges by two or more persons, but comprehends a situation where the rights of the
parties have been previously defined and the execution of the agreement proceeds with an
expedition consistent with orderly procedure.”
• Exception - Services in Exchange for Shares (§ 351(d)): Services, indebtedness not evidenced
by a security, or interest on indebtedness accrued after the shareholder’s holding period are NOT
considered as issued in return for property. HOWEVER, they are considered as part of the
ownership of stock.
• Exception - De Minimus Exception (Reg. § 1.351-1(a)(1)(ii)): You can’t simply put in some
nominal amount of property to make them a transferor of property. An IRS ruling says that if the
value of the stock the shareholder gets for property is more than 10% of the value of the shares
he’s receiving, then this will be considered a transfer of shares in exchange for property.
• Investment Company Exclusion (§ 351(e)(1)): This doesn't apply to a transfer of property to an
investment company. This determination is made using the factors under §351(e)(1).
• Reg. § 1.351-1(c): A company is considered an investment company if the transfer results in
diversification of the transferors' interests, and the transferee is a regulated investment company,
a real estate investment trust, or corporation with more than 80 percent of the value of whose
assets are held for investment and are readily marketable stocks or securities.
• This last one wouldn't be a big issue, BUT § 351(e)(1) treats money as stock and
securities. The way to avoid this is to be sure at least 20% of the assets are not cash or
investment stocks.
“Boot” in a § 351
• § 351(b) Boot with Exchange: If the shareholder receives property or money, then gain shall be
recognized, but not in excess of the amount of money received + the FMV of such other property
received.
• Shareholder Stock Basis §358: Here, the basis of the stock will be the carry-over basis of the
property exchanged minus the FMV of the property and cash received plus the gain recognized
on the transaction.
• Shareholder Boot Basis: The boot’s basis will be the FMV of the boot.
• Corporation Property Basis (§ 362(a)): The corporation’s basis in the property received will be
the carry-over basis PLUS the shareholder’s recognized gain.
• Also, no loss will be recognized, ever.
• Example: A transfers property to X Corp worth 100k with 10k basis. She gets stock worth 80k and
property with FMV of 20k. She’s taxed on the boot she got = 20k gain. A’s basis in the stock would be
10k (original basis) – 20k (FMV of property received) + 20k (gain recognized) = 10k. A’s basis in the
property received is 20k. The corporation’s basis in the property received will be 30k.
• Corporate Tax (§ 351(f)): If property is transferred § 311 applies. § 311 essentially says it is treated as
if the corporation sold the property to the shareholder and is taxed on the gain.
• Corporation Receiving multiple Assets (Rev. Ruling 68-55): If the corporation is receiving multiple
assets, they will be treated as multiple § 351 exchanges and the gain recognized to the shareholder will
be allocated in basis of the property in the corporation based on the relative FMV of each contributed
asset.
• Example Receiving Installment Note: What if the shareholder is receiving more boot than recognized
gain? Problem Page 79(c). Let's say C is transferring in land with a FMV of 50k and a basis of 20k. In
exchange, he's receiving common stock with a FMV of 10k, 5k cash, and an IOU worth 35k. You cannot
recognize more than you realize. Although there is 40k boot, there is not 40k of recognized gain. He's
only going to recognize 30k gain in the end (§ 351(b)(1)).
• When Taxed (§453): The default rule of § 453 is that the gain is not recognized all up front -
rather, we would get to use the installment method. Prop. Reg. § 1.453-1(f).
• Not every installment sale is eligible for § 453. Real estate developers cannot use 453 for
dealer dispositions.
• Also, if that asset is publicly traded security, you don't get to use § 453.
• Assuming §453 applies, the installment method will apply. As each payment comes in, you use
the gross profit ratio: Payment x (Gross Profit)/(Total Contract Price).
• In this example: Payment (5k) x (gross profit (30k))/(total contract price (40k)) = $3.75k
• Basis Of Stock: Here, the IRC treats the shareholder as if they elected out of § 453 installment
method to calculate the basis in the stock. The full amount of recognized gain is used. Here,
Basis of stock = Basis of property (20k) - fmv of noncash "boot" (35k) - cash received (5k) -
recognized loss + dividend + recognized gain (30k) = 10k
• Corporation's Basis in Asset (§362): Carryover basis from the shareholder plus any recognized
gain. The Proposed Regs limit this to whenever the shareholder reports their gain on the
installment. So, the corporation here would start with a 23.75k basis as soon as the shareholder
receives their first installment.
• Nonqualified Preferred Stock (§ 351(g)): Nonqualified preferred stock is treated like boot and is taxed.
• Defined § 351(g)(2)(A): Preferred stock and one of four elements:
• (i) Holder has a right to require company to redeem stock.
• (ii) Company is required to redeem the stock.
• (iii) Company has right to redeem stock and (as of the issue date) it is more likely than
not that such right will be exercised; OR
• (iv) the dividend rate varies in whole or in part with reference to interest rates or other
similar indices.
Assumption of Liabilities § 357
• When the shareholder is transferring an encumbered asset into a corporation with § 351.
• General Rule § 357(a): If the shareholder receives property in a 351 exchange and the company
assumes a liability of the shareholder, then such assumption shall not be treated as money or other
property and shall not prevent the exchange from being a good 351.
• Example: M is transferring an asset with a FMV of 100k, basis of 20k and mortgage of 5k in a good §
351. Normally, with a regular non-recognition transaction, the mortgage would be considered boot.
However, § 357 treats this differently. She has dropped 5k debt, so we reduce her carryover basis in the
stock by the mortgage amount. Her basis in this stock would therefore be 5k due to § 358(d).
• Shareholder's Basis in Stock § 358(d): The assumption of liability will be treated as money received.
So, reduce the stock basis by any liability assumed by the corporation.
• Corporation's Basis § 362: Same as before. Shareholder's Basis (20k) + shareholder's Recognized gain
(0k) = 20k.
• Exceptions:
• Tax Avoidance (§ 357(b)): If it appears the principal purpose of the taxpayer was to avoid
income tax on the exchange or was not a bona fide business purpose, then such assumption shall
be considered as money received by the taxpayer on the exchange.
• Example: shareholder takes out loan on the asset the day before incorporation and uses
those proceeds for something not related to the business.
• Liabilities in Excess of Basis (§ 357(c)): If the liability is greater than the basis of the asset, then
the shareholder will recognize the difference as a gain. REMEMBER: this is done on an
aggregate basis - so, if you can balance this out, you won't recognize this difference.
• Example: Same case, except the mortgage is 50k instead of 5k. The shareholder will
recognize 30k capital gain here. The corporation will now get a 50k basis in the asset
(20k + 30k).
• Peracchi Case: What if the shareholder drops in an IOU alongside the property? The
court here sides with the shareholder because of the reality of the note. This should be
enough to cancel out the § 357 problem. However, this must be a real note and there
should be no suspicion that the note will disappear. Make a clear record of the debt and
actually pay it (payment schedule and make payments).
• Not Real Liabilities (§ 357(d)): A recourse liability will be treated as having been assumed if the
transferee has agreed to and is expected to satisfy such liability. A non-recourse liability is treated
as assumed by the transferee of any asset subject to such liability.
• This is to shut down liabilities that the corporation has agreed to pay but isn't actually
expected to pay.
• Deductible Liabilities (§ 357(c)(3)): If a corporation is assuming a shareholder's liability and
they are on the cash method and they would be able to deduct it, then the liability is excluded in
determining the amount of liabilities assumed.
Incorporation of a Going Business
• Let's say you have an on-going business that has receivables.
• Regardless of the doctrine that you cannot assign income, this will still be considered a good § 351
transaction.
• Rev. Ruling 95-74: You can deduct liabilities that are assumed when incorporating a going business.
This is technically a violation of the assignment of income doctrine.
Contributions to Capital § 118
• Contributions to Capital: This occurs when the shareholder contributes property to a corporation and
doesn't receive any stock or other consideration in exchange.
• § 351 does not apply to capital contributions.
• Shareholder Tax Consequences: Contributing shareholder doesn't recognize any gain or loss on a
contribution of property other than cash to a corporation. Instead, the shareholder may increase the basis
in her stock by the amount of cash and the adjusted basis of any contributed property.
• Corporation Tax Consequences: The contributions are also excludable from the gross income of the
corporation. The corporation's basis in the property received is the same as the transferor's basis.
• Single Shareholder or Pro-rata Contribution: If the contributing partner is the sole shareholder or if
each shareholder contributes property proportionate to their share, the issuance of stock has no economic
effect. Such contributions are therefore constructive § 351 exchanges.
Avoiding § 351
• § 351 is not elective. A shareholder might want to avoid a § 351 if they are contributing property with a
loss. Or, if the corporation will soon sell the asset, you might want to recognize the gain at the
shareholder level so you avoid the double taxation.
• To avoid § 351, simply sell the asset to your corporation - be sure to take out cash.
• Example: M is a sole shareholder and wants to get property into the corporation but take the gain
beforehand. One thing she could do is to sell the property to the corporation. However,t he corporation
would need to have the cash to do this. § 267 might apply.
• No Loss Selling to Related Persons §267: Generally, you cannot take a loss when you sell an asset to a
related person. 267(b)(2) indicates that loss cannot be taken on a sale between an individual and a
corporation which is owned more than 50% by the individual.
• So, the individual would have to own 50% or less of the corporation to take the loss. Stock
owned by family members is treated as owned by you.
• There might also be difficulties if other people are trying to take a § 351 transaction. The IRS will argue
that this was part of the 351 exchange. However, as long as she doesn't take stock, she won't be
considered part of the 351.
• Gain will be Ordinary if Depreciable in hands of Transferee § 1239: Generally in the case of a sale
or exchange of property, any gain recognized to the transferor shall be treated as ordinary income if such
property is, in the hands of the transferee, of a character which is subject to the allowance for
depreciation.
• Land is not depreciable, so it would not apply to a transfer of land.
• Also, be sure that the corporation is paying FMV - if the corporation isn't paying FMV, the IRS
will argue that there was a constructive issuance of stock and will be a 351 exchange.
Organizational and Start-Up Expenses
• Organizational Expenditures § 248: Expenditures which are:
• 1) incident to the creation of the corporation,
• 2) chargeable to capital account, AND
• 3) of a character which, if expended to create a corporation having a limited life, would be
amortizable over that life.
• Examples: legal fees for drafting the corporate charter and bylaws, fees paid to the state of
incorporation, necessary accounting services
• Specifically excluded: costs of issuing or selling stock and expenditures connected with
the transfer of assets to the corporation.
• Start-up Expenditures § 195: Expenditures that the corporation could have deducted currently as trade
or business expenses if they had been incurred in an ongoing business.
• Corporations may elect to deduct up to 5k in organizational expenditures and start-up expenditures in the
taxable year in which the corporation is formed. This 5k is reduced by the amount by which total
organizational expenditures exceed 50k.
• Organizational expenditures that are not currently deductible must be amortized over the next 15 years.
• Problem Page 113: B is an investor. A owns a sole proprietorship business. A negotiates with B to form
a corporation of the proprietorship. They calculate the proprietorship to be worth 510k. B agrees to
contribute 490k for a 49% interest in the new corporation and A will own the remaining 51% by
contributing the proprietorship's assets and liabilities. What are organizational expenditures and either
currently deductible or amortizable under §248?
• A) 3k in fees paid by A to appraise proprietorship - personal expense that can be added to the
basis of the stock.
• B) What if appraisal fees are paid by corporation? This will be treated as an assumption by the
corporation of A's liability. This will be governed by § 357 and 358(d).Unlikely that 357(b)
would apply and without more facts 357(c) doesn't apply.
• C) Legal fees paid by corporation for the following:
• Drafting articles of incorporation, by-laws and minutes of first meeting. If the corporation
makes the § 248 election, the expenses are deductible up to 5k subject to reduction if total
expenditures exceed 50k. Rest is amortized over 15 years.
• Preparation of deeds and bills of sale transferring A's assets to corporation. Costs of
acquiring the specific assets and are added to the basis of the properties.
• Application for a permit from the state commissioner to issue stock and other legal
research for securities. Expenses related to securities are not considered organization
expenditures and are not added to basis of any asset. They are nondeductible capital
expenditures.
• Preparation of a request for a § 351 ruling from IRS. § 212(3) does not allow a deduction
because it only applies to individuals. It is likely more appropriately treated as an
organizational expenditure under § 248.
• Drafting a buy-sell agreement providing for the repurchase of shares by the corporation if
either A or B dies. Organizational expenditure under § 248.
• D) What if A paid all these expenses? This will be treated as a transfer to the corporation and A's
basis in the stock will increase. Corporation will be able to amortize these expenses as if it had
paid them directly.
Capital Structure
Debt vs. Equity § 385
• Factors Considered
• Form: Does it looks like debt? Principal, interest and payment schedule, unconditional payment,
shouldn't depend on corporation profits.
• Interest Rate: The interest rate should be the market rate. If it's too low it might look too
favorable to be a regular creditor.
• Payable Only From Profits: If it's payable only out of profits, this will look more like
equity.
• Debt/Equity Ratio: The higher this ratio is, the more likely this will be classified as equity.
5-10:1 debt:equity ratio probably works.
• Intent of Parties: Objective conduct and facts that prove that people really did consider this to
be debt. Course of conduct can show intent.
• Proportionality: If the shareholder's debt is proportional to their stockholdings, this looks
suspicious. The idea is that proportional holders won't aggressively defend their debt positions
since everyone is proportionally in the same position.
• Subordination: If the debt is subordinated debt.
• Shareholder Guarantees: If the shareholders are jointly and severally liable for other debt,
this will look less subordinated because they will be on the same level as the bank.
• § 385 indicates there are factors to look at - the proposed regs, however, were withdrawn, so there are no
clear-cut lines.
Character of Gain or Loss on Corporate Investment
• You look to the nature of the asset in the hands of the taxpayer before the sale. (§ 1221)
• A capital gain is a gain on sale/exchange of a capital asset.
• Gain on Stock is a capital gain except for broker-dealers selling to customers.
• Gain on Sale of Qualified Small Business Stock § 1202: For an individual other than a corporation,
gross income shall not include 50 percent of any gain from the sale or exchange of these stocks held for
more than 5 years.
• Available for up to 10 M of recognized gain per qualifying corporation.
• The issuing corporation must have less than 50M gross assets at the issuance of stock.
• Rolling Over Gains § 1045: Also, § 1045 allows non-corporate shareholders to elect to defer
otherwise taxable gain from a sale of qualified small business stock held for more than six
months by rolling over the proceeds into new qualified small business stock within 60 days of the
sale.
• Losses on Stock: These are capital losses unless you're a broker or trader making an election.
• Exception § 1244: Ordinary loss on sale or worthlessness if you're dealing with "section 1244
stock. The requirements are:
• Must be a "Small Business Corporation"
• Issued for money or property only
• Five-year look back test from time of loss - morethan 50% must be coming from active
sources and must be an active business five years prior to selling the stock.
• Original holder only
• Limited to 50-100k per year.
• Worthlessness: If the asset becomes completely worthless, you can take your loss at that point.
Stock and debt take different paths here:
• Stock § 165(g)(A): capital loss.
• Most Debt is NOT § 165(g)(C): This only applies to certain debt. When a bond is in
registered form, the corporation is keeping registry of the bonds. If these are the terms,
then it will be treated as a security. This likely won't happen today, instead they will be
non-securities and thus not covered by 165(g).
• Most Debt § 166:
• Business bad debt is ordinary loss
• Non-business bad debt is capital loss
Nonliquidating Distributions
Distributions in General § 301
• (a) In general, a distribution of property made by a corporation to a shareholder with respect to its stock
shall be treated as provided in (c).
• (c) Creates a three tier system:
• 1) Dividend: Any portion that is a divided is entirely gross income. 1(h)(11) still makes this
taxed at the capital gains rate, however there is no basis offset. (Defined by § 316)
• 2) Amount applied against basis: If the shareholder has basis in the stock, the remaining
portion of the distribution will be applied against the basis in the stock and reduce the basis of
the stock by that amount.
• 3) Amount in excess of basis: If there is still more remaining after step 1 and 2, this will be
treated as gain from the sale or exchange of property.
• Property Defined § 317(a): Property means money, securities, and any other property EXCEPT stock in
the corporation making the distribution or rights to acquire such stock.
• §301 does not apply to:
• Distributions of its own stock
• Distributions in corporate liquidation
• Redemptions (buybacks) of stock
• Payments of principal or interest on debt

• Compensation for personal services
• Purchase of property from shareholder
Dividends and Earnings and Profit § 316

• § 316 defines dividend as any distribution of property made out of the corporations E&P. It splits these
up into accumulated E&P and current E&P.
• Distributions made out of E&P are taken out of the most recent E&P first.
• E&P are not eliminated when stock is sold. So, it doesn't matter whether the E&P were earned while the
shareholder owned the shares or not.
• § 312(a): Except as otherwise provided, the E&P of the corporation will decrease by the sum of:
• 1) the amount of money
• 2) the principal amount of the obligations of such corporation; AND
• 3) The adjusted basis of the other property so distributed.
• [In summary, anytime a dividend is paid, the E&P is reduced by that amount.]
• Special Rules:
• Dividends from one corporation to another (e.g. subsidiary to parent) § 243: While this is
treated as gross income, they get to deduct most of or the entire dividend.
• Distributions by S Corporations: Special rules apply here.
• What is E&P: Roughly, you start with the corporation's income statement then:
• Add back certain exclusions such as tax-exempt bond interest
• Add back certain deductions such as dividends received from another corporation
• Deduct certain items normally not deductible such as federal corporate income tax and previous
dividends paid by corporation
• Special timing rules: depreciation is slowed down and no LIFO inventory even if you use LIFO
for everything.
• Computing E&P During Middle of Year (Rev. Rul. 74-164):
• Situation 1: At the beginning of the year, the Corporation has an accumulated E&P of 40k. For
the current year, it had a 50k operating loss for the first 6 months, and then ended up with a 5k
operating profit by the end of the year. Company distributes 15k dividends at the 6mo mark. At
the moment of distribution, the company had -10k E&P. How much of this 15k is a dividend?
Here, the entire distribution is considered a dividend. Under § 312, once a dividend is taxed to
the shareholders, the E&P goes down by that amount. So, the accumulated E&P here would
become 30k.
• Situation 2: The company starts the year with a negative accumulated E&P of -60k. The first
6mo, the company had an operating income of 75k. Then a 15k dividend is paid out in the
middle of the year. However, by the end of the year, the current E&P dropped to only 5k.
According to § 316(a)(1), we apply the current year's E&P first. The rest of the distribution will
be treated as a return of the stock basis.
• Multiple Dividends (Reg. § 1.316-2(b)): What would happen if instead of one
distribution in the middle of the year, we had 2 distributions during the year. The first was
12k and the second 3k. They are split - all distributions are treated equally. The 12k
distribution will be 4k a dividend and the 3k distribution will be 1k of dividend.
Remember - this only applies to current E&P. Accumulated E&P is applied on a first
distribute, first applied basis.
• Situation 3: Same as situation 1 but the company had a deficit in E&P of 5k throughout the year.
According to the rev. ruling, we take the pro-rata portion of the current years operating loss and
apply it against the accumulated E&P. Here, the 5k operating loss is pro-rated to the time of the
distribution. It happens to be in the middle of the year, so that's exactly half. So 40k
(accumulated E&P) - (5k x ½) (prorated current E&P) = 37.5k. This doesn't help in this situation
because the distribution is less than this amount and the entire distribution is a dividend. Reg. §
1.316-2(b).
• The reg. indicates that this only applies if the actual E&P cannot be shown - so if you can
show actual E&P deficit, then you should be able to use that E&P rather than the prorata.
• Situation 4: Same as situation 1 except that the corporation had a deficit in E&P of 55k for the
entire current ear. The Rev Ruling says you can apply the prorated amount of the current year's
operating loss to the accumulated E&P: 40k - 55k x ½ = 12.5k. Therefore, 12.5k of the
distribution will be a dividend and the remaining will be a return of stock basis.
Distributions of Non-Cash Property
• FMV of Property § 301(a)(1): Distribution is equal to the FMV of the property distributed
• Shareholder's Basis in Property Received §301(d): FMV of the property at the time of distribution.
• Tax for Corporation §311: Corporation is taxed on the gain. (a) states that no gain or loss recognized in
a distribution with respect to its stock. However, (b) states that gain shall be recognized to the
corporation as if such property were sold to the distributee at FMV.
• S-corporations suffer this same fate - they don't pay any tax, but the gain flows through to the
shareholders.
• No E&P?: Doesn't matter - by virtue of doing this distribution, it will have E&P equal to the FMV of
the property.
• Property with Liabilities:
• Shareholder: §301(b)(2) - the distribution is reduced (not below zero) by the amount of any
liability of the corp. assumed by the shareholder and the amount of any liability to which the
property received by the shareholder is subject to immediately before the distributions.
• Corporation: § 311(b) It's still treated as if the corporation sold the property to the shareholder.
• Loser Property:
• Shareholder: Shareholder's distribution is the FMV of the property
• Corporation: The loss is not recognized by the corporation under § 311(a). However, § 312(a)(3)
lets the corporation reduce its E&P by the full basis of the property.
• Corporation's Own Obligations: §311(b)(1)(A) carves out the corporation's obligations, so it is not
taxed on this. So, instead § 301 applies. This does trigger immediate gain at the shareholder level equal
to the FMV of the obligation. There's no sale or exchange, so you CANNOT use the installment method.
Constructive Distributions
• Payments on "debt"/equity on a purported debt that is reclassified as stock for tax purposes
• Excessive compensation paid to shareholder/employees - if you have shareholder employees, on a
reasonable allowance for salary will be deductible by the corporation.
• §162(a)(1) - corporation can take a reasonable allowance for salaries and bonuses for services
actually rendered. The excess can be reclassified as a distribution (§ 310) and the corporation
cannot deduct that.
• This can also happen if they are over-compensating an employee who is related to a shareholder.
162 won't allow a deduction for an unreasonable salary here.
• Personal use of corporate assets. Uses of corporate assets are constructive distributions. So, you have to
document a proper purpose for this in order to be a salary and thus deductible.
• Low-Interest loans by corporation to shareholder: IRC § 7872
• If market interest is not being charged, a bunch of constructive transactions happens. Let's say
we have a 100% shareholder of a corporation - he borrows money from corporation by signing
an IOU with below-market-rate interest. We're going to make believe that the loan bore a market-
rate interest and that the forgone interest is treated as transferred from the corporation to the
shareholder (as a dividend) and then immediately transferred back to the corporation as interest.
So, the shareholder has dividend income, and the corporation gets interest income equal to the
difference in payments had the loan been at market rates.
Redemptions and Partial Liquidations
Redemptions Generally §302
• § 302(a) If a corporation redeems its stock such redemption shall be treated as a distribution in part or
full payment in exchange for the stock. However, you must meet the requirements of (b) or it will
simply be considered a distribution under §301.
• Definition of Redemption of Stock §317(b): Redemption if the corporation acquires its stock from a
shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held
as treasury stock.
• § 302(b) Requirements: See the code.
• (1) Redemptions not equivalent to dividends.
• (2) substantially disproportionate redemption of stock.
• (3) termination of shareholder's interest. OR
• (4) redemption from noncorporate shareholder in partial liquidation.
• Shareholder cannot be a corporation; AND
• Distribution must be in relation to partial liquidation of the distributing corporation.
(Such as discontinuing a major portion of the business).
• Redemption and Sale: You simply compare the before with the after rather than separately for each
transaction. This helps shareholders because this can be considered part of their reduction of interest.
• “Zenz” Transaction: If a shareholder redeems shares and sells some in an “integrated plan”, the
proper way to analyze the reduction of interest is after everything.
Complete Termination § 302(b)(3)
• Applies when one shareholder is completely terminating their interest while the company continues.
Doesn’t apply if there’s only one shareholder – that would be a complete liquidation of the company.
• Must look to § 318 for attribution of ownership rules that apply here.
• If the attribution of ownership rules apply and it ends up not being a complete termination, the
distribution is a dividend and the basis of those shares shifts over the shares of the related parties.
Constructive Ownership of Stock § 302(c)
• § 302(c)(1) indicates that § 318(a) applies when determining the ownership of stock for this section.
• Attribution of Ownership § 318(a):
• Operating Rules § 318(a)(5)(A) and (B): Double attribution is allowed EXCEPT for double
family attribution.
• Members of Family § 318(a)(1): spouse (unless divorced), children, grandchildren, parents.
• Attribution From Entities to Individuals § 318(a)(2):
• (A) From Partnerships and Estates: Stock owned by or for a partnership shall be
considered as owned proportionately by its partners or beneficiaries.
• § 318(a)(5)(E): S Corporations are treated as partnership for this section.
• (B) From Trusts: Stock owned by or for a trust shall be considered as owned by its
beneficiaries in proportion to the actuarial interest of such beneficiaries in such trust.
(“Distributional Percentage”)
• (C) From Corporations: If 50 percent or more in value of stock in a corporation is
owned by a person, such person shall be considered as owning all of the stock owned by
that corporation in the proportion of their ownership. Anything less than 50% ownership,
and there’s no attribution.
• Attribution From Individuals To Entities §318(a)(3):
• (A) To Partnerships and Estates: Stock owned by a partner shall be considered as
owned by the partnership.
• (B) To Trusts: Stock owned by beneficiary shall be considered as owned by the trust
unless the beneficiary’s interest is 5 percent or less of the value of the trust.
• (C) To Corporations: If 50% or more of the value of the stock in a corporation is owned
by an individual, such corporation is considered as owning the stock owned by that
person.
• Sideways Attribution § 318(a)(5)(C): Let’s say B and C each own 50% of two C corps. C
redeems all of his shares in one corp. (a)(5)(C) prevents this sideways attribution.
• Option Attribution § 318(a)(4): If you have an option to acquire stock, congress assumes that
you’re going to act on those and are treated as owning that stock here.
• Option Rule in Lieu of Family Rule § 318(a)(5)(D): If attribution through paragraph 1
or 4, they are treated as owned under (4).
• Waiver of Family Attribution § 302(c)(2): The taxpayer can take certain steps to be sure family
attribution doesn’t apply. You must really be terminating your interest and getting out of the company. If
you meet these requirements, the 318(a)(1) family attribution doesn’t apply. Requirements:
• Forward Looking:
• § 302(c)(2)(A)(i): Redeemer has no interest in the corporation (including an interest as officer,
director, or employee) other than an interest as a creditor.
• if you’re getting paid for services rendered, you have failed to meet this requirement –
Lynch
• Being a landlord with a lease at a fair rent is okay per Rev. Rul. 77-467.
• § 302(c)(2)(A)(ii): Redeemer cannot acquire any interest (other than by inheritance) within 10
years from the date of such distribution; AND
• § 302(c)(2)(A)(iii): Redeemer must agree to notify the Secretary and retain records.
• Backward Looking:
• § 302(c)(2)(B)(i): Any portion of the stock redeemed was acquired within the 10 year period
prior from a person whose stock would be attributed to the distribute under 318. OR
• § 302(c)(2)(B)(ii):Any person owns stock which is attributable to the distribute and such person
acquired the stock from the distribute within the 10 year period prior.
• Rev. Rul. 77-293: If you’re retiring and you give a bunch of stock to his kids, this will
still be a good § 302(c)(2) waiver of family attribution.
• Entity Waiver of Family Attribution § 302(c)(2)(C): An entity can waive family attribution only if it’s
a complete termination.
• Example 1:
• Let's say we have a corporation owned partly by a daughter and an estate.
• The sole beneficiary of the estate is the mother

• The estate wants to redeem its stock
• Under 318(a)(1) the daughter's share is attributed to the mother
• Under 318(a)(3) they are then attributed to the estate;
• So this estate constructively owns the shares that the daughter owns.
• So, this estate must get a waiver to use its basis; otherwise it will be a dividend.
• So, this estate and the mom would have to sign a § 302(c)(2)
• Only family attribution can be waived.
• Example 2:
• Mother is sole beneficiary of Estate

• Mother and Estate each own half of a corporation
• §302(c)(2) doesn't work because the attribution is not a family attribution
Substantially disproportionate Redemptions § 302(b)(2)
• Three Tests:
• Substantially Disproportionate: This test looks at the ratio of the voting stock owned / total
voting stock (after the redemption) against the ratio of the voting stock owned / total voting stock
(before the redemption) to see if it’s less than 80 percent. Look at shareholders percentage of
voting power after the redemption - it must be less than 80% of the voting power it had before
the redemption.
• Limitation: The shareholder must own less than 50 percent of the voting power after the
redemption.
• 80% Reduction of Common Stock As Well: Further, there must be an 80 percent reduction of
common stock owned by the redeemer.
Redemptions Not Essentially Equivalent to a Dividend § 302(b)(1)
• Davis Case: Congress is looking for a “meaningful reduction of shareholder’s proportionate interest.”
• Rev. Rul. 75-502: A owns 750 shares of C Corp. B owns 750 shares of C Corp. and Estate owns 250
shares of C Corp. A is sole beneficiary of Estate. Here the estate constructively owned 1000/1750.
• It then turned in all 250 shares. Here we have attribution from the beneficiary to the estate. How
many shares does it own after the attribution. Constructively, it was a controlling shareholder. It
is not a good 302(b)(2) because it's not less than 50%. It's right at 50% though. Isn't this a
meaningful reduction of the shareholder's interest? In effect, she, as a practical matter, was a
controlling shareholder. She had the right to outvote B on everything - the board would be
controlled by her and her family. But after the redemption, that's not the case. They are in a
deadlock position - they both now own 50% of the corporation. This is a serious change in the
control of the company. This is a good §302(b)(1).
• IRS Held: Reduction of voting common stock from 57 percent to 50 percent was meaningful
where the remaining stock was held by a single unrelated shareholder.
• Rev. Rul. 75-512 (Page 232): Whole family tree of people who owned the company. The transaction at
issue was a trust redeeming all of its shares. The trust constructively owned 30% of the company. They
redeem all 75 of the trust's shares, so immediately after the redemption, it owned ~25% of the
corporation. The IRS said that this was a good §302(b)(1).
• IRS Ruling: A reduction from 30 percent to 24.3 percent was meaningful because the redeemed
shareholder experience a reduction in three significant rights: voting, earnings and assets on
liquidation.
• IRS Ruling: A reduction in common stock ownership from 27 percent to 22 percent was
meaningful where the remaining shares were owned by three unrelated shareholders because the
redeemed shareholder lost the ability to control the corporation in concert with only one other
shareholder.
• Rev. Rul. 85-106 (Page 229): There was no controlling shareholder - there was a whole bunch of
shareholders with small portions of shares. The trust here had almost as much control as everyone else.
The point here was that there was no controlling shareholder - they had as much say as anybody else did.
Also, the redemption was of nonvoting shares. There's been no meaningful reduction of the
shareholder's interest. This was NOT a good §302(b)(1).
Partial Liquidations § 302(b)(4)
• Distribution must be in relation to partial liquidation of the distributing corporation. (Such as
discontinuing a major portion of the business).
• § 302(e) Partial Liquidation Defined:
• (1)(A): Distribution cannot be essentially equivalent to a dividend (determined at the corporate
level rather than at the shareholder level); AND
• (1)(B): The distribution is pursuant to a plan and occurs within the taxable year in which the plan
is adopted or within the succeeding taxable year.
• May be Pro rata § 302(e)(4): It doesn’t matter if the redemption is pro rata as long as it’s a
genuine contraction of the corporation’s business.
• § 302(b)(4): There must be a plan (“formalities”). A partial liquidation can succeed under two tests:
• Judicial Test: “Genuine contraction of the corporate business.” They can even be distributing
assets out in kind with the shareholders.
• Statutory Safe Harbor § 302(e)(2): Cessation of a corporate business AND corporation must
conduct a business after the distribution.
• Note: A mere distribution by parent corporation of its subsidiary’s stock is not enough.
Consequences to the Distributing Corporation
• § 311(a) and (b) apply.
• If the corporation redeems shares using its own property, the distributing corporation will recognize it
• Corporation cannot deduct redemption price or related expenses: IRC § 162(k)
• Before this section was added, one corporation managed to take a deduction for the expenses of
redemption and the money paid to the shareholder
• If you have a redemption that passes 302(b) (not a dividend) you still get to reduce the corporations E&P
(IRC §312(n)(7))
• It is reduced by a % of stock redeemed; OR
• If 20% of the stock is redeemed, 20% of the E&P is removed
• Amount of distribution, whichever is LESS.
Redemptions through Related Corporations § 304

• § 304(a)(1) Acquisition by Related Corp (other than subsidiary):
• Stop people from playing the following game:
• Single shareholder owns X corp and Y corp (100 shares in each corporation).
• Each corporation has huge E&P
• If he tries to redeem any shares it will be a dividend and he can't use his basis
• What if sells 60 shares of X corp to Y corp?

• The idea is that this is a sale.
• This doesn't work under §304(a)(1) - instead, it's treated as a redemption.
• This is turned into a redemption of Y shares. This brings 302 into play.
• ALSO, § 304(b)(2) says you use the E&P of BOTH corporations when determining the tax
treatment of the redemption. E&P of the redeeming company first.
• § 304(a)(2) Acquisition by Subsidy:
• Let's say A owns P corp
• P corp owns 100% of S corp.
• What if he sold some stock of the parent to the subsidiary?

• This is §304(a)(2). Such property shall be treated as a distribution in redemption of the stock of the
issuing corporation.
Redemptions to Pay Death Taxes §303
• In General (a): A distribution of property in redemption of part or all of the stock in determining the
gross estate of a decedent shall be treated as a distribution in full payment in exchange for the stock so
redeemed.
• Limitation of What’s Treated as Redemption: Shall not exceed the sum of the estate, taxes
imposed because of decedent’s death and the amount of funeral and administration expenses
allowable as deductions.
• 35% Value Requirement (b)(2): The value of the stock must exceed 35% of the value of the
entire estate.
Stock Dividends and Section 306 Stock
Stock Dividends and Splits
• STOCK DIVIDEND EXAMPLE: Let's say we have 50k total stock. The common stock is 20k and the
earned surplus is 30k. When a stock dividend occurs, they take some money out of earned surplus and
put it into the common stock. So, if they issue another 20k in common stock, the common stock amount
would jump to 40k and the earned surplus drops to 10k.
• STOCK SPLIT EXAMPLE: Let's say we have 50k total stock. The common stock is 20k and the earned
surplus is 30k. When a stock split occurs, then we cut the stated value in half and double the shares
outstanding. This doesn't change the numbers in the dollar column, but now, each stock is worth half and
there are twice as many.
• Companies do stock splits to lower the market price per share so that smaller investors don't feel
inhibited.
• However, they've done studies, the day after a stock split, the stock value does actually go up
overall.
Taxation of Stock Distributions § 305
• (a) Generally: Gross income doesn’t include the amount of any distribution of the stock of a corporation
made by such corporation with respect to its stock.
• (b) Exceptions: Shall be treated as a distribution of property to which § 301 applies if:
• (1) Distribution in lieu of money: if the shareholder can choose stock or property.
• (2) Disproportionate Distributions: If the distribution (or series thereof) has the result of
• (A) the receipt of property by some shareholders, and
• (B) an increase in the proportionate interest of other shareholders.
• (3) Distributions of common and preferred stock: if the distribution (or series thereof) has the
result of
• (A) the receipt of preferred stock by some common shareholders and
• (B) the receipt of common stock by other common shareholders.
• (4) Distributions on preferred stock: if the distribution is with respect to preferred stock. This
is because in most cases, the control is changing.
• (5) Distributions of convertible preferred stock: if the distribution is of convertible preferred
stock unless you can prove that it won’t end up with one person getting stock and another getting
property.
• Defining Preferred Stock Reg. § 1.305-5(a): If the stock has unlimited growth potential, it is not
preferred stock. It cannot participate in corporate growth to any significant extent.
• (c) Certain Transactions Treated As Distributions: Anything having a similar effect on the interest of
any shareholder. Essentially, don’t try to think up clever ways to get around (b).
• Example: Let's say A and B each own 100 shares in C corp. A redeems 80 shares. This is a good
302(b)(2) substantially disproportionate distribution to him. But if 305(c) really means what it
says, the IRS could put out regulations saying that this is a dividend and tax B as well. This is
exactly a 305(b)(2) because B's share is going up and A is receiving money instead.
• If you do it as a redemption, you won't get taxed.
• However, if you do it as a distribution of shares and property, you will get taxed on a
dividend under 305(b)(2).
• IRS SAYS: If the redemption is an isolated transaction, we will not raise 305(c). But if it's part
of a series of transactions, this will look too much like a dividend (say in the last 2 or 3 years).
• Reg. § 1.305-3(b)(3): . . . In addition, a distribution of property incident to an isolated
redemption of stock (for example, pursuant to a tender offer) will not cause section 305(b)(2) to
apply even though the redemption distribution is treated as a distribution of property to which
section 301, 871(a)(1)(A), 881(a)(1), or 356(a)(2) applies.
• See Reg. § 1.305-3(e) Example 8 - if there are regular installments - it might be treated as a
whole bunch of 305(b)(2) redemptions.
• Corporate Tax § 311: No gain or loss is recognized to a corporation on distribution (not in complete
liquidation) with respect to its stock of its stock.
§ 306 Stock
• § 307(a) says that if a shareholder receives stock in a distribution to which 305(a) applies, then the basis
of such new stock and the old stock shall be determined by allocating between the old stock and the new
stock the basis of the old stock.
• Essentially, if you dispose of §306 stock, that stock is treated as if it was a dividend from the company.
So, essentially, the basis from that stock would shift back into the original stock.
• Defining 306 Stock § 306(c):
• If it participates in growth, it's common stock.

• If they don't have a right to participate, then it's a 'preferred' stock for §306.
• Includes tax-free dividends of preferred stock - (c)(1)(A)
• Also includes preferred stock received in recapitalization - (c)(1)(B)
• Shareholders turn in shares and they get new shares of different classes
• Exception if no E&P at time of issuance - (c)(2)
• If no E&P, no application at all - the idea here is to capture growth.
• Taint Remains §306(c)(1)(C): anyone who takes that stock with the same basis as you maintains this
'taint'. It remains § 306 stock.
• § 306(a)(2) - if the disposition is a redemption, the amount realized shall be treated as a distribution of
property to which § 301 applies.
• (b) Exceptions: if you are terminating your interest, it will not be treated as a dividend.
• Additionally, § 306(a)(1)(A) - you only have a dividend to the extent that the corporation had E&P
when you got the stock.
• Triggering Events:
• Sale of § 306 Stock
• Entire amount realized is dividend to extent corporation had E&P when stock was issued
• Any excess is treated as sale - basis allowed for purposes of computing capital gain, BUT
NO LOSSES
• Redemption of § 306 stock
• Automatically treated as distribution covered by IRC § 301

• If termination of entire interest, not treated as dividend.
Complete Liquidations
Complete Liquidations under § 331
• Distributions in complete liquidation are considered as full payment in exchange for the stock. §301
does not apply in a complete liquidation.
• If a corporation liquidates, the E&P disappears. At the shareholder level, it’s no different than if the
shareholder sold his stock to a stranger.
• Complete Liquidation Defined § 346: A distribution is treated as a complete liquidation if it is one of a
series of distributions in redemption of all of the stock of the corporation pursuant to a plan.
• Use of Basis: Because there’s no way to know how much money will come out (unknown
creditors), the IRS lets the shareholders use all of their basis first.
• Using a Trust to Complete Liquidation: Sometimes, the shareholders set up a trust for their benefit and
the corporation will distribute money to that trust. For tax purposes, a distribution to the trust is taxed as
a gain even though the money hasn’t actually been distributed.
• What if the SH receives an installment obligation from the corporation in a liquidation? 331 still
applies if it’s a liquidation. The taxpayer can use 453 an use the installment method to report gain if he
meets the requirements of 453(h). (h) requires that the obligation was received by the company within
12 months after the adoption of a liquidation plan and the plan must be completed within that 12 month
period. Limitations:
• You can't use this for publicly traded companies. 453(k)(2)
• He would have his full gain in year one if it was publicly traded.
• Doesn't apply to notes received before the plan of liquidation.
• This would instead be treated as FMV of the note.

• What if they just distribute all assets, but then a creditor comes out of the woodwork and A is required to
pay 5k 2 years later. What's the tax treatment of that transaction?
• Arrowsmith Case: This is considered a 5k capital loss. This transaction is related back to the
source.
• Basis in Property Received in Corporate Liquidation § 334(a): Basis is the FMV of such property at
the time of distribution.
• What if you get property in a distribution with a mortgage on it? Only the equity of the
property goes into the shareholder's gain. If the shareholder was receiving 8k in cash and 12k
property with a 5k mortgage (and he had 10k basis in his shares), he would be treated as
realizing 15k. Therefore, he would have a 5k capital gain. The basis in the property would be the
full FMV of the property, however. It only makes sense.
• Corporate Taxation § 336: Gain or loss is recognized to a liquidating corporation on the distribution of
property in complete liquidation as if sold to the SH at FMV.
• S-Corps: Same thing, though no corporate tax.
• Limitation on Recognition of Loss (d): No loss is recognized if such distribution to related
person is not pro-rata or such property is disqualified Property.
• Disqualified Property (d)(1)(B): Property acquired by the corporation to which 351
applied or as a contribution during the 5 year period before liquidation.
Liquidation of a Subsidiary § 332 (Parent) and § 337 (Subsidiary)
• This is a tax free transaction.
• The E&P of the subsidiary goes into the parent corporation.
• The parent’s basis in the stock disappears.
• Requirements § 332(b):
• (1) The parent must own at least 80% of the stock of the subsidiary from the time of the plan of
liquidation through until the actual liquidation. AND EITHER:
• (2) The Transfer must happen in one taxable year; OR
• (3) the transfer must be a series of distributions in complete redemption of all its stock
that is completed within 3 years from the adoption of the plan of liquidation.
• Basis of property received § 334(b): carryover basis from subsidiary.
• § 337 Subsidiary: No gain or loss recognized to liquidating subsidiary to which § 332 applies.
• If you have a minority shareholder, distributions are made to the minority shareholder as well -
they are NOT covered by 332, 337.
• The subsidiary recognizes gain here on this sale. Also, the sub can never take a loss in this
situation under 336(d)(3).
Taxable Corporate Acquisitions
Stock Acquisition
• If P buys the stock of T, this is considered a “stock deal”. This is a taxable sale, so there will be capital
gain here. T can then be liquidated into P. However, even though the company was purchased at the full
FMV of T, the basis of the assets will remain the same because P’s basis in T’s stock disappears when T
liquidates as a sub of P.
• P may liquidate T under IRC §§ 332, 337
• No gain/loss, carryover basis on asset
• Restrictions on carryover of tax attributes under IRC § 382

• NOL carryforwards don't get eliminated, but they get slowed down.
• Companies used to purchase companies with tons of NOL in order to deduct them against
gains.
• §382 says that when a company is sold, the NOL carryforwards are slowed way down - can only
be used based on the value of the target company. How much was the T company really worth?
You can use the NOL carryfowards at say 3% a year. You can use the NOL to offset the profits
from turning that company around. If you dump a bunch of more assets in there, you can't use
the NOL against your other asset's gains. Only based on an annual percentage of the assets in the
company when you bought the target company.
• § 338: If you do a stock deal, and the purchaser is really unhappy that the basis of the assets didn't step
up, you can make an election under 338 to treat the deal as an asset deal. For state law, it will still be a
stock deal, but it can be treated as an asset deal. There will be corporate tax, though - why ever do this?
You don't. Do not make a 338 election.
• This MIGHT make sense if the target company was an S corporation or a controlled subsidiary.
This is because no corporate tax will be triggered because the liquidation would be tax free
anyway. §336(e)
• You would want to do it in these cases because you would get a stepped up basis for nothing.
Asset Acquisition
• If T sells all assets to P and then liquidates all of that cash to the shareholders of T, this is an asset
acquisition. When T sells their assets, this is a taxable even and T will recognize the gain – you then
have all the asset gain taxed at the corporate level. P will then get a stepped up basis in the assets (cost
basis). Now, when T liquidates, A will have capital gain on the money remaining in T. This is the double
tax nightmare. The good news is that P will get a stepped up basis in the assets. But, why pay corporate
tax now for basis later? From a present value standpoint, this is worse.
• One point would be to purchase only the assets without the potential liabilities of the corporation.
Although, sometimes the liabilities come with the assets and even some states indicate that
product liability can come with the purchase.
• Gain is calculated on an asset by asset basis
• Seller's concerns
• If assets are capital gains assets, more of the sale price will want to be for these assets
• Buyer's concerns
• Buyer wants to put as much basis as possible for inventory and other ordinary income type assets
(and depreciable assets)
• Amortization of intangibles (IRC §197) - (i.e. goodwill of the business, non-compete

agreements, going concern value) this is depreciated over 15 years. If you purchase intangibles in
this situation, they have to be amortized over these 15 years. As a buyer, you don't want the basis
here - this is 15 years of straight line depreciation.
• Allocation of price
• Buyer's and seller's allocations must match
• IRC §1060: If you have an agreement as to the allocation, they have to use that on their tax
return. The IRS doesn't have to accept this, but the parties are bound by it for tax purposes.
Default rule (no contract): see below.
• IRC § 1060:
• Parties bound by their contractual allocation for tax purposes
• If no allocation in contract, must use "residual" method of allocation
• Tangible assets should be allocated first based on their actual FMV values, intangibles get
what's left over
• Both parties must report allocation on particular IRS form

• Easy for IRS to compare
• IRS will check to make sure allocations are somewhat close.
Reorganizations
Reorganizations (Ch 9-12)
• Have one company acquired by the other without anyone paying any taxes.
• This could be a company splitting into multiple corporations
• Statutory Merger: We've got T, a corporation with valuable assets (400k FMV). Corporation P wants
T's assets. Let's assume that A (shareholder of target company) is willing to accept stock of P as
consideration for the deal. If he's willing to accept this as consideration, you can have P take over T and
it will be taxfree to everybody.
• Most of the consideration that A is getting must be P's stock. If P's a publicly traded company,
this isn't much of a risk.
• This is considered a statutory merger. T goes out of existence and all of the assets and liabilities
of T go to P.
• If A does get cash in addition, that cash would be boot and it would be taxable. But, the stock
won't be.
• If A gets all cash, it's a taxable deal - not a reorg. The shareholder is shielded by §354.
• § 362 - P takes assets with a carryover basis.

• § 358 - The shareholder gets the stock in P with a carryover basis from their old stock.
• § 382 - anytime a corporation changes ownership - any loss carryovers get slowed down.
• The E&P does not disappear - it carries over to the surviving corporation.
§ 361 - Corporations in a Reorganization

• (a) General rule: No gain or loss shall be recognized to a corporation if such corporation is a party to a
reorganization and exchanges property, in pursuance of the plan of reorganization, solely for stock or
securities in another corporation a party to the reorganization.
§ 354 - Shareholders in a Reorganization

• (a) General rule (1) In general: No gain or loss shall be recognized if stock or securities in a corporation
a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or
securities in such corporation or in another corporation a party to the reorganization.
In order to be a Reorganization:
• Fit into one of the seven "types" in IRC § 368(a)
• (A) Statutory merger/consolidation

• (B) Stock for stock - p exchanges stock in P for T's stock - this is a B-reorg. It must be SOLELY
for voting stock of P. No Boot is allowed.
• Not a merger or acquisition, but roughly the same.
• This is if T's board of directors won't do the merger. P can make an offer enough to get
80% of T's stock in exchange for stock in P>
• (C) Stock for Assets

• Here, P issues its stock in exchange for all of the assets of T and then T liquidates and
distributes all the P shares to the shareholders of T. The majority of what the shareholder
gets must be voting stock.
• (D) Corporate divisions (and others)

• Allows you to split one corporation into two (main D reorg - a divisive reorg)
• Let's say we have a corporation engaged in two businesses and it splits the businesses
into two corporations. You can achieve this split and have it be tax free to the
shareholders. There are three different formats:
• 1) "Spinoff": Corporation forms a new subsidiary, drops one of the businesses into
the subsidiary in exchange for stock in new corp. Then, parent distributes out
stock of the subsidiary to its shareholders
• 2) "Splitoff": Same - but instead have shareholder turn in stock as part of the deal.
• 3) "Splitup": Corporation forms 2 subsidiaries then liquidates itself and distributes
the shares of subsidiaries to its shareholders.
• § 355 rules as well must be met.
• Boot is allowed, but it is taxed.

• (E) Recapitalization - existing shareholders exchange shares for new shares
• Boot is allowed, but taxed
• (F) Migration: Mere change in identity, form: changing where your company is filed
• (G) Bankruptcy Reorganization -
• Must meet three judge-made tests:
• Continuity of shareholder interest (COSI) - target-company shareholder must be mostly getting

stock
• Continuity of Business Enterprise (COBI) - assets of target company must still be around and
employed in a business in a transaction
• Business purpose requirement (easy to meet)
• If not a reorganization, acquisition is taxable (chapter 8).
§ 368(a)(2)(E) Triangular Mergers

• Do this if the end goal is for T to become an entirely new subsidiary of P. P would give stock to a newly
created subsidiary S. S would then merge T into S. (This can be done in §368(a)(2)(D))
• A "Reverse" would be if S merges into T instead.
Anti-Avoidance Rules
Economic Substance Doctrine
• Substance prevails over form.
• It's hard to know whether clients win or use on this issue.
• United Parcel Service v. Commissioner (619): UPS is a successful business. Accountants say - set up a
subsidiary in a country with low tax (Ireland today) and farm the insurance part of your business
offshore. The subsidiary then makes a portion of your business.
• They gave the shares in this new sub as a taxable dividend to their shareholders. TO avoid even
further, UPS sent the insurance money to a separate company which then pays it to your
subsidiary corporation. (Run it through a third party).
• IRS audits, drags to court, wins in tax court on the theory that this is a sham.
• Case goes to the 11 circuit - 11 circuit sides with UPS.

• So...who knows?
• IRS has authority under §482 to recast all transactions between brother-sister corporations as arms-
length deals.
• § 7701(o)
Accumulated Earnings Tax (§ 531)

• If a corporation does not pay dividends, then we start to examine what the corporation has been doing
more carefully. In addition to having to pay it's regular corporate tax, it might have to pay this penalty
tax.
• A corporation can get subjected to this:
• Accumulating earnings beyond reasonable needs of business, then we tax on undistributed

earnings.
Personal Holding Company Tax

• If corporation is closely held and most of its income is investment income
• If a corporatino is engaged in supplying services to people and the service provider is the shareholder.
This is to stop athletes from forming corporations and supplying themselves through a corporation.
• These are not a problem if you're paying dividends.
S Corporations
Generally
• More S-Corps than C-Corps by a wide margin
• Even more S-Corps than partnerships

• Single-Tax: When an S-Corporation earns a profit, the corporation is not taxed
• "Pass-Through": The income passes through and ends up on tax returns of shareholders - this is 100%
pass through - it doesn't matter if there's a distribution or not - it's taxed immediately upon recognition
by the s-corp of the income.
• Losses also pass through and are not trapped on a corporate tax return
• Non-tax Distributions: Distributions are generally not taxed, unlike a c-corp.
• An S-corp does not have E&P (unless they used to be a c-corp)

• 1361: eligibility requirements
• Be a 'small business corporation"

• Doesn't have to be small
• And doesn't have to carry on a business
• Make an election
• Even LLCs can check the box to be a corporation and then elect to be an S-Corp
• They do this so they can revert back to a partnership without having to go through
liquidation.
• 1363: says no tax for s-corps

• 1366: says the tax flows through to the shareholders - everything that happens in the s-corp shows up on
the shareholder's tax returns
S Corporation Not Taxed § 1363
• (a) General rule: Except as otherwise provided in this subchapter, an S corporation shall not be subject
to the taxes imposed by this chapter.
• (b) Computation of corporation’s taxable income: The taxable income of an S corporation shall be
computed in the same manner as in the case of an individual . . .
Shareholder of S Corporation Pass-Thru Tax § 1366

• (a) Determination of shareholder’s tax liability
• (1) In general: In determining the tax under this chapter of a shareholder for the shareholder’s
taxable year in which the taxable year of the S corporation ends (or for the final taxable year of a
shareholder who dies, or of a trust or estate which terminates, before the end of the corporation’s
taxable year), there shall be taken into account the shareholder’s pro rata share of the
corporation’s—
• (A) items of income (including tax-exempt income), loss, deduction, or credit the
separate treatment of which could affect the liability for tax of any shareholder, and
• (B) nonseparately computed income or loss.
Eligibility Requirements § 1361

• (a) S corporation defined
• (1) In general: For purposes of this title, the term “S corporation” means, with respect to any
taxable year, a small business corporation for which an election under section 1362 (a) is in
effect for such year.
• (b) Small business corporation

• (1) In general: For purposes of this subchapter, the term “small business corporation” means a
domestic corporation which is not an ineligible corporation and which does not—
• (A) have more than 100 shareholders,
• (B) have as a shareholder a person (other than an estate, a trust described in subsection
(c)(2), or an organization described in subsection (c)(6)) who is not an individual,
• (C) have a nonresident alien as a shareholder, and

• (D) have more than 1 class of stock.
• (2) Ineligible corporation defined: For purposes of paragraph (1), the term “ineligible
corporation” means any corporation which is—
• (A) a financial institution which uses the reserve method of accounting for bad debts
described in section 585,
• (B) an insurance company subject to tax under subchapter L,
• (C) a corporation to which an election under section 936 applies, or

• (D) a DISC or former DISC.
"Small Business Corporation" under IRC § 1361(b)

• Not an "ineligible corporation" (b)(2)
• Domestic corporation
• Requirements (b)(1):
• Not more than 100 shareholders
• Spouses and family members are treated as a single shareholder (1361(c)(1))

• No shareholders who are not individuals
• Except: decedent's estates, most trusts, pension funds, and charities

• Except S corporation parent owning 100% of the stock (IRC § 1361(b)(3)): this is a QSub
(qualified subsidiary).
• (c)(6) stock can be with charity
• Can't have a partnership/corporation as shareholder
• No nonresident alien shareholders

• Can only have 1 class of stock
• Differences in voting rights are ignored
Election: IRC § 1362

• All shareholders must consent.
• You have to be careful with community property laws. In a community property state, each
person in a marriage owns half. This means that the spouses would have to consent.
• (b) Election generally starts at the beginning of a taxable year.
• Can be good for current year if made within 2 and ½ months of start of year
• The taxable year of the S-Corp doesn't start until it comes into existence.
• The S-Election is good until it is revoked or is terminated.
• You don't have to get signature of new shareholders.

• HOWEVER: you need to get consent of everyone since beginning of 2.5 months of start of year.
And each shareholder during that period would have to be eligible shareholders.
Terminating S Status
• Voluntary revocation - IRC §1362(d)(1)
• Must have more than ½ of shareholders consent
• If you revoke within the first 2.5 months, you can revoke to the beginning of this year.
• You can also specify a future date.

• Ceasing to be small business corporation - IRC § 1362(d)(2)
• Anytime one of the eligibility requirements is not longer fit

• The timing is effective on and after the date of cessation.
• You want to sign an agreement to prevent shareholders from screwing this up.
• Some S corps. That used to be C corps. - IRC § 1362(d)(3)

• This only applies if the s-corp used to be a c-corp.
• Inadvertent terminations - IRC § 1362(f): IRS can forgive if you correct the problem and you must show
that it mustn't be on purpose. They have been very generous to grant these.
• Can't go back to Sub S for five years - IRC § 1362(g) - you're allowed to change once, but you cannot
change back for five years
S Corporation Operations
• Under 1366 - income and losses "pass thru" - shareholders must put their pro-rata share of everything
that happens in the corporation. It must be on their tax return regardless of a distribution or not.
• The character (ordinary v capital) is determined at corporate level (1366(b)) and then retains that
character when it passes through
• Any elections are made at a corporate level (e.g. 1033) - this is 1366(c)
• Shareholders are stuck with it

• When income passes through to the shareholder, their basis on their stock goes up (1367) - same thing
with a deduction (basis in stock would come down). For every pass through action there is a basis
reaction.
• If it was never a C corporation, distributions are treated as return of stock basis, and then capital gain if
it exceeds the basis in the stock (§ 1368(b))
• 1371(c) - s-corporations do not generate E&P while they are S-corps
Example
• Three shareholders of S corp.
• S corp earns 15k profit
• This 15k profit passes through to shareholder - each shareholder pays taxes on 5k of income
• Now, their basis in their stock goes up by 5k.
• Then, if each shareholder takes 5k out as a distribution, this will be tax free for them
• Then, their basis in their stock goes down by 5k.

S-Corporation Operations
• Loss "pass-thru" limited to stock basis + debt basis (1366(d))
• Debt basis = shareholders who are creditors to that company
• You can't take losses beyond this basis - they carry over to the future if at a later time the
corporation earns money and the shareholder gets a basis
• You can't take losses if you don't have basis

• This can create problems if the corporation borrows money from third party:
• Corporate debt to third parties does not create usable basis for shareholder ( even if shareholders
guarantee it!)
• Harris (page 679) and many other cases
• Losses that represent the corporation burning through the bank loan won't pass through to
shareholder.
• So, you might not want to put the owners in an s-corp if they are going to be guaranteeing a loan.
• Instead - have the shareholders borrow the money and then lend it to the s-corp.
C-Corps To S-Corps
• Switching over is not a taxable event. Congress could have treated this as a liquidation and formation,
but they didn't.
• Electing S is not a taxable event, but:
• Double tax on appreciated property doesn't go away

• E&P (dividend potential) doesn't go away
• If E&P is present, excess passive investment income creates problems
• E.g. Interest/dividends, rents - the corporation has to pay a tax on that and if it persists, it
could terminated S-status under 1362(d)(3)
• Tax at corporate level

• Eventual termination of S status
• The idea here is that they were afraid that there would be a bunch of c-corps that, instead
of liquidating to close up shop, they become an S-corp to avoid liquidation taxes and just
continue to invest the E&P in a portfolio of passive investments.
• Don't ever be a C-Corp if you're going to be an S-corp.
Example
• Let's say we have a 100% shareholder of a c-corp that owns a property with FMV of 20k and basis of
11k.
• This property is lobster trapped. What congress doesn't want is for that corporation to make an s-election
and then sell that asset to shareholders tax free.
• The corporation will still pay a tax on this asset on the 9k gain.
Former C-Corps: Appreciated Property

• Can't eliminate corporate tax on asset appreciation inside c-corporation
• § 1374 taxes the s-corporation on "built-in" gain (BIG) that was present when S election was made
• "taint" persists with the corporation for 5 years after S election is made (IRC § 1374(d)(7))
Former C-Corps: Dividends

• What if you still have accumulated E&P from your c-corp days?
• Distributions of old c-corp. e&P are dividends - taxable to the shareholders
• BUT, previously "passed thru" S-corp. income not taxed.

• If you take a distribution, you look to previously passed through income and it won't be taxed
again - only if they take out distributions beyond the income passed through to them.
• Distributions are treated as previously taxed S corp. income first - "AAA" account (1368(e)(1))
• The Accumulated Adjustments Account - sum total of all the ups and downs of your share
interest
• Distributions beyond AAA are § 301 - taxable to extent of remaining E&P

• Example:
• C-Corp with $100 E&P - what if we switch over to S-corp and pay $100 out?
• Is this a dividend?
• You have to ask - did any income pass through to shareholder? He's entitled to take that much
out tax-free first before we use the E&P as a dividend.
• So, it's tax free to the extent of the AAA account.
Former C-Corps with E&P And Passive Investment Income

• IRC §1375 - corporation taxed on passive income if it has old E&P
• § 1362(d)(3) - lose S status after three years of that

• Clean out the old E&P before turning old c-corp into s-holding company!!!
• You can clean it out after it becomes an S-corp as well - you can bypass the AAA account if you want to.
Stoker Ostler April 2018 Stoker Ostler April 2018
Suzie Eyrich is a Financial Planner with BMO Private Bank.

Suzie provides customized financial planning solutions to high net worth individuals and families as part of an overall
Wealth Planning Update
personal wealth management strategy. Suzie joined BMO Private Bank in 2016 with over 10 years of experience in the
financial services industry. Suzie earned her BS in Global Business and Financial Management from Arizona State University,
and her Master of Science in Taxation from Golden Gate University. She is a CERTIFIED FINANCIAL PLANNER™ practitioner. Choosing the
right retirement plan
Suzie holds Life & Health Insurance licenses.
tax deductible. If you’re looking to put away as much as possible, and

have the cash flow to do so, a defined benefit plan may be right for you.
• Project the annual tax savings possible given your personal and
business situations.
for your business
Pros and cons of defined benefit/pension plans You may find it makes sense to fully fund a tax-deferred plan up
to IRS limits, split savings between pretax and after-tax vehicles, or
+ Save more than any - Most expensive option to save a portion to a tax-deferred account and put the rest back into
other type of plan maintain the business. Working with your advisors will enable you to make Understanding the benefits of IRAs, 401(k)s and defined benefit plans for you and your employees.
+ Can be paired - Requires annual reporting and the best decision for you and your business. As a business owner, you naturally focus your energy, time and resources on growing and sustaining your
with a 401(k) or actuary calculations
profit sharing
Just as a business plan sets your company up for success, a retirement business, while fostering an environment where your employees can thrive and support your vision. As you
- Must have consistent income plan can help both you and your employees prepare for a better
plan to maximize available to cover IRS minimum
set your priorities, planning for retirement may fall to the bottom of your list.
contributions future. Ask your financial professional for help understanding and
funding requirements
choosing the right business retirement plan for you. In fact, according to a 2016 BMO Wealth Management survey of more With a retirement plan, you can:
than 400 business owners, 75% had saved less than $100,000 for • Take control of your future, particularly if you don’t have the
their retirement. This illustrates that most business owners prioritize benefit of a company pension or stock plan.
Getting started Feel confident about your future their business over retirement planning.
• Realize tax benefits today and in the future that can save you
Establishing a retirement plan does not need to be complicated or Stoker Ostler — its professionals, its disciplined approach, and Whether you don’t see the benefit of planning now or simply have money every year.
time-consuming. Your financial professional can help by handling the comprehensive advisory platform — can provide financial peace not had the time for it, failing to plan for retirement can come at a
of mind. Call your Stoker Ostler Portfolio Manager today. • Earn compound growth on your nest egg, giving you greater flexibility
setup, directing you to investment options that are appropriate for your high cost. You may forego the tax and wealth planning opportunities
to work as much or as little as you want as you approach retirement.
situation, and sending you annual reports to share with your accountant. www.stokerostler.com that a well-structured retirement savings strategy can provide, while
Start by engaging your financial and tax professionals to help you: your employees may miss an important benefit that can help them • Retain valuable employees by providing an important benefit to
prepare for their futures. them that may be of minimal cost to you.
• Project your retirement needs and define how much you can
safely put away to meet those needs. Below, we review three categories of retirement savings plans
available to business owners — Individual Retirement Accounts IRAs: The easiest way to start saving
(“IRAs”), 401(k)s and defined benefit/pension plans. We identify
Both you and your employees can take advantage of the benefits of
pros and cons of each and provide specific ideas to help you put a
an Individual Retirement Account, at little to no cost to your business.
plan in place. We’ve also included a detailed comparison chart to
help you decide which may be right for you. Traditional or Roth IRA. Anyone with earned income can open an
IRA (though there are income limits for Roth IRAs). Although these
1
Use IRS Pub 560 Chapter 4 and 5 to calculate Plan Contribution for Owner. "Compensation" is equal to Net Earnings from Self Employment, reduced by deductible portion of types of IRAs have the lowest contribution limits, you can set one up
S/E Tax and owner's plan contribution. Do you really need a retirement plan? in conjunction with another retirement plan to increase savings.
2
Deduction limited to Lesser of 25% Participants Compensation or 100% of contribution. Self-employed: use computation as mentioned in (1) above.
If your business is thriving and generating a steady income, you may
3
Roth Withdrawals are tax free ("qualified") if taken after 59 1/2 & account has been open for 5 years. See IRA Pub 590-B for additional rules. SIMPLE IRA. Designed for small businesses with fewer than 100
4
If owner or spouse can participate in a workplace plan, deductibility of Traditional IRA contributions subject to Income Limits. not see the benefit of putting retirement money aside today. Perhaps
employees, a SIMPLE IRA allows employees and employers to make
5
Actuary calculates contribution allowed within those limits based on factors such as age of owner and employees, income and years to retirement. you are overwhelmed by the options available or are hesitant to add
Annual Compensation limit of $275,000 applies to all qualified plans when calculating contribution and benefit limits. Example: if plan provides for matching up to 5% of
contributions. Employees can choose whether or not to contribute,
another responsibility to your already lengthy list. If the value of your
compensation, only $275,000 can be used. but as the employer, you must make matching contributions up to
All combined contributions to Defined Contributions Plans are limited to a lesser of $55,000 or 100% Compensation. This includes SEP IRAs, 401(k). business has been growing, you may plan to sell it and monetize
3% of compensation or 2% nonelective contributions, so you will
The information and opinions expressed herein are obtained from sources believed to be reliable and up-to-date, however their accuracy and completeness cannot be guaranteed. the value later in life, essentially considering the business to be
Opinions expressed reflect judgment current as of the date of this publication and are subject to change.
need to be committed to the plan year after year. In addition, the
your retirement plan. However, unforeseen factors may impact the
This information is being used to support the promotion or marketing of the planning strategies discussed herein. This information is not intended to be legal advice or tax advice business (generally) cannot maintain another retirement plan in
to any taxpayer and is not intended to be relied upon. BMO Harris Bank N.A. and its affiliates do not provide legal advice to clients. You should review your particular circumstances value of your business and your ability to continue running it, such
conjunction with a SIMPLE plan.
with your independent legal and tax advisors. as health, family or economic changes. In such cases, a separate
Estate planning requires legal assistance which BMO Harris Bank N.A. and its affiliates do not provide. Please consult with your legal advisor. retirement plan can help provide an important safety net.
Stoker Ostler Wealth Advisors, Inc is an SEC-registered investment advisor.
BMO Private Bank is a brand name used in the United States by BMO Harris Bank N.A. Member FDIC. Not all products and services are available in every state and/or location.
Investment Products are: NOT FDIC INSURED – NOT BANK GUARANTEED – NOT A DEPOSIT – MAY LOSE VALUE.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP® and CERTIFIED FINANCIAL PLANNER™ in the U.S.
C11# 6944139 © BMO Financial Group (04/18)
Stoker Ostler April 2018 Stoker Ostler April 2018
SEP IRA. With this plan, the contribution limits are higher than with
any other type of IRA; you can potentially put away up to $55,000
TIP Consider hiring your spouse to boost household savings. Retirement Plan Options for Business Owners
per year for yourself, depending on your income. In addition, you Work with your CPA to determine if a SEP IRA or Solo 401(k) will allow
SEP IRA Traditional/Solo 401(k) SIMPLE IRA Traditional/Roth IRA Defined Benefit Plan
have the flexibility to contribute or not each year, depending on for higher contributions based on your salary and business income.
Solo 401(k): Sole
the cash flow needs of your business. The percentage of salary In many cases, particularly for an S Corp owner with flexibility in Any Individual. Wants Business owner who
Proprietor. No employees
Sole Proprietor Business with less than to increase tax deferred wants to maximize
contributed to all plans must be equal, so if you have employees, wage distributions, a Solo 401(k) can allow for higher contributions (except spouse). Wants to
Generally Few to no employees. 100 employees. Want savings and 1) is already contributions above any
maximize contributions.
you’re required to invest the same percentage of their salary in their with less income. This is because SEP IRA contributions are only Best For Wants flexibility and ease ease of administration & contributing to a qualified other plan limits. Values
Traditional 401(k): Wants
of administration. employee participation. plan or 2) only wants to maximum savings ability
accounts as your own salary. profit-sharing (generally limited to 25% net self-employment income to provide more saving
contribute minimal amount. over administrative costs.
option for employees.
up to $55,000), whereas a Solo 401(k) includes both an employee
If you need to set up a new plan and contribute for the prior
TIP deferral of compensation (up to $18,500) and profit sharing (up to Deadline to Tax filing plus extensions December 31 for year of October 1 for year of
Tax filing (not including
December 31 for year of
year, a SEP IRA may be your only solution. Establish for year of contribution. contribution. contribution.
extensions) for year of
contribution.
a combined $55,000). contribution.
Employer-sponsored IRA. Designed to help your employees
Traditional 401(k). Employees can contribute up to $18,500 pretax ER Contribution: Tax filing
save faster, this plan allows them to contribute to an IRA through plus extension. Tax filing (not including 15 days after each quarter
per year, commonly through payroll deductions. Business owners can Deadline to
payroll deductions. Tax filing plus extensions. Tax filing plus extensions. EE Contribution: 30 days extensions) for year of (contributions usually made
Contribute
make matching contributions to encourage employee participation, after month for which contribution. quarterly).
Self-directed IRA. These plans allow you to direct your retirement contribution is elected.
or profit sharing contributions based on cash flow each year, all of
savings to an area of investing in which you’re particularly savvy, which are tax deductible for the business.
Earned income
Income to Employee: W-2 wages. Employee: W-2 wages. Employee: W-2 wages. (wages; net earnings from Employee: W-2 wages.
such as real estate, private equity or hard money lending. Traditional Qualify Owner: Sch C or SE income. Owner: Sch C or SE income. Owner: Sch C or SE income. self-employment; taxable Owner: Sch C or SE income.
Roth 401(k). Like a Roth IRA, there is no up-front tax savings, but
and Roth tax benefits and contribution limits apply. alimony).
any growth and subsequent withdrawals are tax-free in retirement.
Use self-directed IRAs with care; according to IRS self-dealing Maximum 100% "earned income" up
Contributions to a Roth 401(k) are not subject to the income limits N/A $12,500 + $3,000 catch up $5,500 + $1,000 catch up N/A
TIP Employee to $18,500 + $6,000 catch
rules, if you make a transaction that benefits you or a Employer only contributions. over 50. over 50. Employer only contributions.
that apply to Roth IRAs. Employer matching contributions are pretax Contribution up over 50.1
“disqualified person”(such as funding a repair on a real-estate and may not be directed to the Roth portion. Owner: 20% Net Owner: 20% Net
investment), the account could become taxable. You’re responsible adjusted profits (sole adjusted profits (sole
Annual benefit cannot
If you believe your taxes will be higher when you retire, consider Maximum prop, partnership)/25% prop, partnership)/25% Dollar for dollar match up
for understanding and complying with these rules. TIP exceed smaller of $220,000
Employer compensation (corporation) compensation (corporation) to 3% compensation or N/A
directing all or part of your contributions to this option. or 100% Highest 3 years
Contribution up to $55,000.1 Employee: up to $55,000.1 Employee: fixed 2% of compensation.
avg. compensation.5
25% compensation up to 25% compensation up to
Pros and cons of IRAs Ask your plan administrator about including a Roth savings option in $55,000. $55,000.
a traditional 401(k) plan to allow for after-tax savings.
Traditional IRA:
+ Low cost and very easy to start - May have lower Owner can deduct on Deductible Contributions.
contribution limits Effect on EE Contributions are pre-
1040. No deduction for Taxable Withdrawals N/A
+ No plan administrator required Pros and cons of 401(k)s Income Tax: Owner can deduct on 1040. tax (Traditional). Reduce
employee, but contribution Roth IRA: NonDeductible Employer only contributions.
than defined benefit Employee taxable Income.
+ No annual compliance testing or 401(k) plans pre-tax. Contributions. Tax Free
+ Higher tax-deferred contribution limits - More costly Withdrawals.3
+ Flexible contributions - No loan options than IRAs
(except SIMPLE IRAs) + Employer matching of employee Effect on
100% deductible 100% deductible 100% deductible N/A
Deductible contributions
Income Tax: - limit based on actuary
contributions allowed - Additional forms Employer
contributions.2 contributions.2 contributions.2 Funded by individual.
computation.
for bigger plans
+ End-of-year profit sharing to Traditional IRA: N/A.4
incentivize employees allowed Income Roth IRA: $120,000 to
401(k)s: Greater savings ability + Tax-free loans up to IRS limits
Limitations
N/A N/A N/A
$135,000 (Single); $186,000
N/A
to $196,000 (MFJ).
with greater flexibility Loan
None. Allowed. None. None. None.
In general, 401(k) plans may be a bit more complex and costly to Provisions
set up than IRAs. However, most plans will allow both you and your Defined benefit/pension plans: Employee Contributions
Pre-Tax. Owner can
Depending on age of
employer/employees,
employees to set aside more money for retirement.
maximum retirement savings Only plan that can be
make both employee
contributions and employer
May incentivize employees
owner can potentially defer
large sums annually to
Solo 401(k). This solution allows a sole proprietor with no employees Other Benefits established and funded "profit sharing" to
to participate with Can set up spousal IRA for
increase tax deduction for
These plans allow you to sock away more than any other type of matching employer non working spouse.
(except a spouse) to make contributions as both the employer and after the tax year. maximize contribution. Solo
contribution requirements.
business and savings for
retirement plan. An actuary uses statistics, such as the age of the 401(k) filing requirements employer/employees. May
employee, potentially up to $55,000 (plus $6,000 catch-up if you’re are minimal compared to combine with profit sharing
participants (you and your employees), salary levels and years until
over age 50), depending on your income. Contributions as employee traditional 401(k) plans. plan to increase further.
retirement to calculate the contribution limits. Older business owners
and employer may be fully tax-deductible, further reducing your IRS Pub 560. IRC Sec 401.
with younger employees can potentially maximize benefits to their IRS Pub 4333 www.irs.gov/retirement- IRS Pub 560. IRS Pub 4334
income taxes. You can also establish the plan as a traditional 401(k) References IRS Pub 590A and 590B IRS Pub 560
own accounts based on these calculations, in some cases resulting in (SEPs for small business) plans/one-participant-401k- (SIMPLE Plans)
or Roth 401(k), depending on your goals. plans
allowable contributions of $100,000 or more. Contributions are fully
Wealth Planning Update 2 Wealth Planning Update 3

2017 Plan Comparison
Traditional lRA Roth lRA SEP SIMPLE lRA Profit Sharing/ 403(b)(7)*/Roth 403(b)(7) 401(k)/Roth 401(k) Safe Harbor 401(k)/ Individual K/
Money Purchase Roth Safe Harbor 401(k) Roth Individual K
Plan Features Contributions may be tax Tax-free growth and distributions Employer-funded; easy to establish Employee-funded; easy to Employer-funded; allows Primarily employee-funded; easy Employee-funded with possible Employee- and employer-funded; Employee- and employer-funded;
deductible (if individual falls (provided certain conditions are and maintain; minimal IRS filings establish and maintain; no ADP/ restricted coverage; allows to establish and maintain; pre- employer contribution; allows allows employers to maximize allows control over when the
within income guidelines); can met); nondeductible contributions and paperwork; low cost ACP nondiscrimination testing; control over when the money tax contributions may reduce restricted coverage; allows control contributions made by highly money will be withdrawn;
be used in conjunction with any may be made even after age 701 ⁄ 2 ; mandatory employer contributions; will be withdrawn; may allow employee's current taxable income over when the money will be compensated employees; may allow for loans; designed
retirement plan can be used in conjunction with any employer cannot maintain another for loans withdrawn; may allow for loans mandatory employer contributions; specifically for owner-only
retirement plan retirement plan no ADP/ACP discrimination testing businesses
Who May Establish Age limit: 701 ⁄ 2 Age limit: None Sole proprietors, partnerships, Employers with 100 or fewer Sole proprietors, partnerships, Public schools and 501(c)(3) Sole proprietors, partnerships, Sole proprietors, partnerships, Employer-only businesses
Income limit: None Income limit: $133,000 for single corporations, nonprofits, employees, including sole corporations, nonprofits, organizations corporations, nonprofits corporations, nonprofits including sole proprietors,
and $196,000 for joint government entities proprietors, partnerships, government entities partnerships, corporations,
corporations, nonprofits, and and nonprofits (may employ
government entities spouse)
Establishment Deadline Tax filing deadline Tax filing deadline Tax filing deadline plus extensions October 1 Plan year end, usually December Plan year end, usually December Plan year end, usually December October 1 Plan year end, usually December
(generally April 15) (generally April 15) 31 for calendar year plans 31 for calendar year plans 31 for calendar year plans 31 for calendar year plans
Contribution Tax filing deadline Tax filing deadline Tax filing deadline plus extensions Salary deferrals made on each pay Tax filing deadline plus Salary deferrals made on each pay Salary deferrals withheld each pay Salary deferrals withheld each pay Salary deferrals withheld
Deadline (generally April 15) (generally April 15) period; employer contributions by extensions period; employer contributions by period; for sole proprietors, when period; for sole proprietors, when each pay period; for sole
tax filing deadline plus extensions tax filing deadline plus extensions business income is determined; business income is determined; proprietors, when business
employer contributions by tax filing employer contributions by tax filing income is determined; employer
deadline plus extensions deadline plus extensions contributions by tax filing
deadline plus extensions
Contribution Annual contributions of up to Annual contributions of up to 25% of compensation up to Employees can defer up to $12,500; 25% of compensation up to Employees can defer up to Employees can defer up to Employees can defer up to $18,000; Employees can defer up to
Limit/Requirements $5,500 or 100% of compensation $5,500 or 100% of compensation $54,000; approximately 20% catch-up contributions of $3,000 $54,000; approximately 20% $18,000; catch-up contributions $18,000; catch-up contributions catch-up contributions of $6,000 if $18,000; catch-up contributions
(whichever is less); catch-up (whichever is less); catch-up for sole proprietors (due to self- if age 50 or older; employer must for sole proprietors (due to self- of $6,000 if age 50 or older; of $6,000 if age 50 or older; age 50 or older; employer typically of $6,000 if age 50 or older;
contributions of $1,000 if age is contributions of $1,000 if age is employment deduction) match dollar for dollar up to 3% employment deduction); PSP employer contribution of 25% of employer contribution of 25% contributes dollar for dollar on the employer contribution of 25%
50 or older; nonemployed spouses 50 or older; nonemployed spouses of compensation (can be lowered contributions are discretionary compensation; total combined of compensation (approximately first 3% and $.50 on the dollar of compensation (approximately
may also contribute up to $5,500 may also contribute up to $5,500 to 1% for two of every five years) and MPP contributions are employer and employee 20% for sole proprietors due for the next 2%; other employer 20% for sole proprietors due
per year if conditions are met per year if conditions are met OR 2% of compensation as a non- required by percentage specified contributions cannot exceed $54,000 to self-employment deduction); contribution options are available; to self-employment deduction);
($6,500 if over 50) ($6,500 if over 50) elective contribution in plan document (excludes catch-up contribution); total combined employer and additional non-safe harbor employer total combined employer and
long-tenured catch-up contribution employee contributions cannot contributions are allowed employee contributions cannot
for employees of 15 years or more exceed $54,000 (excludes catch-up exceed $54,000 (excludes catch-
with same employer contribution) up contribution)
Who Contributes Individual Individual Employer Employee and Employer Employer Employee and Employer Employee and Employer Employee and Employer Individual
Maximum Employee N/A N/A Age 21 or older, worked three of Earned at least $5,000 during Age 21 or older, worked one year Generally, all employees Age 21 or older, worked one year; Age 21 or older, worked one year; N/A
Eligibility Restrictions last five years and earned at least any two prior years and is (or two years if 100% immediate may exclude employees who work may exclude union employees and
$600 in each of those years; may expected to earn at least $5,000 vesting); may exclude employees less than 1,000 hours per year, union nonresident aliens; may not exclude
exclude union employees and in current year; may exclude who work less than 1,000 hours employees, and nonresident aliens employees due to minimum hours or
nonresident aliens union employees and nonresident per year, union employees, and last-day rules
aliens; no age limit restriction nonresident aliens
Vesting 100% 100% 100% 100% for both employee and Vesting schedule allowed 100% 100% for employee contributions; 100% for both employee and Vesting schedule allowed but
employer contributions vesting schedule allowed for employer contributions; vesting generally not used
employer contributions schedule allowed for any employer
contributions made in addition to
mandatory safe harbor contributions
Distributions Distributions taken prior to Tax-free distributions allowed Distributions taken prior to Distributions taken prior to age Distributions can only be taken Distributions can only be taken Distributions can only be taken with Distributions can only be taken with Distributions can only be taken
age 591 ⁄ 2 may be subject to a provided certain conditions are age 591 ⁄ 2 may be subject to a 591 ⁄ 2 may be subject to 10% with a triggering event such with a triggering event such a triggering event such as death, a triggering event such as death, with a triggering event such
10% penalty tax, in addition to met; no minimum distributions 10% penalty tax, in addition to penalty tax, in addition to ordinary as death, permanent disability, as death, permanent disability, permanent disability, attainment permanent disability, attainment as death, permanent disability,
ordinary income tax; minimum required at age 701 ⁄ 2 ordinary income tax; minimum income tax (25% penalty applies attainment of plan’s normal attainment of 591 ⁄ 2 , separation of plan’s normal retirement age, of plan’s normal retirement age, attainment of plan’s normal
distributions required at 701 ⁄ 2 ; distributions required at 701 ⁄ 2 ; if distribution is within two retirement age, separation from from service or plan termination, separation from service or plan separation from service or plan retirement age, separation from
exceptions to 10% penalty exceptions to 10% penalty years of participation); minimum service or plan termination; any or hardship; any distributions termination; any distributions termination; any distributions service or plan termination; any
may apply may apply distributions required at 701 ⁄ 2 ; distributions taken prior to age taken prior to age 591 ⁄ 2 (age 55 if taken prior to age 591 ⁄ 2 (age 55 taken prior to age 591 ⁄ 2 (age 55 distributions taken prior to age
exceptions to 10% penalty 591 ⁄ 2 (age 55 if separated from separated from service) may be if separated from service) may if separated from service) may 591 ⁄ 2 (age 55 if separated from
may apply service) may be subject to 10% subject to a 10% penalty tax, in be subject to 10% penalty tax, in be subject to 10% penalty tax, in service) may be subject to 10%
penalty tax, in addition to ordinary addition to ordinary income tax; addition to ordinary income tax; addition to ordinary income tax; penalty tax, in addition to ordinary
income tax; minimum distributions minimum distributions may be minimum distributions may be minimum distributions may be income tax; minimum distributions
may be required at 701 ⁄ 2 required at 701 ⁄ 2 required at 701 ⁄ 2 required at 701 ⁄ 2 may be required at 701 ⁄ 2
Loan Features Not available Not available Not available Not available Allowed Allowed Allowed Allowed Allowed
Plan Administration None None None None IRS Form 5500 and other ERISA IRS Form 5500 and other ERISA IRS Form 5500 and other ERISA IRS Form 5500 and other ERISA IRS 5500 EZ when plan assets
requirements** requirements if subject to ERISA** requirements** requirements** reach $250,000
*Employer may make matching or discretionary contributions within an ERISA 403(b); ERISA 403(b)s are subjected to ERISA requirements. **Owner-only plans are not required to file IRS 5500 until assets reach $250,000 or terminate. LPL Financial does not provide tax advice. Please consult your tax advisor.
Retirement Plan Portability
Receiving Plan Annual Contribution Limits 2016 2017 Tax Deductibility of IRA Contributions
(Tax Year 2017) for Participants in
To IRA Traditional IRA, Roth IRA, $5,500 $5,500 Employer-Sponsored Retirement Plans
Roth SIMPLE Coverdell Qualified SIMPLE Government
(Traditional SEP IRA Roth 401(k) 403(b) Roth 403(b) Spousal, Guardian
From IRA IRA ESA Plans3 401(k) 457(b)
Spousal) - IRA contributions are fully deductible if neither you nor your spouse
Traditional, Roth, Spousal IRA $1,000 $1,000 participates in an employer-sponsored retirement plan such as 401(k),
IRA Transfer or Transfer or
2
Catch-Up Contribution
Transfer or Conversion NO Rollover NO Rollover NO Rollover Rollover 403(b), or pension plan.
(Traditional Rollover Rollover2
Spousal) Rollover
- Deductibility is limited if you or your spouse participate in an
Coverdell ESA (per beneficiary) $2,000 $2,000 employer-sponsored retirement plan. Refer to the chart below to
Roth Recharacter- Transfer or Recharacter- NO NO NO NO NO NO NO NO figure your deduction.
IRA ization Rollover ization Employer Deduction Limit (SEP, MPP, 25% 25%
PSP, 401(k)5) aggregate aggregate
Transfer or Transfer or Transfer2 or comp comp Modified Adjusted Gross Income Maximum Maximum
SEP IRA Conversion NO Rollover NO Rollover NO Rollover Rollover
Rollover Rollover Rollover2 2017 2017
Elective Deferral (402(g) Limit): 401(k), $18,000 $18,000
SARSEP, 457 and 403(b)) Deduction Deduction
Married Filing Jointly Married
SIMPLE Transfer2 or Transfer2 or Transfer or Single for Those for Those
Conversion NO Rollover2 NO Rollover2 NO Rollover2 Rollover2
Delivering Plan
IRA Rollover2 Rollover2 Rollover Defined Contribution 415 Limit 100% comp 100% comp Filing Under Age 50 and
Filers You Only Spouse
(the lesser of) or $53,000 or $54,000 Separately Age 50 Older
Participate Participates
Coverdell Transfer or
NO NO NO NO NO NO NO NO NO NO Salary Deferral Catch-Up Limit $6,000 $6,000
ESA Rollover $62,000 $99,000 $186,000
(does not count against 415 limits $0 $5,500 $6,500
& under & under & under
Qualified Transfer or
4 in a 401(k) plan)
Rollover Conversion Rollover Rollover2 NO Rollover Rollover NO Rollover Rollover $63,000 $101,000 $187,000 $1,000 $4,950 $5,850
Plans3 Rollover
SIMPLE Plan Deferral $12,500 $12,500
$64,000 $103,000 $188,000 $2,000 $4,400 $5,200
Transfer4 or
Roth 401(k) NO Rollover NO NO NO NO NO Rollover NO NO SIMPLE IRA Catch-Up Limit $3,000 $3,000
Rollover $65,000 $105,000 $189,000 $3,000 $3,850 $4,550
Transfer or Defined Benefit 415 Limit $210,000 $215,000 $66,000 $107,000 $190,000 $4,000 $3,300 $3,900
403(b) Rollover Conversion Rollover Rollover2 NO Rollover NO Rollover Rollover Rollover
Rollover
$67,000 $109,000 $191,000 $5,000 $2,750 $3,250
Annual Compensation Cap $265,000 $270,000
Transfer4 or $68,000 $111,000 $192,000 $6,000 $2,200 $2,600
Roth 403(b) NO Rollover NO NO NO NO Rollover NO NO NO
Rollover SEP Participation Compensation $600 $600
$69,000 $113,000 $193,000 $7,000 $1,650 $1,950
SIMPLE Highly Compensated Employee (HCE) $120,000 $120,000 $70,000 $115,000 $194,000 $8,000 $1,100 $1,300
Rollover Conversion Rollover Rollover2 NO Rollover NO Rollover NO Rollover Rollover
401(k)
Key Employee Officer Definition $170,000 $175,000 $71,000 $117,000 $195,000 $9,000 $550 $650
Government Transfer or
Rollover Conversion Rollover Rollover 2
NO Rollover NO Rollover NO NO $72,000 $119,000 $196,000 $10,000
457(b) Rollover Social Security Taxable Wage Base $118,500 $127,200 $0 $0
& over & over & over & over
1
After-tax contributions require special consideration. Client should consult with a 3
Qualified plans include profit sharing, money purchase, defined benefit, ESOP, 5
Owner-only plans are not required to file IRS Form 5500EZ SF until assets reach This chart is designed to give you a basic overview of IRA deductions.
tax advisor for portability guidelines. target benefit. $250,000 or terminate. LPL Financial does not provide LPL Financial recommends you consult with a qualified tax advisor
2
Available only after the individual has been a SIMPLE plan participant for over 4
Only a plan merger could be done as a transfer. All other movement would need tax advice. Please consult your tax advisor. before making IRA decisions.
two years. to be done as a rollover.
PORTABILITY DEFINITIONS
Transfer Conversion Contribution Eligibility for Roth IRAs 2017

– Movement of assets from one account to another in which both accounts – Movement of assets from an eligible qualified plan or IRA to a Roth IRA. This type of
are considered to be like plans. This type of transaction does not generate transaction generates a 1099-R on the delivering side and a 5498 on the receiving Modified Adjusted Gross Income Phase Out Range
any tax reporting to the IRS and is therefore nontaxable. If the assets are side. This is generally a taxable event.
changing custodians, the receiving custodian will need to sign a letter of Married Filing Married Filing
Recharacterization Single Filers
acceptance accepting custodial responsibility of the account. Jointly Separately
– Movement of assets from one account into another account to undo a previous
Rollover transaction. This transaction is most common from a Roth IRA to an eligible IRA to $118,000–$133,000 $186,000–$196,000 $0–$10,000
– Movement of assets from one account to another. This type of undo a Roth conversion. Transaction will generate a 1099-R on the delivering side
transaction generates a 1099-R on the delivering side and a 5498 on and a 5498 on the receiving side. Member FINRA/SIPC
the receiving side for IRAs. The event may be nontaxable if it is done RP-0113-0217
properly and within 60 days. Tracking #1-575971 (Exp.02/19)
Corporate Tax Outline
Business Taxation Overview....................................................................................................... 1
Tax Imposed - § 11.................................................................................................................. 1
Deductions for “Reasonable” Salaries - § 162(a)(1)................................................................1
Corporation De'ned - § 7701(a)(3)......................................................................................... 1
Publicly Traded Partnerships - § 7704..................................................................................... 2
Social Security and Medicare Taxes........................................................................................ 2
Corporations vs. Trusts........................................................................................................... 3
Separate Corporations with Same Owners - § 1561................................................................3
Subsidiary Dividend to Parent Corporation - § 243.................................................................3
Consolidated Filing § 1501...................................................................................................... 4
Corporate Agent (Commissioner v. Bollinger).........................................................................4
Alternative Minimum Tax § 56................................................................................................. 4
Net Investment Income Tax and Pass-through Income...........................................................4
Formation of a Corporation........................................................................................................ 5
Section 351 Exchanges........................................................................................................... 5
Corporation’s Tax E7ect (§ 1032) and Basis (§ 362)................................................................5
Depreciation Recapture (§ 1245)............................................................................................ 5
Installment Notes and § 453B................................................................................................. 5
E7ect of a Good § 351 Exchange............................................................................................ 6
Requirements of a Good § 351................................................................................................ 6
“Boot” in a § 351..................................................................................................................... 7
Assumption of Liabilities § 357............................................................................................... 8
Incorporation of a Going Business.......................................................................................... 9
Contributions to Capital § 118................................................................................................ 9
Avoiding § 351........................................................................................................................ 9
Organizational and Start-Up Expenses.................................................................................10
Capital Structure...................................................................................................................... 11
Debt vs. Equity § 385............................................................................................................ 11
Character of Gain or Loss on Corporate Investment.............................................................11
Nonliquidating Distributions..................................................................................................... 12
Distributions in General § 301............................................................................................... 12
Dividends and Earnings and Pro't § 316............................................................................... 13
Distributions of Non-Cash Property....................................................................................... 14
Constructive Distributions.................................................................................................... 14
Redemptions and Partial Liquidations...................................................................................... 15
Redemptions Generally §302................................................................................................ 15
Complete Termination § 302(b)(3)........................................................................................ 15
Constructive Ownership of Stock § 302(c)............................................................................ 15
Substantially disproportionate Redemptions § 302(b)(2)......................................................17
Redemptions Not Essentially Equivalent to a Dividend § 302(b)(1)......................................17
Partial Liquidations § 302(b)(4)............................................................................................. 18
Consequences to the Distributing Corporation.....................................................................18
Redemptions through Related Corporations § 304................................................................19
Redemptions to Pay Death Taxes §303................................................................................. 19
Stock Dividends and Section 306 Stock................................................................................... 19
Stock Dividends and Splits.................................................................................................... 19
Taxation of Stock Distributions § 305....................................................................................20
§ 306 Stock........................................................................................................................... 21
Complete Liquidations............................................................................................................. 21
Complete Liquidations under § 331...................................................................................... 21
Liquidation of a Subsidiary § 332 (Parent) and § 337 (Subsidiary)........................................22
Taxable Corporate Acquisitions................................................................................................ 23
Stock Acquisition.................................................................................................................. 23
Asset Acquisition................................................................................................................... 23
Reorganizations....................................................................................................................... 24
Reorganizations (Ch 9-12).................................................................................................... 24
§ 361 - Corporations in a Reorganization.............................................................................. 24
§ 354 - Shareholders in a Reorganization.............................................................................. 25
In order to be a Reorganization:........................................................................................... 25
§ 368(a)(2)(E) Triangular Mergers......................................................................................... 26
Anti-Avoidance Rules................................................................................................................ 26
Economic Substance Doctrine.............................................................................................. 26
Accumulated Earnings Tax (§ 531)........................................................................................ 26
Personal Holding Company Tax............................................................................................. 26
S Corporations......................................................................................................................... 27
Generally.............................................................................................................................. 27
S Corporation Not Taxed § 1363............................................................................................ 27
Shareholder of S Corporation Pass-Thru Tax § 1366..............................................................27
Eligibility Requirements § 1361............................................................................................. 28
"Small Business Corporation" under IRC § 1361(b)...............................................................28
Election: IRC § 1362.............................................................................................................. 29
Terminating S Status............................................................................................................. 29
S Corporation Operations...................................................................................................... 29
Example................................................................................................................................ 30
S-Corporation Operations..................................................................................................... 30
C-Corps To S-Corps................................................................................................................ 30
Example................................................................................................................................ 30
Former c-corps. - Appreciated Property................................................................................ 31
Former C-Corps. - Dividends................................................................................................. 31
Former C-Corps with E&P And Passive Investment Income...................................................31
Business Taxation Overview
Tax Imposed - § 11
• 15% on 'rst $50,000
• 25% on next $25,000
• 34% on income from $75,000 to $10,000,000
• 35% on income over $10,000,000
• For corporations with substantial amounts of income, the tax bene'ts of the lower
brackets are phased out – over 18,333,333 Hat 35% on all income
o For corporations earning over 100k, the amount of tax is increased by the lesser of
5% of such excess or $11,750.
o If the corporation has more than $15M, the amount of tax is increased by an
additional amount equal to the less of 3% of such excess or $100k.
• Personal Service Corporation Exception §11(b)(2): Personal Service corporations do
not get the lower brackets. Instead, they are taxed at 35 percent.
o De#ned § 448(d)(2): Two Requirements:
 1) Substantially all of the activities of the corporation involve the
performance of services in health, law, engineering, architecture, accounting,
actuarial science, performing arts, or consulting, and
 2) substantially all of the stock (by value) is held directly (or indirectly
through companies/partnerships) by employees, retired employees, estates
of employees, or any other person who had acquired the stock from such an
employee.
o They can, however, use the cash-method of accounting under § 448.
Deductions for “Reasonable” Salaries - § 162(a)(1)

• A “reasonable” allowance for salaries and other compensation for personal services
• This is to prevent the corporation from paying dividends as salaries to escape paying
corporate tax.
Corporation De#ned - § 7701(a)(3)

• “corporation” includes associations, joint-stock companies, and insurance companies.
• Reg. § 301.7701-1: discusses whether a separate entity exists at all.
o Certain joint undertakings give rise to entities for federal tax purposes.
o A joint venture or contractual arrangement may create a separate entity if the
participants:
 Carry on a trade, business, 'nancial operation, or venture and divide the
pro'ts.
 Exception: This does not include a joint undertaking merely to share
expenses.
 Exception: This also does not include mere co-ownership of property that is
maintained and rented or leased.
• Reg. § 301.7701-2: De'nes what IS a corporation.
o A business entity is any entity recognized for federal tax purposes that is not a
trust.
o A business entity with two or more members is either a corporation or a partnership
o A business entity with only one owner is classi'ed as a corporation or disregarded.
1
o A business entity is a corporation if a federal or state statute describes it as a
corporation. So, if you’re a corporation under state law, you are a corporation for
IRC.
o An association – as de'ned under 301-7701-3.
o A joint-stock company or association.
o Insurance company.
o State chartered business entity conducting banking activities
o Certain foreign entities.
• Reg. § 301-7701-3 (“Check the Box Regulation”)
o (a) A business not already classi'ed as a corporation can elect to be classi'ed as an
association (and thus corporation).
o (b) If you don’t make this election, then (b) de'nes your tax status. These are the
default rules.
 If you have two or more members, you’re a partnership.
 Otherwise, you’re a disregarded entity.
o (c)(1)(iv) Limitation: Once you make an election, you cannot elect to change its
classi'cation in the next 5 years.
o (g) Changing Tax Treatment:
 (1)(i) Partnership to Association: If an election is made, the following occurs:
the partnership contributes all of its assets and liabilities to the association in
exchange for the stock in the association and then the partnership liquidates
by distributing the stock of the association to its partners.
 (1)(ii) Association to Partnership: If an election is made, the following occurs:
the association distributes all of its assets and liabilities to its shareholders in
liquidation of the association and immediately thereafter, the shareholders
contribute all of those assets and liabilities to a newly formed partnership.
 This isn’t a big deal going from partnership to association, but the tax
implications for liquidating a corporation can be huge when going from
association to partnership.

• (a) Generally, publicly traded partnerships are treated as a corporation.
• (c) provides a narrow exception for if 90% or more of the company’s gross income comes
from quali'ed income as de'ned by (d).

o 6.2% Social Security tax for employer and employee
o 1.45% Medicare tax for employer and employee
o No Personal Exemption
o Social Security Wage Base for 2015: $118,500 – this is the capped social security
wage tax amount
• Self Employment
o 12.5% social security tax
o 2.9% medicare tax
o Tax base: 92.35% of net earnings from self-employment
o Filing threshold: $400 of net earnings from self-employment
o Social security base for 2015: $118,500 minus wages
2
• Medicare Surtax: After $200k ($250k for married, joint return) of wages, compensation, or
self-employment income, taxpayer pays an additional 0.9% in Medicare surtax.
o 3.8% of net investment income
o Applicable only to extent adjusted gross income is greater than $200,000 ($250,000
married)
o Applicable to investment income (dividends, interest, recognized gains on stocks,
bonds) income from 'nancial trading business, and passive activity income
o Not applicable to income from non-rental, non-'nancial-trading business activities in
which taxpayer materially participates
o Not imposed on wages or self employment income
o This is § 1411.
o Partnerships and Wages: Wage tax is not applicable to partners in a partnership
o Partnerships and Self-Employment Tax: Self-employment tax is imposed on pass
through income from partnership business to general partners (NOT imposed to
limited parters)
o S-Corporations Pass-Through Income: Self-employment tax is NOT imposed on pass-
through income from S corporations to shareholders
o S-Corporations Wages: Wage tax is imposed on S corporation shareholders only to
the extent of wages paid.
 If you don’t take out wages, you never have to pay SS/Medicare taxes –
however, the IRS will look at blatantly evasive actions – you’re supposed to
take out a ‘reasonable’ wage.
Corporations vs. Trusts

• Trusts are not pass-through entities, but they are single-tax. When a trust earns income,
that is taxed to the trust if the trust accumulates it. If it distributes to the bene'ciaries,
just the bene'ciaries pay the tax.
• Reg. § 301.7701-4:
o (a) Ordinary Trusts:
o (b) Business Trusts: Generally created by the bene'ciaries simply as a device to
carry on a pro't-making business which normally would have been carried on
through business organizations. These are classi'ed as corporations or partnerships
under the IRC. So, if the trustee is actively carrying on a business, it cannot be a
trust.
 This often arises in property rental. If the trustee is simply receiving a check,
you’re likely a trust, but if there’s a bunch of property management, that
would be a business trust.
Separate Corporations with Same Owners - § 1561

• IRC § 1561(a)(1): If you have a controlled group of corporation, their tax liability is
combined. It will essentially treat this group of corporations as one.
• § 1561(a)(2) Brother-Sister Controlled Group: Two or more corporations will aggregate their
income if 5 or fewer persons possess more than 50% of the total combine voting power or
more than 50% of the total value of shares of each corporation.
• § 1561(e) Constructive Ownership: Shares held by family members are considered held by
you for determining this aggregate value.
3
Subsidiary Dividend to Parent Corporation - § 243
• The parent corporation must pay tax on this dividend, but it gets a deduction equal to
most of or the entire dividend.
o § 243(a)(2): 100 percent deduction in the case of dividends received by a small
business investment company.
o § 243(a)(3): 100 percent in the case of qualifying dividends de'ned in (b)(1)
o § 243(a)(1): 70 percent deduction in all other cases.
• § 243(b)(1) Qualifying Dividends: Any dividend received by a corporation if such
corporation is a member of the same aNliated group. (b)(2) says that “aNliated group” is
de'ned by § 1504(a).
• § 1504(a) ANliated Group: An aNliated group means 1 or more chains of includible
corporations. The ownership of stock of any corporation meets the requirement if (A) it
possesses at least 80 percent of the total voting power of the stock and (B) has a value of
at least 80 percent of the total value of the stock.
o So, essentially, the parent company must own 80% of the voting power and total
value of the stock to get the 100% deduction. Otherwise, you’re stuck with the 70%
deduction.
o 70% to 80% Bump: Further § 243(c) indicates that if you own at least 20% of the
value and voting power of the subsidiary, the 70% deduction can be bumped to
80%.
Consolidated Filing § 1501

• An “ANliated Group” can 'le a consolidated tax return for the whole group in lieu of
separate returns.
o Cannot contain foreign companies.
o Further, any transactions within the group are ignored.
Corporate Agent (Commissioner v. Bollinger)

• Agency relationship is established if:
o Written agency agreement
o Corporation functions as agent and never as principal
o Corporation is held out as agent in all dealings with third parties
• This is all you need to ignore the c-corporation.
• And, you CAN have a related party be your agent - you don't need the arm's length
relationship.
• National Carbide Factors:
o Corporation operates in the name and for the account of the principal
o Corporation binds the principal
o Transmits money to the principal
o Income attributable to services of the employees of the principal
o Relations with the principal must not be dependent upon the fact that it is owned by
the principal; AND business purpose must be the carrying on of the normal duties of
an agent.
4
Alternative Minimum Tax § 56
Net Investment Income Tax and Pass-through Income
• Net investment income tax is not imposed on tax-free distributions from s-corporations to
shareholders, or from partnerships to partners
• Net investment income tax is imposed on investment income passing through from s-
corporations to shareholders, and from partnerships to partners
5
Formation of a Corporation
Section 351 Exchanges
• General Rule: No gain or loss is recognized if property is transferred to a corporation
solely in exchange for stock in such corporation and immediately after the exchange, such
persons are in control of the corporation.
o In this case, property includes money.
o Control here is de'ned in § 368(c): ownership of stock possessing at least 80
percent of the total combined voting power and at least 80 percent of the total
number of shares.
• Shareholder’s Basis (§358): The shareholder’s basis in the shares received is generally
equal to the property exchanged for the shares. (§ 358)
o The Basis is decreased by:
 FMV of any other property (EXCEPT MONEY) received by the taxpayer
 The amount of any money received by the taxpayer, and
 The amount of loss to the taxpayer which was recognized on such exchange
o The Basis is increased by:
 The amount which was treated as a dividend, and
 The amount of gain to the taxpayer which was recognized on such exchange.
Corporation’s Tax E:ect (§ 1032) and Basis (§ 362)

• General Rule §1032: The corporation never has income when it issues stock in exchange
for property (including money).
• Corporation’s Basis (§362): The corporation gets a carry-over basis from the
shareholder.
o Basis Haircut: If the property exchanged has a lower FMV than basis, the property
gets a basis haircut in the property down to the FMV of the property at the time of
the exchange. (§ 362(e)(2)).
 Aggregate Transfer: This applies in aggregate to all of the transferred
property. So, you add up the aggregate FMV and the aggregate bases of the
property exchanged.
 Shareholder Haircut Election: 362(e)(2)(C) allows the haircut to be taken
on the shareholder’s basis in the shares received rather than the
corporation’s basis in the property received.
• This election is not good for S-Corps. Don’t do this election if the
company is to become an S-Corp.
• Tacking the Holding Period (§ 1223): Also, the holding period tacks with the property
whenever the basis goes with the property.
Depreciation Recapture (§ 1245)

• Generally, any gain attributable to depreciation should be ordinary income rather than a
capital gain. 1245(a)(1) says that if section 1245 property is disposed of, you only get to
use the cost-basis rather than the basis adjusted for depreciation, when calculating how
much capital gains you have. The rest is ordinary income. Essentially, this forces the
depreciation you took to be ordinary income.
• 1245 Property: This is typically anything you use in your business other than real
property.
6
• Application to § 351 Exchange: This doesn’t apply to a good § 351 exchange according
to § 1245(b)(3).
Installment Notes and § 453B

• Ordinary, when you exchange an installment note, you realize all of the gain.
• Gain/Loss Calculation: Di7erence between the basis and
o 1) the amount realized in the case of satisfaction at other than face value or a sale
or exchange; OR
o 2) The FMV of the obligation at the time of exchange.
• Application to §351 Exchange: Reg. § 1.453-9(c)(2) which makes an exception when
the exchange is a § 351 exchange.
• Death of Installment Holder: §453B(c) treats this gain as income in respect of
decedent.
E:ect of a Good § 351 Exchange

§ 351
A B C D E
Exch.
Equipment
worth Installment note
Unimproved land
Inventory worth $25,000 worth
worth
$10,000 ($5,000 $20,000
Partner Gives $25,000 cash $20,000
($5,000 basis due to ($2,000
($25,000
basis) 20k basis sold
basis)
depreciation last year)
taken)
Partner Received 25 shares 10 shares 20 shares 25 shares 20 shares
Not a taxable
Tax event. No gain/loss No gain/loss No gain/loss No gain/loss
Consequenc Nothing recognized recognized recognized recognized
es? even (§ 351) (§ 351) (§ 351) (§ 351)
realized.
$5,000 (carry- $25,000 (carry-
Basis in Stock $25,000 (Cost
over basis § over basis § $5,000 (§ 358) $2,000 (§ 358)
Received? basis §1012)
358) 358)
Holding period
does not
Probably could
tack Previous holding
Holding Period Not a capital Previous holding tack the
because this period is
for Stock gains item period (§ holding
is not a tacked (§
Received? (§1221) 1223(1)) period (§
capital 1223)
1223)
gains item
(§ 1221)
For the
§ 1032 - corporation never has income when it issues stock in exchange for property(including
Corporation
money).
itself?
§ 362(e)(2) -
Basis
Corporation
$25,000 (§ 362) $5,000 (§ 362) Haircut $5,000 (§362) $2,000 (§362)
Basis?
Applies!
$20,000 basis
$5,000 gain is
realized
No gain OR LOSS § 453B doesn't
under
Buying with cash is § 1245 doesn't apply
§1001, but §
isn’t a recognized. apply because of
Notes 351
taxable § 351 is a because of Reg. §
prevents
event. two-way 1245(b)(3). 1.453-9(c)
this gain
street. (2)
from being
recognized
7
Requirements of a Good § 351
• Control (351(a)): Immediately after the exchange the transferors of property
participating in the exchange are in control of the corporation.
o Control De#ned (§ 368(c)): Control requires:
 Ownership of 80% voting power; AND
 Ownership of 80% of the number of shares of the corporation.
o “Immediately after the exchange” (Reg. § 1.351-1(a)): Immediately after the
exchange simply means can be right after the exchange or after the end of an
integrated plan.
 “The phrase “immediately after the exchange” does not necessarily require
simultaneous exchanges by two or more persons, but comprehends a
situation where the rights of the parties have been previously de'ned and the
execution of the agreement proceeds with an expedition consistent with
orderly procedure.”
o Exception - Services in Exchange for Shares (§ 351(d)): Services,
indebtedness not evidenced by a security, or interest on indebtedness accrued after
the shareholder’s holding period are NOT considered as issued in return for property.
HOWEVER, they are considered as part of the ownership of stock.
o Exception - De Minimus Exception (Reg. § 1.351-1(a)(1)(ii)): You can’t simply
put in some nominal amount of property to make them a transferor of property. An
IRS ruling says that if the value of the stock the shareholder gets for property is
more than 10% of the value of the shares he’s receiving, then this will be
considered a transfer of shares in exchange for property.
• Investment Company Exclusion (§ 351(e)(1)): This doesn't apply to a transfer of
property to an investment company. This determination is made using the factors under
§351(e)(1).
o Reg. § 1.351-1(c): A company is considered an investment company if the transfer
results in diversi'cation of the transferors' interests, and the transferee is a
regulated investment company, a real estate investment trust, or corporation with
more than 80 percent of the value of whose assets are held for investment and are
readily marketable stocks or securities.
 This last one wouldn't be a big issue, BUT § 351(e)(1) treats money as stock
and securities. The way to avoid this is to be sure at least 20% of the
assets are not cash or investment stocks.
“Boot” in a § 351
• § 351(b) Boot with Exchange: If the shareholder receives property or money, then gain
shall be recognized, but not in excess of the amount of money received + the FMV of such
other property received.
o Shareholder Stock Basis §358: Here, the basis of the stock will be the carry-over
basis of the property exchanged minus the FMV of the property and cash received
plus the gain recognized on the transaction.
o Shareholder Boot Basis: The boot’s basis will be the FMV of the boot.
o Corporation Property Basis (§ 362(a)): The corporation’s basis in the property
received will be the carry-over basis PLUS the shareholder’s recognized gain.
• Also, no loss will be recognized, ever.
8
• Example: A transfers property to X Corp worth 100k with 10k basis. She gets stock worth
80k and property with FMV of 20k. She’s taxed on the boot she got = 20k gain. A’s basis in
the stock would be 10k (original basis) – 20k (FMV of property received) + 20k (gain
recognized) = 10k. A’s basis in the property received is 20k. The corporation’s basis in the
property received will be 30k.
• Corporate Tax (§ 351(f)): If property is transferred § 311 applies. § 311 essentially says
it is treated as if the corporation sold the property to the shareholder and is taxed on the
gain.
• Corporation Receiving multiple Assets (Rev. Ruling 68-55): If the corporation is
receiving multiple assets, they will be treated as multiple § 351 exchanges and the gain
recognized to the shareholder will be allocated in basis of the property in the corporation
based on the relative FMV of each contributed asset.
• Example Receiving Installment Note: What if the shareholder is receiving more boot
than recognized gain? Problem Page 79(c). Let's say C is transferring in land with a FMV of
50k and a basis of 20k. In exchange, he's receiving common stock with a FMV of 10k, 5k
cash, and an IOU worth 35k. You cannot recognize more than you realize. Although there is
40k boot, there is not 40k of recognized gain. He's only going to recognize 30k gain in the
end (§ 351(b)(1)).
o When Taxed (§453): The default rule of § 453 is that the gain is not recognized all
up front - rather, we would get to use the installment method. Prop. Reg. § 1.453-
1(f).
 Not every installment sale is eligible for § 453. Real estate developers cannot
use 453 for dealer dispositions.
 Also, if that asset is publicly traded security, you don't get to use § 453.
o Assuming §453 applies, the installment method will apply. As each payment comes
in, you use the gross pro't ratio: Payment x (Gross Pro't)/(Total Contract Price).
 In this example: Payment (5k) x (gross pro't (30k))/(total contract price
(40k)) = $3.75k
o Basis Of Stock: Here, the IRC treats the shareholder as if they elected out of § 453
installment method to calculate the basis in the stock. The full amount of
recognized gain is used. Here, Basis of stock = Basis of property (20k) - fmv of
noncash "boot" (35k) - cash received (5k) - recognized loss + dividend + recognized
gain (30k) = 10k
o Corporation's Basis in Asset (§362): Carryover basis from the shareholder plus
any recognized gain. The Proposed Regs limit this to whenever the shareholder
reports their gain on the installment. So, the corporation here would start with a
23.75k basis as soon as the shareholder receives their 'rst installment.
• Nonquali#ed Preferred Stock (§ 351(g)): Nonquali'ed preferred stock is treated like
boot and is taxed.
o De#ned § 351(g)(2)(A): Preferred stock and one of four elements:
 (i) Holder has a right to require company to redeem stock.
 (ii) Company is required to redeem the stock.
 (iii) Company has right to redeem stock and (as of the issue date) it is more
likely than not that such right will be exercised; OR
 (iv) the dividend rate varies in whole or in part with reference to interest rates
or other similar indices.
9
Assumption of Liabilities § 357
• When the shareholder is transferring an encumbered asset into a corporation with § 351.
• General Rule § 357(a): If the shareholder receives property in a 351 exchange and the
company assumes a liability of the shareholder, then such assumption shall not be treated
as money or other property and shall not prevent the exchange from being a good 351.
• Example: M is transferring an asset with a FMV of 100k, basis of 20k and mortgage of 5k
in a good § 351. Normally, with a regular non-recognition transaction, the mortgage would
be considered boot. However, § 357 treats this di7erently. She has dropped 5k debt, so we
reduce her carryover basis in the stock by the mortgage amount. Her basis in this stock
would therefore be 5k due to § 358(d).
• Shareholder's Basis in Stock § 358(d): The assumption of liability will be treated as
money received. So, reduce the stock basis by any liability assumed by the corporation.
• Corporation's Basis § 362: Same as before. Shareholder's Basis (20k) + shareholder's
Recognized gain (0k) = 20k.
• Exceptions:
o Tax Avoidance (§ 357(b)): If it appears the principal purpose of the taxpayer was
to avoid income tax on the exchange or was not a bona 'de business purpose, then
such assumption shall be considered as money received by the taxpayer on the
exchange.
 Example: shareholder takes out loan on the asset the day before
incorporation and uses those proceeds for something not related to the
business.
o Liabilities in Excess of Basis (§ 357(c)): If the liability is greater than the basis
of the asset, then the shareholder will recognize the di7erence as a gain.
REMEMBER: this is done on an aggregate basis - so, if you can balance this out,
you won't recognize this di7erence.
 Example: Same case, except the mortgage is 50k instead of 5k. The
shareholder will recognize 30k capital gain here. The corporation will now get
a 50k basis in the asset (20k + 30k).
 Peracchi Case: What if the shareholder drops in an IOU alongside the
property? The court here sides with the shareholder because of the reality of
the note. This should be enough to cancel out the § 357 problem. However,
this must be a real note and there should be no suspicion that the note will
disappear. Make a clear record of the debt and actually pay it (payment
schedule and make payments).
o Not Real Liabilities (§ 357(d)): A recourse liability will be treated as having been
assumed if the transferee has agreed to and is expected to satisfy such liability. A
non-recourse liability is treated as assumed by the transferee of any asset subject
to such liability.
 This is to shut down liabilities that the corporation has agreed to pay but isn't
actually expected to pay.
o Deductible Liabilities (§ 357(c)(3)): If a corporation is assuming a shareholder's
liability and they are on the cash method and they would be able to deduct it, then
the liability is excluded in determining the amount of liabilities assumed.
Incorporation of a Going Business

• Let's say you have an on-going business that has receivables.
10
• Regardless of the doctrine that you cannot assign income, this will still be considered a
good § 351 transaction.
• Rev. Ruling 95-74: You can deduct liabilities that are assumed when incorporating a
going business. This is technically a violation of the assignment of income doctrine.
Contributions to Capital § 118

• Contributions to Capital: This occurs when the shareholder contributes property to a
corporation and doesn't receive any stock or other consideration in exchange.
• § 351 does not apply to capital contributions.
• Shareholder Tax Consequences: Contributing shareholder doesn't recognize any gain
or loss on a contribution of property other than cash to a corporation. Instead, the
shareholder may increase the basis in her stock by the amount of cash and the adjusted
basis of any contributed property.
• Corporation Tax Consequences: The contributions are also excludable from the gross
income of the corporation. The corporation's basis in the property received is the same as
the transferor's basis.
• Single Shareholder or Pro-rata Contribution: If the contributing partner is the sole
shareholder or if each shareholder contributes property proportionate to their share, the
issuance of stock has no economic e7ect. Such contributions are therefore constructive §
351 exchanges.
Avoiding § 351
• § 351 is not elective. A shareholder might want to avoid a § 351 if they are contributing
property with a loss. Or, if the corporation will soon sell the asset, you might want to
recognize the gain at the shareholder level so you avoid the double taxation.
• To avoid § 351, simply sell the asset to your corporation - be sure to take out cash.
• Example: M is a sole shareholder and wants to get property into the corporation but take
the gain beforehand. One thing she could do is to sell the property to the corporation.
However,t he corporation would need to have the cash to do this. § 267 might apply.
• No Loss Selling to Related Persons §267: Generally, you cannot take a loss when you
sell an asset to a related person. 267(b)(2) indicates that loss cannot be taken on a sale
between an individual and a corporation which is owned more than 50% by the individual.
o So, the individual would have to own 50% or less of the corporation to take the loss.
Stock owned by family members is treated as owned by you.
• There might also be diNculties if other people are trying to take a § 351 transaction. The
IRS will argue that this was part of the 351 exchange. However, as long as she doesn't
take stock, she won't be considered part of the 351.
• Gain will be Ordinary if Depreciable in hands of Transferee § 1239: Generally in the
case of a sale or exchange of property, any gain recognized to the transferor shall be
treated as ordinary income if such property is, in the hands of the transferee, of a
character which is subject to the allowance for depreciation.
o Land is not depreciable, so it would not apply to a transfer of land.
o Also, be sure that the corporation is paying FMV - if the corporation isn't paying
FMV, the IRS will argue that there was a constructive issuance of stock and will be a
351 exchange.
Organizational and Start-Up Expenses

• Organizational Expenditures § 248: Expenditures which are:
11
o 1) incident to the creation of the corporation,
o 2) chargeable to capital account, AND
o 3) of a character which, if expended to create a corporation having a limited life,
would be amortizable over that life.
o Examples: legal fees for drafting the corporate charter and bylaws, fees paid to the
state of incorporation, necessary accounting services
 Speci'cally excluded: costs of issuing or selling stock and expenditures
connected with the transfer of assets to the corporation.
• Start-up Expenditures § 195: Expenditures that the corporation could have deducted
currently as trade or business expenses if they had been incurred in an ongoing business.
• Corporations may elect to deduct up to 5k in organizational expenditures and start-up
expenditures in the taxable year in which the corporation is formed. This 5k is reduced by
the amount by which total organizational expenditures exceed 50k.
• Organizational expenditures that are not currently deductible must be amortized over the
next 15 years.
• Problem Page 113: B is an investor. A owns a sole proprietorship business. A negotiates
with B to form a corporation of the proprietorship. They calculate the proprietorship to be
worth 510k. B agrees to contribute 490k for a 49% interest in the new corporation and A
will own the remaining 51% by contributing the proprietorship's assets and liabilities. What
are organizational expenditures and either currently deductible or amortizable under
§248?
o A) 3k in fees paid by A to appraise proprietorship - personal expense that can be
added to the basis of the stock.
o B) What if appraisal fees are paid by corporation? This will be treated as an
assumption by the corporation of A's liability. This will be governed by § 357 and
358(d).Unlikely that 357(b) would apply and without more facts 357(c) doesn't
apply.
o C) Legal fees paid by corporation for the following:
 Drafting articles of incorporation, by-laws and minutes of 'rst meeting. If the
corporation makes the § 248 election, the expenses are deductible up to 5k
subject to reduction if total expenditures exceed 50k. Rest is amortized over
15 years.
 Preparation of deeds and bills of sale transferring A's assets to corporation.
Costs of acquiring the speci'c assets and are added to the basis of the
properties.
 Application for a permit from the state commissioner to issue stock and other
legal research for securities. Expenses related to securities are not
considered organization expenditures and are not added to basis of any
asset. They are nondeductible capital expenditures.
 Preparation of a request for a § 351 ruling from IRS. § 212(3) does not allow a
deduction because it only applies to individuals. It is likely more appropriately
treated as an organizational expenditure under § 248.
 Drafting a buy-sell agreement providing for the repurchase of shares by the
corporation if either A or B dies. Organizational expenditure under § 248.
o D) What if A paid all these expenses? This will be treated as a transfer to the
corporation and A's basis in the stock will increase. Corporation will be able to
amortize these expenses as if it had paid them directly.
12
Capital Structure
Debt vs. Equity § 385
• Factors Considered
o Form: Does it looks like debt? Principal, interest and payment schedule,
unconditional payment, shouldn't depend on corporation pro'ts.
 Interest Rate: The interest rate should be the market rate. If it's too low it
might look too favorable to be a regular creditor.
 Payable Only From Pro#ts: If it's payable only out of pro'ts, this will look
more like equity.
o Debt/Equity Ratio: The higher this ratio is, the more likely this will be classi'ed as
equity. 5-10:1 debt:equity ratio probably works.
o Intent of Parties: Objective conduct and facts that prove that people really did
consider this to be debt. Course of conduct can show intent.
o Proportionality: If the shareholder's debt is proportional to their stockholdings,
this looks suspicious. The idea is that proportional holders won't aggressively
defend their debt positions since everyone is proportionally in the same position.
o Subordination: If the debt is subordinated debt.
 Shareholder Guarantees: If the shareholders are jointly and severally liable
for other debt, this will look less subordinated because they will be on the
same level as the bank.
• § 385 indicates there are factors to look at - the proposed regs, however, were withdrawn,
so there are no clear-cut lines.
Character of Gain or Loss on Corporate Investment

• You look to the nature of the asset in the hands of the taxpayer before the sale. (§ 1221)
• A capital gain is a gain on sale/exchange of a capital asset.
• Gain on Stock is a capital gain except for broker-dealers selling to customers.
• Gain on Sale of Quali#ed Small Business Stock § 1202: For an individual other than a
corporation, gross income shall not include 50 percent of any gain from the sale or
exchange of these stocks held for more than 5 years.
o Available for up to 10 M of recognized gain per qualifying corporation.
o The issuing corporation must have less than 50M gross assets at the issuance of
stock.
o Rolling Over Gains § 1045: Also, § 1045 allows non-corporate shareholders to
elect to defer otherwise taxable gain from a sale of quali'ed small business stock
held for more than six months by rolling over the proceeds into new quali'ed small
business stock within 60 days of the sale.
• Losses on Stock: These are capital losses unless you're a broker or trader making an
election.
o Exception § 1244: Ordinary loss on sale or worthlessness if you're dealing with
"section 1244 stock. The requirements are:
 Must be a "Small Business Corporation"
 Issued for money or property only
 Five-year look back test from time of loss - morethan 50% must be coming
from active sources and must be an active business 've years prior to selling
the stock.
 Original holder only
 Limited to 50-100k per year.
13
o Worthlessness: If the asset becomes completely worthless, you can take your loss at
that point. Stock and debt take di7erent paths here:
 Stock § 165(g)(A): capital loss.
 Most Debt is NOT § 165(g)(C): This only applies to certain debt. When a
bond is in registered form, the corporation is keeping registry of the bonds. If
these are the terms, then it will be treated as a security. This likely won't
happen today, instead they will be non-securities and thus not covered by
165(g).
 Most Debt § 166:
• Business bad debt is ordinary loss
• Non-business bad debt is capital loss
Nonliquidating Distributions
Distributions in General § 301
• (a) In general, a distribution of property made by a corporation to a shareholder with
respect to its stock shall be treated as provided in (c).
• (c) Creates a three tier system:
o 1) Dividend: Any portion that is a divided is entirely gross income. 1(h)(11) still
makes this taxed at the capital gains rate, however there is no basis o7set. (De'ned
by § 316)
o 2) Amount applied against basis: If the shareholder has basis in the stock, the
remaining portion of the distribution will be applied against the basis in the stock
and reduce the basis of the stock by that amount.
o 3) Amount in excess of basis: If there is still more remaining after step 1 and 2,
this will be treated as gain from the sale or exchange of property.
• Property De#ned § 317(a): Property means money, securities, and any other property
EXCEPT stock in the corporation making the distribution or rights to acquire such stock.
• §301 does not apply to:
o Distributions of its own stock
o Distributions in corporate liquidation
o Redemptions (buybacks) of stock
o Payments of principal or interest on debt
o Compensation for personal services
o Purchase of property from shareholder
Dividends and Earnings and Pro#t § 316

• § 316 de#nes dividend as any distribution of property made out of the corporations E&P.
It splits these up into accumulated E&P and current E&P.
• Distributions made out of E&P are taken out of the most recent E&P 'rst.
• E&P are not eliminated when stock is sold. So, it doesn't matter whether the E&P were
earned while the shareholder owned the shares or not.
14
• § 312(a): Except as otherwise provided, the E&P of the corporation will decrease by the
sum of:
o 1) the amount of money
o 2) the principal amount of the obligations of such corporation; AND
o 3) The adjusted basis of the other property so distributed.
o [In summary, anytime a dividend is paid, the E&P is reduced by that amount.]
• Special Rules:
o Dividends from one corporation to another (e.g. subsidiary to parent) §
243: While this is treated as gross income, they get to deduct most of or the entire
dividend.
o Distributions by S Corporations: Special rules apply here.
• What is E&P: Roughly, you start with the corporation's income statement then:
o Add back certain exclusions such as tax-exempt bond interest
o Add back certain deductions such as dividends received from another corporation
o Deduct certain items normally not deductible such as federal corporate income tax
and previous dividends paid by corporation
o Special timing rules: depreciation is slowed down and no LIFO inventory even if you
use LIFO for everything.
• Computing E&P During Middle of Year (Rev. Rul. 74-164):
o Situation 1: At the beginning of the year, the Corporation has an accumulated E&P
of 40k. For the current year, it had a 50k operating loss for the 'rst 6 months, and
then ended up with a 5k operating pro't by the end of the year. Company
distributes 15k dividends at the 6mo mark. At the moment of distribution, the
company had -10k E&P. How much of this 15k is a dividend? Here, the entire
distribution is considered a dividend. Under § 312, once a dividend is taxed to the
shareholders, the E&P goes down by that amount. So, the accumulated E&P here
would become 30k.
o Situation 2: The company starts the year with a negative accumulated E&P of
-60k. The 'rst 6mo, the company had an operating income of 75k. Then a 15k
dividend is paid out in the middle of the year. However, by the end of the year, the
current E&P dropped to only 5k. According to § 316(a)(1), we apply the current
year's E&P 'rst. The rest of the distribution will be treated as a return of the stock
basis.
 Multiple Dividends (Reg. § 1.316-2(b)): What would happen if instead of
one distribution in the middle of the year, we had 2 distributions during the
year. The 'rst was 12k and the second 3k. They are split - all distributions are
treated equally. The 12k distribution will be 4k a dividend and the 3k
distribution will be 1k of dividend. Remember - this only applies to current
E&P. Accumulated E&P is applied on a 'rst distribute, 'rst applied basis.
o Situation 3: Same as situation 1 but the company had a de'cit in E&P of 5k
throughout the year. According to the rev. ruling, we take the pro-rata portion of the
current years operating loss and apply it against the accumulated E&P. Here, the 5k
operating loss is pro-rated to the time of the distribution. It happens to be in the
middle of the year, so that's exactly half. So 40k (accumulated E&P) - (5k x ½)
(prorated current E&P) = 37.5k. This doesn't help in this situation because the
distribution is less than this amount and the entire distribution is a dividend. Reg. §
1.316-2(b).
15
 The reg. indicates that this only applies if the actual E&P cannot be shown -
so if you can show actual E&P de'cit, then you should be able to use that E&P
rather than the prorata.
o Situation 4: Same as situation 1 except that the corporation had a de'cit in E&P of
55k for the entire current ear. The Rev Ruling says you can apply the prorated
amount of the current year's operating loss to the accumulated E&P: 40k - 55k x ½
= 12.5k. Therefore, 12.5k of the distribution will be a dividend and the remaining
will be a return of stock basis.
Distributions of Non-Cash Property

• FMV of Property § 301(a)(1): Distribution is equal to the FMV of the property distributed
• Shareholder's Basis in Property Received §301(d): FMV of the property at the time of
distribution.
• Tax for Corporation §311: Corporation is taxed on the gain. (a) states that no gain or
loss recognized in a distribution with respect to its stock. However, (b) states that gain
shall be recognized to the corporation as if such property were sold to the distributee at
FMV.
o S-corporations su7er this same fate - they don't pay any tax, but the gain Hows
through to the shareholders.
• No E&P?: Doesn't matter - by virtue of doing this distribution, it will have E&P equal to the
FMV of the property.
• Property with Liabilities:
o Shareholder: §301(b)(2) - the distribution is reduced (not below zero) by the
amount of any liability of the corp. assumed by the shareholder and the amount of
any liability to which the property received by the shareholder is subject to
immediately before the distributions.
o Corporation: § 311(b) It's still treated as if the corporation sold the property to the
shareholder.
• Loser Property:
o Shareholder: Shareholder's distribution is the FMV of the property
o Corporation: The loss is not recognized by the corporation under § 311(a). However,
§ 312(a)(3) lets the corporation reduce its E&P by the full basis of the property.
• Corporation's Own Obligations: §311(b)(1)(A) carves out the corporation's obligations,
so it is not taxed on this. So, instead § 301 applies. This does trigger immediate gain at the
shareholder level equal to the FMV of the obligation. There's no sale or exchange, so you
CANNOT use the installment method.
Constructive Distributions
• Payments on "debt"/equity on a purported debt that is reclassi'ed as stock for tax
purposes
• Excessive compensation paid to shareholder/employees - if you have shareholder
employees, on a reasonable allowance for salary will be deductible by the corporation.
o §162(a)(1) - corporation can take a reasonable allowance for salaries and bonuses
for services actually rendered. The excess can be reclassi'ed as a distribution (§
310) and the corporation cannot deduct that.
16
o This can also happen if they are over-compensating an employee who is related to a
shareholder. 162 won't allow a deduction for an unreasonable salary here.
o Personal use of corporate assets. Uses of corporate assets are constructive distributions.
So, you have to document a proper purpose for this in order to be a salary and thus
deductible.
o Low-Interest loans by corporation to shareholder: IRC § 7872
o If market interest is not being charged, a bunch of constructive transactions

happens. Let's say we have a 100% shareholder of a corporation - he borrows
money from corporation by signing an IOU with below-market-rate interest. We're
going to make believe that the loan bore a market-rate interest and that the forgone
interest is treated as transferred from the corporation to the shareholder (as a
dividend) and then immediately transferred back to the corporation as interest. So,
the shareholder has dividend income, and the corporation gets interest
income equal to the di$erence in payments had the loan been at market
rates.
Redemptions and Partial Liquidations

Redemptions Generally §302
• § 302(a) If a corporation redeems its stock such redemption shall be treated as a
distribution in part or full payment in exchange for the stock. However, you must meet the
requirements of (b) or it will simply be considered a distribution under §301.
• De#nition of Redemption of Stock §317(b): Redemption if the corporation acquires its
stock from a shareholder in exchange for property, whether or not the stock so acquired is
cancelled, retired, or held as treasury stock.
• § 302(b) Requirements: See the code.
o (1) Redemptions not equivalent to dividends.
o (2) substantially disproportionate redemption of stock.
o (3) termination of shareholder's interest. OR
o (4) redemption from noncorporate shareholder in partial liquidation.
 Shareholder cannot be a corporation; AND
 Distribution must be in relation to partial liquidation of the distributing
corporation. (Such as discontinuing a major portion of the business).
• Redemption and Sale: You simply compare the before with the after rather than
separately for each transaction. This helps shareholders because this can be considered
part of their reduction of interest.
o “Zenz” Transaction: If a shareholder redeems shares and sells some in an
“integrated plan”, the proper way to analyze the reduction of interest is after
everything.
Complete Termination § 302(b)(3)

• Applies when one shareholder is completely terminating their interest while the company
continues. Doesn’t apply if there’s only one shareholder – that would be a complete
liquidation of the company.
• Must look to § 318 for attribution of ownership rules that apply here.
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• If the attribution of ownership rules apply and it ends up not being a complete termination,
the distribution is a dividend and the basis of those shares shifts over the shares of the
related parties.
Constructive Ownership of Stock § 302(c)

• § 302(c)(1) indicates that § 318(a) applies when determining the ownership of stock for
this section.
• Attribution of Ownership § 318(a):
o Operating Rules § 318(a)(5)(A) and (B): Double attribution is allowed EXCEPT
for double family attribution.
o Members of Family § 318(a)(1): spouse (unless divorced), children,
grandchildren, parents.
o Attribution From Entities to Individuals § 318(a)(2):
 (A) From Partnerships and Estates: Stock owned by or for a partnership
shall be considered as owned proportionately by its partners or bene'ciaries.
• § 318(a)(5)(E): S Corporations are treated as partnership for this
section.
 (B) From Trusts: Stock owned by or for a trust shall be considered as owned
by its bene'ciaries in proportion to the actuarial interest of such bene'ciaries
in such trust. (“Distributional Percentage”)
 (C) From Corporations: If 50 percent or more in value of stock in a
corporation is owned by a person, such person shall be considered as owning
all of the stock owned by that corporation in the proportion of their
ownership. Anything less than 50% ownership, and there’s no attribution.
o Attribution From Individuals To Entities §318(a)(3):
 (A) To Partnerships and Estates: Stock owned by a partner shall be
considered as owned by the partnership.
 (B) To Trusts: Stock owned by bene'ciary shall be considered as owned by
the trust unless the bene'ciary’s interest is 5 percent or less of the value of
the trust.
 (C) To Corporations: If 50% or more of the value of the stock in a
corporation is owned by an individual, such corporation is considered as
owning the stock owned by that person.
o Sideways Attribution § 318(a)(5)(C): Let’s say B and C each own 50% of two C
corps. C redeems all of his shares in one corp. (a)(5)(C) prevents this sideways
attribution.
o Option Attribution § 318(a)(4): If you have an option to acquire stock, congress
assumes that you’re going to act on those and are treated as owning that stock
here.
 Option Rule in Lieu of Family Rule § 318(a)(5)(D): If attribution through
paragraph 1 or 4, they are treated as owned under (4).
• Waiver of Family Attribution § 302(c)(2): The taxpayer can take certain steps to be
sure family attribution doesn’t apply. You must really be terminating your interest and
getting out of the company. If you meet these requirements, the 318(a)(1) family
attribution doesn’t apply. Requirements:
o Forward Looking:
o § 302(c)(2)(A)(i): Redeemer has no interest in the corporation (including an
interest as oNcer, director, or employee) other than an interest as a creditor.
18
 if you’re getting paid for services rendered, you have failed to meet this
requirement – Lynch
 Being a landlord with a lease at a fair rent is okay per Rev. Rul. 77-467.
o § 302(c)(2)(A)(ii): Redeemer cannot acquire any interest (other than by
inheritance) within 10 years from the date of such distribution; AND
o § 302(c)(2)(A)(iii): Redeemer must agree to notify the Secretary and retain
records.
o Backward Looking:
o § 302(c)(2)(B)(i): Any portion of the stock redeemed was acquired within the 10
year period prior from a person whose stock would be attributed to the distribute
under 318. OR
o § 302(c)(2)(B)(ii):Any person owns stock which is attributable to the distribute and
such person acquired the stock from the distribute within the 10 year period prior.
 Rev. Rul. 77-293: If you’re retiring and you give a bunch of stock to his kids,
this will still be a good § 302(c)(2) waiver of family attribution.
• Entity Waiver of Family Attribution § 302(c)(2)(C): An entity can waive family
attribution only if it’s a complete termination.
o Example 1:
 Let's say we have a corporation owned partly by a daughter and an estate.
 The sole bene'ciary of the estate is the mother
 The estate wants to redeem its stock
 Under 318(a)(1) the daughter's share is attributed to the mother
 Under 318(a)(3) they are then attributed to the estate;
 So this estate constructively owns the shares that the daughter owns.
 So, this estate must get a waiver to use its basis; otherwise it will be a
dividend.
 So, this estate and the mom would have to sign a § 302(c)(2)
 Only family attribution can be waived.
o Example 2:
 Mother is sole bene'ciary of Estate
 Mother and Estate each own half of a corporation
 §302(c)(2) doesn't work because the attribution is not a family attribution
Substantially disproportionate Redemptions § 302(b)(2)

• Three Tests:
19
o Substantially Disproportionate: This test looks at the ratio of the voting stock
owned / total voting stock (after the redemption) against the ratio of the voting
stock owned / total voting stock (before the redemption) to see if it’s less than 80
percent. Look at shareholders percentage of voting power after the
redemption - it must be less than 80% of the voting power it had before
the redemption.
o Limitation: The shareholder must own less than 50 percent of the voting power
after the redemption.
o 80% Reduction of Common Stock As Well: Further, there must be an 80 percent
reduction of common stock owned by the redeemer.
Redemptions Not Essentially Equivalent to a Dividend § 302(b)(1)

• Davis Case: Congress is looking for a “meaningful reduction of shareholder’s proportionate
interest.”
• Rev. Rul. 75-502: A owns 750 shares of C Corp. B owns 750 shares of C Corp. and Estate
owns 250 shares of C Corp. A is sole bene'ciary of Estate. Here the estate constructively
owned 1000/1750.
o It then turned in all 250 shares. Here we have attribution from the bene'ciary to the
estate. How many shares does it own after the attribution. Constructively, it was a
controlling shareholder. It is not a good 302(b)(2) because it's not less than 50%. It's
right at 50% though. Isn't this a meaningful reduction of the shareholder's interest?
In e7ect, she, as a practical matter, was a controlling shareholder. She had the right
to outvote B on everything - the board would be controlled by her and her family.
But after the redemption, that's not the case. They are in a deadlock position - they
both now own 50% of the corporation. This is a serious change in the control of the
company. This is a good §302(b)(1).
o IRS Held: Reduction of voting common stock from 57 percent to 50 percent was
meaningful where the remaining stock was held by a single unrelated shareholder.
• Rev. Rul. 75-512 (Page 232): Whole family tree of people who owned the company. The
transaction at issue was a trust redeeming all of its shares. The trust constructively owned
30% of the company. They redeem all 75 of the trust's shares, so immediately after the
redemption, it owned ~25% of the corporation. The IRS said that this was a good §302(b)
(1).
o IRS Ruling: A reduction from 30 percent to 24.3 percent was meaningful because
the redeemed shareholder experience a reduction in three signi'cant rights: voting,
earnings and assets on liquidation.
o IRS Ruling: A reduction in common stock ownership from 27 percent to 22 percent

was meaningful where the remaining shares were owned by three unrelated
shareholders because the redeemed shareholder lost the ability to control the
corporation in concert with only one other shareholder.
20
• Rev. Rul. 85-106 (Page 229): There was no controlling shareholder - there was a whole
bunch of shareholders with small portions of shares. The trust here had almost as much
control as everyone else. The point here was that there was no controlling shareholder -
they had as much say as anybody else did. Also, the redemption was of nonvoting shares.
There's been no meaningful reduction of the shareholder's interest. This was NOT a good
§302(b)(1).
Partial Liquidations § 302(b)(4)

• Distribution must be in relation to partial liquidation of the distributing corporation. (Such
as discontinuing a major portion of the business).
• § 302(e) Partial Liquidation De#ned:
o (1)(A): Distribution cannot be essentially equivalent to a dividend (determined at
the corporate level rather than at the shareholder level); AND
o (1)(B): The distribution is pursuant to a plan and occurs within the taxable year in
which the plan is adopted or within the succeeding taxable year.
o May be Pro rata § 302(e)(4): It doesn’t matter if the redemption is pro rata as
long as it’s a genuine contraction of the corporation’s business.
• § 302(b)(4): There must be a plan (“formalities”). A partial liquidation can succeed under
two tests:
o Judicial Test: “Genuine contraction of the corporate business.” They can even be
distributing assets out in kind with the shareholders.
o Statutory Safe Harbor § 302(e)(2): Cessation of a corporate business AND
corporation must conduct a business after the distribution.
 Note: A mere distribution by parent corporation of its subsidiary’s stock is not
enough.
Consequences to the Distributing Corporation

• § 311(a) and (b) apply.
• If the corporation redeems shares using its own property, the distributing corporation will
recognize it
• Corporation cannot deduct redemption price or related expenses: IRC § 162(k)
o Before this section was added, one corporation managed to take a deduction for the
expenses of redemption and the money paid to the shareholder
• If you have a redemption that passes 302(b) (not a dividend) you still get to reduce the
corporations E&P (IRC §312(n)(7))
o It is reduced by a % of stock redeemed; OR
 If 20% of the stock is redeemed, 20% of the E&P is removed
o Amount of distribution, whichever is LESS.
21
Redemptions through Related Corporations § 304
• § 304(a)(1) Acquisition by Related Corp (other than subsidiary):
• Stop people from playing the following game:
o Single shareholder owns X corp and Y corp (100 shares in each corporation).
o Each corporation has huge E&P
o If he tries to redeem any shares it will be a dividend and he can't use his basis
• What if sells 60 shares of X corp to Y corp?
o The idea is that this is a sale.
o This doesn't work under §304(a)(1) - instead, it's treated as a redemption.
o This is turned into a redemption of Y shares. This brings 302 into play.
o ALSO, § 304(b)(2) says you use the E&P of BOTH corporations when determining
the tax treatment of the redemption. E&P of the redeeming company 'rst.
• § 304(a)(2) Acquisition by Subsidy:
• Let's say A owns P corp
• P corp owns 100% of S corp.
• What if he sold some stock of the parent to the subsidiary?
• This is §304(a)(2). Such property shall be treated as a distribution in redemption of the

stock of the issuing corporation.
Redemptions to Pay Death Taxes §303

• In General (a): A distribution of property in redemption of part or all of the stock in
determining the gross estate of a decedent shall be treated as a distribution in full
payment in exchange for the stock so redeemed.
o Limitation of What’s Treated as Redemption: Shall not exceed the sum of the
estate, taxes imposed because of decedent’s death and the amount of funeral and
administration expenses allowable as deductions.
o 35% Value Requirement (b)(2): The value of the stock must exceed 35% of the
value of the entire estate.
22
Stock Dividends and Section 306 Stock
Stock Dividends and Splits
• STOCK DIVIDEND EXAMPLE: Let's say we have 50k total stock. The common stock is 20k
and the earned surplus is 30k. When a stock dividend occurs, they take some money out
of earned surplus and put it into the common stock. So, if they issue another 20k in
common stock, the common stock amount would jump to 40k and the earned surplus
drops to 10k.
• STOCK SPLIT EXAMPLE: Let's say we have 50k total stock. The common stock is 20k and
the earned surplus is 30k. When a stock split occurs, then we cut the stated value in half
and double the shares outstanding. This doesn't change the numbers in the dollar column,
but now, each stock is worth half and there are twice as many.
o Companies do stock splits to lower the market price per share so that smaller
investors don't feel inhibited.
o However, they've done studies, the day after a stock split, the stock value does
actually go up overall.
Taxation of Stock Distributions § 305

• (a) Generally: Gross income doesn’t include the amount of any distribution of the stock
of a corporation made by such corporation with respect to its stock.
• (b) Exceptions: Shall be treated as a distribution of property to which § 301 applies if:
o (1) Distribution in lieu of money: if the shareholder can choose stock or
property.
o (2) Disproportionate Distributions: If the distribution (or series thereof) has the
result of
 (A) the receipt of property by some shareholders, and
 (B) an increase in the proportionate interest of other shareholders.
o (3) Distributions of common and preferred stock: if the distribution (or series
thereof) has the result of
 (A) the receipt of preferred stock by some common shareholders and
 (B) the receipt of common stock by other common shareholders.
o (4) Distributions on preferred stock: if the distribution is with respect to
preferred stock. This is because in most cases, the control is changing.
o (5) Distributions of convertible preferred stock: if the distribution is of
convertible preferred stock unless you can prove that it won’t end up with one
person getting stock and another getting property.
• De#ning Preferred Stock Reg. § 1.305-5(a): If the stock has unlimited growth
potential, it is not preferred stock. It cannot participate in corporate growth to any
signi'cant extent.
• (c) Certain Transactions Treated As Distributions: Anything having a similar e7ect on
the interest of any shareholder. Essentially, don’t try to think up clever ways to get around
(b).
23
o Example: Let's say A and B each own 100 shares in C corp. A redeems 80 shares.
This is a good 302(b)(2) substantially disproportionate distribution to him. But if
305(c) really means what it says, the IRS could put out regulations saying that this
is a dividend and tax B as well. This is exactly a 305(b)(2) because B's share is
going up and A is receiving money instead.
 If you do it as a redemption, you won't get taxed.
 However, if you do it as a distribution of shares and property, you will get

taxed on a dividend under 305(b)(2).
o IRS SAYS: If the redemption is an isolated transaction, we will not raise 305(c). But
if it's part of a series of transactions, this will look too much like a dividend (say in
the last 2 or 3 years).
o Reg. § 1.305-3(b)(3): . . . In addition, a distribution of property incident to an

isolated redemption of stock (for example, pursuant to a tender o7er) will not cause
section 305(b)(2) to apply even though the redemption distribution is treated as a
distribution of property to which section 301, 871(a)(1)(A), 881(a)(1), or 356(a)(2)
applies.
o See Reg. § 1.305-3(e) Example 8 - if there are regular installments - it might be

treated as a whole bunch of 305(b)(2) redemptions.
• Corporate Tax § 311: No gain or loss is recognized to a corporation on distribution (not in

complete liquidation) with respect to its stock of its stock.
24
§ 306 Stock
• § 307(a) says that if a shareholder receives stock in a distribution to which 305(a) applies,
then the basis of such new stock and the old stock shall be determined by allocating
between the old stock and the new stock the basis of the old stock.
• Essentially, if you dispose of §306 stock, that stock is treated as if it was a dividend from
the company. So, essentially, the basis from that stock would shift back into the original
stock.
• De#ning 306 Stock § 306(c):
o If it participates in growth, it's common stock.
o If they don't have a right to participate, then it's a 'preferred' stock for §306.
o Includes tax-free dividends of preferred stock - (c)(1)(A)
o Also includes preferred stock received in recapitalization - (c)(1)(B)
 Shareholders turn in shares and they get new shares of di7erent classes
o Exception if no E&P at time of issuance - (c)(2)
 If no E&P, no application at all - the idea here is to capture growth.
• Taint Remains §306(c)(1)(C): anyone who takes that stock with the same basis as you
maintains this 'taint'. It remains § 306 stock.
• § 306(a)(2) - if the disposition is a redemption, the amount realized shall be treated as a

distribution of property to which § 301 applies.
• (b) Exceptions: if you are terminating your interest, it will not be treated as a dividend.
• Additionally, § 306(a)(1)(A) - you only have a dividend to the extent that the
corporation had E&P when you got the stock.
• Triggering Events:
o Sale of § 306 Stock
 Entire amount realized is dividend to extent corporation had E&P when stock
was issued
 Any excess is treated as sale - basis allowed for purposes of computing

capital gain, BUT NO LOSSES
o Redemption of § 306 stock
25
 Automatically treated as distribution covered by IRC § 301
o If termination of entire interest, not treated as dividend.
Complete Liquidations
Complete Liquidations under § 331
• Distributions in complete liquidation are considered as full payment in exchange for the
stock. §301 does not apply in a complete liquidation.
• If a corporation liquidates, the E&P disappears. At the shareholder level, it’s no di7erent
than if the shareholder sold his stock to a stranger.
• Complete Liquidation De#ned § 346: A distribution is treated as a complete liquidation
if it is one of a series of distributions in redemption of all of the stock of the corporation
pursuant to a plan.
o Use of Basis: Because there’s no way to know how much money will come out
(unknown creditors), the IRS lets the shareholders use all of their basis 'rst.
• Using a Trust to Complete Liquidation: Sometimes, the shareholders set up a trust for
their bene't and the corporation will distribute money to that trust. For tax purposes, a
distribution to the trust is taxed as a gain even though the money hasn’t actually been
distributed.
• What if the SH receives an installment obligation from the corporation in a liquidation?
331 still applies if it’s a liquidation. The taxpayer can use 453 an use the installment
method to report gain if he meets the requirements of 453(h). (h) requires that the
obligation was received by the company within 12 months after the adoption of a
liquidation plan and the plan must be completed within that 12 month period.
Limitations:
o You can't use this for publicly traded companies. 453(k)(2)
 He would have his full gain in year one if it was publicly traded.
o Doesn't apply to notes received before the plan of liquidation.
 This would instead be treated as FMV of the note.
• What if they just distribute all assets, but then a creditor comes out of the woodwork and A
is required to pay 5k 2 years later. What's the tax treatment of that transaction?
o Arrowsmith Case: This is considered a 5k capital loss. This transaction is related

back to the source.
• Basis in Property Received in Corporate Liquidation § 334(a): Basis is the FMV of

such property at the time of distribution.
o What if you get property in a distribution with a mortgage on it? Only the
equity of the property goes into the shareholder's gain. If the shareholder was
receiving 8k in cash and 12k property with a 5k mortgage (and he had 10k basis in
his shares), he would be treated as realizing 15k. Therefore, he would have a 5k
26
capital gain. The basis in the property would be the full FMV of the property,
however. It only makes sense.
• Corporate Taxation § 336: Gain or loss is recognized to a liquidating corporation on the

distribution of property in complete liquidation as if sold to the SH at FMV.
o S-Corps: Same thing, though no corporate tax.
o Limitation on Recognition of Loss (d): No loss is recognized if such distribution

to related person is not pro-rata or such property is disquali'ed Property.
 Disquali#ed Property (d)(1)(B): Property acquired by the corporation to

which 351 applied or as a contribution during the 5 year period before
liquidation.
Liquidation of a Subsidiary § 332 (Parent) and § 337 (Subsidiary)

• This is a tax free transaction.
• The E&P of the subsidiary goes into the parent corporation.
• The parent’s basis in the stock disappears.
• Requirements § 332(b):
o (1) The parent must own at least 80% of the stock of the subsidiary from the time of
the plan of liquidation through until the actual liquidation. AND EITHER:
 (2) The Transfer must happen in one taxable year; OR
 (3) the transfer must be a series of distributions in complete redemption of all
its stock that is completed within 3 years from the adoption of the plan of
liquidation.
• Basis of property received § 334(b): carryover basis from subsidiary.
• § 337 Subsidiary: No gain or loss recognized to liquidating subsidiary to which § 332
applies.
o If you have a minority shareholder, distributions are made to the minority

shareholder as well - they are NOT covered by 332, 337.
o The subsidiary recognizes gain here on this sale. Also, the sub can never take a loss
in this situation under 336(d)(3).
Taxable Corporate Acquisitions

Stock Acquisition
• If P buys the stock of T, this is considered a “stock deal”. This is a taxable sale, so there
will be capital gain here. T can then be liquidated into P. However, even though the
company was purchased at the full FMV of T, the basis of the assets will remain the same
because P’s basis in T’s stock disappears when T liquidates as a sub of P.
• P may liquidate T under IRC §§ 332, 337
o No gain/loss, carryover basis on asset
27
• Restrictions on carryover of tax attributes under IRC § 382
o NOL carryforwards don't get eliminated, but they get slowed down.
 Companies used to purchase companies with tons of NOL in order to deduct

them against gains.
o §382 says that when a company is sold, the NOL carryforwards are slowed way
down - can only be used based on the value of the target company. How much was
the T company really worth? You can use the NOL carryfowards at say 3% a year.
You can use the NOL to o7set the pro'ts from turning that company around. If you
dump a bunch of more assets in there, you can't use the NOL against your other
asset's gains. Only based on an annual percentage of the assets in the company
when you bought the target company.
• § 338: If you do a stock deal, and the purchaser is really unhappy that the basis of the
assets didn't step up, you can make an election under 338 to treat the deal as an asset
deal. For state law, it will still be a stock deal, but it can be treated as an asset deal. There
will be corporate tax, though - why ever do this? You don't. Do not make a 338 election.
o This MIGHT make sense if the target company was an S corporation or a controlled
subsidiary. This is because no corporate tax will be triggered because the liquidation
would be tax free anyway. §336(e)
o You would want to do it in these cases because you would get a stepped up basis for
nothing.
Asset Acquisition
• If T sells all assets to P and then liquidates all of that cash to the shareholders of T, this is
an asset acquisition. When T sells their assets, this is a taxable even and T will recognize
the gain – you then have all the asset gain taxed at the corporate level. P will then get a
stepped up basis in the assets (cost basis). Now, when T liquidates, A will have capital gain
on the money remaining in T. This is the double tax nightmare. The good news is that P will
get a stepped up basis in the assets. But, why pay corporate tax now for basis later? From
a present value standpoint, this is worse.
o One point would be to purchase only the assets without the potential liabilities of
the corporation. Although, sometimes the liabilities come with the assets and even
some states indicate that product liability can come with the purchase.
• Gain is calculated on an asset by asset basis
• Seller's concerns
o If assets are capital gains assets, more of the sale price will want to be for these
assets
• Buyer's concerns
28
o Buyer wants to put as much basis as possible for inventory and other ordinary
income type assets (and depreciable assets)
o Amortization of intangibles (IRC §197) - (i.e. goodwill of the business, non-compete

agreements, going concern value) this is depreciated over 15 years. If you purchase
intangibles in this situation, they have to be amortized over these 15 years. As a
buyer, you don't want the basis here - this is 15 years of straight line depreciation.
• Allocation of price
o Buyer's and seller's allocations must match
o IRC §1060: If you have an agreement as to the allocation, they have to use that on
their tax return. The IRS doesn't have to accept this, but the parties are bound by it
for tax purposes. Default rule (no contract): see below.
• IRC § 1060:
o Parties bound by their contractual allocation for tax purposes
o If no allocation in contract, must use "residual" method of allocation
 Tangible assets should be allocated 'rst based on their actual FMV values,
intangibles get what's left over
o Both parties must report allocation on particular IRS form
 Easy for IRS to compare
 IRS will check to make sure allocations are somewhat close.
Reorganizations
Reorganizations (Ch 9-12)
• Have one company acquired by the other without anyone paying any taxes.
• This could be a company splitting into multiple corporations
• Statutory Merger: We've got T, a corporation with valuable assets (400k FMV).
Corporation P wants T's assets. Let's assume that A (shareholder of target company) is
willing to accept stock of P as consideration for the deal. If he's willing to accept this as
consideration, you can have P take over T and it will be taxfree to everybody.
o Most of the consideration that A is getting must be P's stock. If P's a publicly traded
company, this isn't much of a risk.
o This is considered a statutory merger. T goes out of existence and all of the assets
and liabilities of T go to P.
29
o If A does get cash in addition, that cash would be boot and it would be taxable. But,
the stock won't be.
o If A gets all cash, it's a taxable deal - not a reorg. The shareholder is shielded by
§354.
o § 362 - P takes assets with a carryover basis.
o § 358 - The shareholder gets the stock in P with a carryover basis from their old
stock.
o § 382 - anytime a corporation changes ownership - any loss carryovers get slowed
down.
o The E&P does not disappear - it carries over to the surviving corporation.
§ 361 - Corporations in a Reorganization
• (a) General rule: No gain or loss shall be recognized to a corporation if such corporation is
a party to a reorganization and exchanges property, in pursuance of the plan of
reorganization, solely for stock or securities in another corporation a party to the
reorganization.
§ 354 - Shareholders in a Reorganization
• (a) General rule (1) In general: No gain or loss shall be recognized if stock or securities in a
corporation a party to a reorganization are, in pursuance of the plan of reorganization,
exchanged solely for stock or securities in such corporation or in another corporation a
party to the reorganization.
In order to be a Reorganization:
• Fit into one of the seven "types" in IRC § 368(a)
o (A) Statutory merger/consolidation
o (B) Stock for stock - p exchanges stock in P for T's stock - this is a B-reorg. It must
be SOLELY for voting stock of P. No Boot is allowed.
 Not a merger or acquisition, but roughly the same.
 This is if T's board of directors won't do the merger. P can make an o7er
enough to get 80% of T's stock in exchange for stock in P>
o (C) Stock for Assets
 Here, P issues its stock in exchange for all of the assets of T and then T
liquidates and distributes all the P shares to the shareholders of T. The
majority of what the shareholder gets must be voting stock.
30
o (D) Corporate divisions (and others)
 Allows you to split one corporation into two (main D reorg - a divisive reorg)
 Let's say we have a corporation engaged in two businesses and it splits the
businesses into two corporations. You can achieve this split and have it be tax
free to the shareholders. There are three di7erent formats:
• 1) "Spino7": Corporation forms a new subsidiary, drops one of the

businesses into the subsidiary in exchange for stock in new corp. Then,
parent distributes out stock of the subsidiary to its shareholders
• 2) "Splito7": Same - but instead have shareholder turn in stock as part

of the deal.
• 3) "Splitup": Corporation forms 2 subsidiaries then liquidates itself and

distributes the shares of subsidiaries to its shareholders.
 § 355 rules as well must be met.
 Boot is allowed, but it is taxed.
o (E) Recapitalization - existing shareholders exchange shares for new shares
 Boot is allowed, but taxed
o (F) Migration: Mere change in identity, form: changing where your company is 'led
o (G) Bankruptcy Reorganization -
• Must meet three judge-made tests:
o Continuity of shareholder interest (COSI) - target-company shareholder must be

mostly getting stock
o Continuity of Business Enterprise (COBI) - assets of target company must still be

around and employed in a business in a transaction
o Business purpose requirement (easy to meet)
• If not a reorganization, acquisition is taxable (chapter 8).
31
§ 368(a)(2)(E) Triangular Mergers
• Do this if the end goal is for T to become an entirely new subsidiary of P. P would give
stock to a newly created subsidiary S. S would then merge T into S. (This can be done in
§368(a)(2)(D))
• A "Reverse" would be if S merges into T instead.
Anti-Avoidance Rules
Economic Substance Doctrine
• Substance prevails over form.
• It's hard to know whether clients win or use on this issue.
• United Parcel Service v. Commissioner (619): UPS is a successful business.

Accountants say - set up a subsidiary in a country with low tax (Ireland today) and farm
the insurance part of your business o7shore. The subsidiary then makes a portion of your
business.
o They gave the shares in this new sub as a taxable dividend to their shareholders. TO
avoid even further, UPS sent the insurance money to a separate company which
then pays it to your subsidiary corporation. (Run it through a third party).
o IRS audits, drags to court, wins in tax court on the theory that this is a sham.
o Case goes to the 11 circuit - 11 circuit sides with UPS.
o So...who knows?
• IRS has authority under §482 to recast all transactions between brother-sister corporations
as arms-length deals.
• § 7701(o)
Accumulated Earnings Tax (§ 531)
• If a corporation does not pay dividends, then we start to examine what the corporation has
been doing more carefully. In addition to having to pay it's regular corporate tax, it might
have to pay this penalty tax.
• A corporation can get subjected to this:
o Accumulating earnings beyond reasonable needs of business, then we tax on

undistributed earnings.
32
Personal Holding Company Tax
• If corporation is closely held and most of its income is investment income
• If a corporatino is engaged in supplying services to people and the service provider is the
shareholder. This is to stop athletes from forming corporations and supplying themselves
through a corporation.
• These are not a problem if you're paying dividends.
33
S Corporations
Generally
• More S-Corps than C-Corps by a wide margin
• Even more S-Corps than partnerships
• Single-Tax: When an S-Corporation earns a pro't, the corporation is not taxed
• "Pass-Through": The income passes through and ends up on tax returns of shareholders -
this is 100% pass through - it doesn't matter if there's a distribution or not - it's taxed
immediately upon recognition by the s-corp of the income.
o Losses also pass through and are not trapped on a corporate tax return
• Non-tax Distributions: Distributions are generally not taxed, unlike a c-corp.
• An S-corp does not have E&P (unless they used to be a c-corp)
• 1361: eligibility requirements
o Be a 'small business corporation"
 Doesn't have to be small
 And doesn't have to carry on a business
o Make an election
 Even LLCs can check the box to be a corporation and then elect to be an S-
Corp
• They do this so they can revert back to a partnership without having to

go through liquidation.
• 1363: says no tax for s-corps
• 1366: says the tax Hows through to the shareholders - everything that happens in the s-
corp shows up on the shareholder's tax returns
S Corporation Not Taxed § 1363
• (a) General rule: Except as otherwise provided in this subchapter, an S corporation shall
not be subject to the taxes imposed by this chapter.
• (b) Computation of corporation’s taxable income: The taxable income of an S corporation

shall be computed in the same manner as in the case of an individual . . .
34
Shareholder of S Corporation Pass-Thru Tax § 1366
• (a) Determination of shareholder’s tax liability
o (1) In general: In determining the tax under this chapter of a shareholder for the
shareholder’s taxable year in which the taxable year of the S corporation ends (or
for the 'nal taxable year of a shareholder who dies, or of a trust or estate which
terminates, before the end of the corporation’s taxable year), there shall be taken
into account the shareholder’s pro rata share of the corporation’s—
 (A) items of income (including tax-exempt income), loss, deduction, or credit

the separate treatment of which could a7ect the liability for tax of any
shareholder, and
 (B) nonseparately computed income or loss.
35
Eligibility Requirements § 1361
• (a) S corporation de'ned
o (1) In general: For purposes of this title, the term “S corporation” means, with
respect to any taxable year, a small business corporation for which an election
under section 1362 (a) is in e7ect for such year.
• (b) Small business corporation
o (1) In general: For purposes of this subchapter, the term “small business
corporation” means a domestic corporation which is not an ineligible corporation
and which does not—
 (A) have more than 100 shareholders,
 (B) have as a shareholder a person (other than an estate, a trust described in

subsection (c)(2), or an organization described in subsection (c)(6)) who is
not an individual,
 (C) have a nonresident alien as a shareholder, and
 (D) have more than 1 class of stock.
o (2) Ineligible corporation de'ned: For purposes of paragraph (1), the term “ineligible
corporation” means any corporation which is—
 (A) a 'nancial institution which uses the reserve method of accounting for
bad debts described in section 585,
 (B) an insurance company subject to tax under subchapter L,
 (C) a corporation to which an election under section 936 applies, or
 (D) a DISC or former DISC.
"Small Business Corporation" under IRC § 1361(b)
• Not an "ineligible corporation" (b)(2)
• Domestic corporation
• Requirements (b)(1):
o Not more than 100 shareholders
 Spouses and family members are treated as a single shareholder (1361(c)(1))
36
o No shareholders who are not individuals
 Except: decedent's estates, most trusts, pension funds, and charities
 Except S corporation parent owning 100% of the stock (IRC § 1361(b)(3)): this
is a QSub (quali'ed subsidiary).
 (c)(6) stock can be with charity
 Can't have a partnership/corporation as shareholder
o No nonresident alien shareholders
o Can only have 1 class of stock
 Di7erences in voting rights are ignored
37
Election: IRC § 1362
• All shareholders must consent.
o You have to be careful with community property laws. In a community property

state, each person in a marriage owns half. This means that the spouses would have
to consent.
• (b) Election generally starts at the beginning of a taxable year.
o Can be good for current year if made within 2 and ½ months of start of year
 The taxable year of the S-Corp doesn't start until it comes into existence.
• The S-Election is good until it is revoked or is terminated.
o You don't have to get signature of new shareholders.
o HOWEVER: you need to get consent of everyone since beginning of 2.5 months of
start of year. And each shareholder during that period would have to be eligible
shareholders.
Terminating S Status
• Voluntary revocation - IRC §1362(d)(1)
o Must have more than ½ of shareholders consent
o If you revoke within the 'rst 2.5 months, you can revoke to the beginning of this
year.
o You can also specify a future date.
• Ceasing to be small business corporation - IRC § 1362(d)(2)
o Anytime one of the eligibility requirements is not longer 't
o The timing is e7ective on and after the date of cessation.
o You want to sign an agreement to prevent shareholders from screwing this up.
• Some S corps. That used to be C corps. - IRC § 1362(d)(3)
o This only applies if the s-corp used to be a c-corp.
• Inadvertent terminations - IRC § 1362(f): IRS can forgive if you correct the problem and
you must show that it mustn't be on purpose. They have been very generous to grant
these.
38
• Can't go back to Sub S for 've years - IRC § 1362(g) - you're allowed to change once, but
you cannot change back for 've years
S Corporation Operations
• Under 1366 - income and losses "pass thru" - shareholders must put their pro-rata share of
everything that happens in the corporation. It must be on their tax return regardless of a
distribution or not.
o The character (ordinary v capital) is determined at corporate level (1366(b)) and

then retains that character when it passes through
o Any elections are made at a corporate level (e.g. 1033) - this is 1366(c)
 Shareholders are stuck with it
• When income passes through to the shareholder, their basis on their stock goes up (1367)
- same thing with a deduction (basis in stock would come down). For every pass through
action there is a basis reaction.
• If it was never a C corporation, distributions are treated as return of stock basis, and then
capital gain if it exceeds the basis in the stock (§ 1368(b))
• 1371(c) - s-corporations do not generate E&P while they are S-corps
39
Example
• Three shareholders of S corp.
• S corp earns 15k pro't
• This 15k pro't passes through to shareholder - each shareholder pays taxes on 5k of
income
• Now, their basis in their stock goes up by 5k.
• Then, if each shareholder takes 5k out as a distribution, this will be tax free for them
• Then, their basis in their stock goes down by 5k.
S-Corporation Operations
• Loss "pass-thru" limited to stock basis + debt basis (1366(d))
o Debt basis = shareholders who are creditors to that company
o You can't take losses beyond this basis - they carry over to the future if at a later
time the corporation earns money and the shareholder gets a basis
o You can't take losses if you don't have basis
o This can create problems if the corporation borrows money from third party:
• Corporate debt to third parties does not create usable basis for shareholder ( even if
shareholders guarantee it!)
o Harris (page 679) and many other cases
o Losses that represent the corporation burning through the bank loan won't pass
through to shareholder.
o So, you might not want to put the owners in an s-corp if they are going to be
guaranteeing a loan.
 Instead - have the shareholders borrow the money and then lend it to the s-
corp.
C-Corps To S-Corps
• Switching over is not a taxable event. Congress could have treated this as a liquidation
and formation, but they didn't.
• Electing S is not a taxable event, but:
40
o Double tax on appreciated property doesn't go away
o E&P (dividend potential) doesn't go away
o If E&P is present, excess passive investment income creates problems
 E.g. Interest/dividends, rents - the corporation has to pay a tax on that and if
it persists, it could terminated S-status under 1362(d)(3)
 Tax at corporate level
 Eventual termination of S status
 The idea here is that they were afraid that there would be a bunch of c-corps
that, instead of liquidating to close up shop, they become an S-corp to avoid
liquidation taxes and just continue to invest the E&P in a portfolio of passive
investments.
• Don't ever be a C-Corp if you're going to be an S-corp.
Example
• Let's say we have a 100% shareholder of a c-corp that owns a property with FMV of 20k
and basis of 11k.
• This property is lobster trapped. What congress doesn't want is for that corporation to
make an s-election and then sell that asset to shareholders tax free.
• The corporation will still pay a tax on this asset on the 9k gain.
Former C-Corps: Appreciated Property
• Can't eliminate corporate tax on asset appreciation inside c-corporation
• § 1374 taxes the s-corporation on "built-in" gain (BIG) that was present when S election
was made
• "taint" persists with the corporation for 5 years after S election is made (IRC § 1374(d)(7))
Former C-Corps: Dividends
• What if you still have accumulated E&P from your c-corp days?
• Distributions of old c-corp. e&P are dividends - taxable to the shareholders
• BUT, previously "passed thru" S-corp. income not taxed.
41
o If you take a distribution, you look to previously passed through income and it won't
be taxed again - only if they take out distributions beyond the income passed
through to them.
• Distributions are treated as previously taxed S corp. income 'rst - "AAA" account (1368(e)
(1))
o The Accumulated Adjustments Account - sum total of all the ups and downs of your
share interest
• Distributions beyond AAA are § 301 - taxable to extent of remaining E&P
• Example:
o C-Corp with $100 E&P - what if we switch over to S-corp and pay $100 out?
o Is this a dividend?
o You have to ask - did any income pass through to shareholder? He's entitled to take
that much out tax-free 'rst before we use the E&P as a dividend.
o So, it's tax free to the extent of the AAA account.
Former C-Corps with E&P And Passive Investment Income
• IRC §1375 - corporation taxed on passive income if it has old E&P
• § 1362(d)(3) - lose S status after three years of that
• Clean out the old E&P before turning old c-corp into s-holding company!!!
• You can clean it out after it becomes an S-corp as well - you can bypass the AAA account if
you want to.
42
C a e Ta a O e
I. Overvie of Enterprise Ta ation
H c a e c e fede a a ed?
T ee ca eg e e C de:
1. S e e ( d d a e)
2. Pa e
3. C a
A. Conduit v. Entit Ta ation
1. Sole Proprietorships
B e d ec ed b e
Ta ed de 1, Sc ed e C a c e a
B e a f a e ed e a ae e
J e a be ea ed d d a a e e f a e
J e a d d a e ec e d ffe e acc g e d , e c. e a
f
C . Pa e , a eb db f dec
2. Partnerships
Pa - C d a a
Ca c a ed a a b e , b a ed e d d a a e
701 a ed a c e f e f d ec , b a c e e a e .
702 de e g c e a , eac a e a ed acc d g e ee eb e
a a a ba fb e c e . See a 703, 704.
Ke : A ca a e fd b ed a e
Pa e a e e d b e ae f f c e, e e f ac a d b ed. If
a e e a ea g, a e ae a ed.
3. Corporations
11(a) c a c e f a d a ed a a e
11(b) g e i e a ched e, b a ab e c a (e ce e a ge e )ae b ec
a f a a e f 34%
T e de 11
61(a)(7) d de d a d e d b e a . C a a ed ce, a d ea g a ed aga e
d b ed a c e d d a a e de
A. C Corporations
Reg a c ai
. C a e ea i g a e bjec d be a , ce c a e ea i g , a d ce e
e ea g a ed b ed a e de g e c e a e.
M de f d b e a . A e TP a a e fC X, c ade $100 f
ea . A ea cab e a a e a e c a e, 46%; d d a , 70%; LTCG, 40%:
Dividend Distribution a af e a f d b ed a e de
S e a.k.a. d ble a
CIT 46
D de d 54
PIT 37.80 (.7 54)
TP af e a ceed 16.20 (54 37.80)
C b ed effec e a a e ( f a a e a e ce f g a c e) 83.8%
Deductible Distribution X d b e a $100 TP a e a d (ded c b e de
162(a)(3)) f e e ea ed f TP ad a e de , b c ed a a
b e e e e ead f a d de d. M c c e edc , e d be
e f- ced b e a ed a e de a ge a d de edc
D ed d de d d ed a - e b e a e e e a e de
CIT 0
D b a e 100
W ede bec S g 2002 RJZ 1

C a e Ta a O e
PIT 70
TP s after tax proceeds 30
C b ed effec e a a e 70%
Ae e ea e DD a eg ? O fc e edc .
Rea ab e e rent in this situation would be subject to a substance test in
e e . Ta c e e ce a e c ed b e, f ec a ee
d b eag e a a e e ed a e de f a e e eg
e, e d be e a ea f e ce d b . S b a ce
e f e .
Retained Earnings X e a a d e e e $100; TP e a c Xa e d f
ea
Ca a a ba
CIT 46
RE 54
Price paid for add l assets 54
PIT 15.12 (.7 .4 54, a g LTCP a efe e ce)
TP s after tax proceeds 38.88 (54 15.12)
1001 ea ed ga / ae ceed g b ea f e e e ,b e
d d a ba e a ea ea e adf e c e g a b g .
C b ed effec e a a e 61.12%
N e: e e ea a e ed f e c . I ba c a , e de e a e
fac e e e e d a ca a a e . I ca e, e a e e c
a d e $54 RE.
Ke to profitable follo ing of RE strateg is based SOLELY on higher/lo er
PIT/CIT rate differential!
Ae e ea g a e RE a eg be a e ad a age f?
Pe a a e (acc a ed ea g a 531/532/535(a),(c)(1)/537(a)(1), e a
d gc a a AET/541/)
AET: Congress encourages retention to foster reasonable anticipated (from 537(a))
e a g ( c de e a e a a d ac acc d g T ea
eg a ), b e ce e ab e f RE e a e a c e e ce
g e AET f a ab e
N e b ec e e 532 a cab e c a e f ed
a a ed a d a ab !
PHCT: N b ec e e a AET. T a e (% f c e a PHC
c e, 5 fe e c g c de e )
C a e ede f c (a e d b ,b a a d de d)
L da fc a e c a ge c f a e
Beca e f e e a ed ea g de , c a a e ad a bee ed a a ed c
e c e . S a e de e a e f ae f c (1001 ca a ga ), a d e e
g a ab e f f d de d . Le a a f e ad bee e e , e a a e
e a eg e .
C e e ce f a c a e a eg e: a ae . U e eSc a , eCc a
ce e ca e beca e d a a e e de acc d g e
e ec e a e, b aea . T a d ad a age a a e de ( e ge a c
d g a fe a e f c ).
B. S Corporations
If e e c a e e ec a f ad a age RE c e e, e a e ec c aea S
c . A d a ab c a e ea g , b ea g be e ed. S a e de a e
en taxed on their pro rata share of the corporate earnings no matter the income s disposition
(d b ed a e de ). T e c a ac e f e e e ed ( , ga , ded c ,
credit) is retained in the taxpayer s hands.
L a

C a e Ta a O e
o E gb Ca c aea S f e a 75 a e de , e e f eg ,
a a e de a d d a, e a eca f c e . A
a e de a e eS c e. 1361(a)
o L e a e de ca ded c e Cc beca e c a e aae
e ,b Sc ae a e e a e a e aga e a ed c e. 172.
L ed e a ab e a ff e e ce age e . 1366(d)(1). Le ge e
a a e a a ce , g .
o S ec a a ca ba a ca beca e f eca f c . 1361(a).
o O e -f a ac ill c lled b C le , hile a e hi a e . 1371(a).
C d a eg e e e a a a ae a ae ea c e,
e e e ab e g ef a f e ca e .
4. Partnerships and Limited Liabilit Companies
A. Pa e
B. L ed L ab C a e
Pe a e ce c a (PSC ) ge e a f ded c b e d b a eg e
5. Policies
A. T e d b e a ea g c a a e a aee e f e a e de . Ce a e e
c ae a a . C c a eff c e b a ed 1) aga c aea ed
c ae e e , 2) fa f e ce e deb f a c g f C c , a d 3) fa f RE
a ec a e e e a e a d de d d b .
B. H g e e a a e c ea e ce ef c ae e e
C. Fa ab e ca a ga a e c ea e ce ef g- e e e
D. N ec g ga e a ab e ea ed a e, e c a ge, e e e a
a e e ea ea ab e
6. Common la
A. S a a ac a ac a e e cc ed b e e e ed b e a a e a a g
cc ed. U a e e ed f e eg eg ca e , ca def ed e e c f d a
a a e a a ed b b e e e a ba g a be ef , a d e e
b a ce e a ac beca e ea ab e b f f e
B. S b a ce e f a b i e defi i i f a di ed a ac i i de e i a i e. Wha
e a ac acc e, a e a a e d be, f e c a e e e
C. B e e a db e eb c ea e a a g
D. S e a ac d c e c b a ff a d c a ac de e e a
ea e f e eg a ed e e f e e . I e e a ed e fe e a e aga
a ea ( ec e e b d g ega c e e f c g e e f e a ac ,
he i l l k f al i e de e de ce )
B. The Corporation as a Ta able Entit 1-27
1. Corporate income ta
A. Rates 11(b)(1)
Ta ab e c e Ra e
0 $50K 15%
$50,001 $75K 25%
$75,001 $10M 34%
* $100K 335K add 5%
* $15M+ add e e f 3% $100K
$18,333,333 35% f a a e

C a e Ta a O e
* - Rate bubbles to wipe out the advantages of the first $75K in income at the earlier rates. See
11(b).
B. Determination of ta able income 63(a)

C ed a e a c e a e, f g e ce :
N e a de e de c e e , ed ca e e e, a , e c., ded c
N a da d ded c
70-100% ded c a ed c a e a e de f b d a d de d d b
ae c
Effec f 70% d de d ece ed ded c a c a e b ec 10.2% a
a ae d de d (34% a e 30% c dab e f d de d ). 243(a).
10% ded c c a ab e c b
$1M e ea b c aded c f e ec ec e a
C e ded c b e e e fc ga 1211
E ce a be ca ed bac ee ea f a df e
C. Special features of CIT

L e b ac e f 11. PSC a ed a 35% - e g b e f g ad a ed a e . 11(b)(2), 1561.
Re c ed acc g e d . 448. C c ge e a a ed e ca e d
acc g e acc a e d acc g. C c ca ge e a aff d a
someone the extra money for accrual, and it s m e acc a e.
Cc ca c f ca ea , PSC a e e ca e da ea . 441( ).
D b f b da e ee ab e, 243(a). O a a ab e C c .
D. Fairness and CIT

T e b ea d a a d e ca e a e ca ed a e
La ge c a d f a e de e a a ea g a e e ca e
T d d a , A & B, a c fc Aa dc B, e ec e . C A&B a e
e a e e ea d e a ge e e
Add a , eed a eac c d g ea g
A e a b c d b e a af e a f a d de d . W d de
a e .
A e A ca a e d c e c e ;B a c ,b c ae
deb . B ee e ded c b e ee e fc a e deb , e ee g
ec ca de ca A . V ae a e
E. Incidence of CIT
S b de a e de f d e fec c e e (c d )
eg a ed e
L g f g f b de e f ALL ca a
o Xc c e d de d d b
Y a e
D ffe e a cc af e a ca e a ea d ec f ca a
e a c ea ed beca e f g e f ca a ( e a , e c e, e
eed f f a c g, e ca ba c e, e ee ae )
F. Economic neutralit and inefficiencies in allocative resources

CIT fa c a ed e c a ed b e e
CIT fa RE e c e d b
CIT fa deb a e a e ca a a
Ne e e a ed 25% dead e g a CIT a e e e
2. Alternative minimum ta 55, 56(a)(1)(A), (c), (g)(1-3; 4(A-Cii)), (5), (6); 57(a)(5-6)
Fa ae a ed a b ade c e ba e a e a ab e c e a d c ed f e
regular corporate tax. Payable only to the extent that it exceeds corp s regular tax liability.

C a e Ta a O e
AMT c e (AMTI) a ed a 20% af e a $40K e e . AMTI = CTI + a efe e ce
e ce a g be ef f eg a a a
Ad ed c e ea g (ACE)
Re ead . 16-17. C f g.
3. Multiple corporations
O e e e e gc ae f a g a e c a e a
ab . 11(b)(2).
4. S corporation alternative
A d ACE/AMT a e b a gc ae a g e a ae de e e . Ge e a
f :
Problem 19
(a) B , I c. a ab e i c e $900,000
Reg a a ab $
(b)
(c)
(d)
5. The integration alternative

P b e eg a fc aea d d d a a e g e, c e e , a d e ab e
e .
A. Distribution relief
a. D de d a d ded c c a ( e e e a e ). W d e a e deb
ca a a fa ab e e . E a e CIT
b. D de d ece ed e c E a e SH a
c. I a -c ed e CIT e a , d de d a ed SH, b d de d c ea ed
c f he CIT a d CIT i ea ed a a c edi agai SH a iabi i (i.e. $100 fi * .35
= $65 di ide d, b g /i e d de d b CIT, SH e $100 d de d
c e ca c a e CIT a c ed . SH a 40% a ab e a e $35 c ed , e
a $5 d ffe e ce)
d. D b e ef a e a e :
C a d SH a e e a ,
A a e de a ab e, AND
N c a efe e ce , e a ee f ab e e d a e e .
B. Shareholder allocation
C d a ea e , b d ff c de e ea a e a ca e a ea e beca e f
d aae c ca ea e . Ge e a e a e d ffe e c a e f c a e a ed,
c e c e ca i a c e e e hi e f i eg a i . Be i i ci e i e ,
Ca e 2002.
C. General capital ta
T ea 1992 C ehe i e B i e I c e Ta (CBIT) a . Add e ed bia be ee
d b a d RE a eg e . A f :
a. De ded c f a a e ca a e ( e e /d de d ),
b. I e e a d d de d ece ed e c ded f ec d d f a a
c. A e a b e , ega d e fb e f
C. Corporate Classification
1. In general
Fede a c a f ca fb e e e d e ge a e a abe . H e e, ae a
g e a ce f ega e a de e c e a a e fede a c a f ca a e ba ed .

C a e Ta a O e
T e e fede a ada a ons of the o erall resemblance test are contained in Reg. 301.7701-1 g -
3. It lists si characteristics normall found in a pure corporation:
A cae ( e e a ed c a d e )
A b ec e ca eb e a d d de e ga e ef
C f fe
Ce a a f a age e
L ed ab
F ee a fe ab f e e ( a e de ab d e f e ae)
Ab e be ea ed a a c a de fede a a a f ec e e e be
ga a a d e a a e . T ce fd g g be ee e a ca ed
be .
2. Corporations v. partnerships
A. Historical standards
Ab e ce f f c a ac e c e e ga a f c a f ca a a a ca .
W e d g g be ee a c a a d a e , e a f a ec de ed a d
e g ed e a . C a f ca a a a ca cc f ee f e e a gf
ae ee .
B. Limited liabilit companies

IRS c a f ed a a e . P c a be ef f LLC e ed a e a dSc
( e a - g e e) a e a e ed ab ,b a a c ae b e
a age e . A , c e gb e e e eSc ,a dfe b a a de
S bc a e K. L be e d a ga a a f f ef e eeab e f e.
C. Check the Bo reg lations

Beca e f g e be ee a e a def fc a d a e , IRS c c ed e
f -factor s stem in fa or of default ta classification as partnerships unless electi el checking
the bo to be ta ed as a C corp. This is onl for businesses that ha e not incorporated under
e ae c a a , beca e c a ge e eg a g e g e d f ee e
from the statutor definition of corporation in 7701(a)(3) a d f a e e a c de. IRS eg
ha e no authorit to re ise statutes, but as a matter of polic are probabl indicating that the d
eC ge c a ge e a e e f.
B e e a a e e ec af e f c ga a Sc e a a ef a -
g e . See 301.7701-3.c. .
D. Publicl traded partnerships

Te a ea d d b e a eg e a a e ded c b c ge e ee
bega be aded f e e c . 7704. PTP a e ec a f ed a c e e e a ee e
1) aded a e ab ed ec e a e , 2) ead adab e a ec da a e.
E ce f ec a f ca 90% e fg c e f a e c e e
(d de d , e , e c.).
3. Corporations v. trusts
301.7701-4. N d b e a c e. D b a e a ed e ec e ee e f e
trusts distributable net income. If trust income is accumulated, then it is ta ed at 1(e) rates, and
a a ed aga f e acc a ed ea g a ed b ed a e . If e bec e a
ac e ade b e , a ed a a a c a .
T ca e f : 1) C e e e (301.7701-4.a), and 2) Acti e business trusts
(301.7701-4.b). Regs suggest that ultimate test is hether state la trust is a state la business
entit .
O e c de a f .c a : 1) ac e c d c f b e , a d 2) a
a ca fb e a e =c a e a e ed aga . S e d f ae c
c d . See E a e f Bede , 86 T.C. 1207 (1986).

C a e Ta a O e
Problem 36
(a) N d b e a e ec e . T a a ead a ed.
(b)
(c)
D. Recognition of the corporate entit

A bg ea be ee age a d c a e a ed.
Bollinger 37 (1988)
S e c a ed a age f a e a d ae a a da ac f ba
f a c g. W e e e e c ed, B ge a ed e acce e a ed de ec a ded c f e
ea e a e e a a e ( ea a e ) c ef e ce . IRS d a ed beca e
f ae a f a a a e , a g a e be a b ed c . Ta c e ed,
US aff ed. If a c eg ae f ed f ea e a ec f ca a d g a
c e e ce , a d e c ac g a a age f ce a a e e a c ea d ca ed c
c a e, ab e a da ce c e e e .
W a S c ? Se e e a a - g f e ( f ga , g ).
II. Ta ation of C Corporations
Quick ta able income overvie

I c e ea e e
Rea a , a g age 61, e 61(a)(3), 1001(a). Ta ec g e e e
e a ed.
Rec g , 1001(c)
Def f 1001(c)*: A ea ed 1001(b) + ca e a
- Ad ed ba 1011 1012, ad e 1016
Ga / C f e e e ece ed
e a .
Definition of gross income: Amount spent in consumption + change in ta pa er s wealth.
* E e g e e a ea ed ga , c g e a c e a a g . M c beca e
ga ea ed ec ca e e, b e e c ed a f . See e. . 1031(a) ( fe e
e c a ge ), 351 ( a fe c a ec g ). E e ec g e a a a c a ed ba
e. See e. . 358 (a c a ed ba e f 351).
I c a , 351 ec g a cc f a a fe e c a ge ca a a e (a def ed 1221,

e e a ed e ce )f c a e e ce e e a c a ge f f e a e e
the transferred propert . The catch is when the transferor s basis in the propert is different than its FMV, and
c ge a ed f a e af e e a fe ( .e. a fe ed a e e e
ece ed c a d ea e a d ec g e e FMV ga bef e e/ e ca ec e e ba ).
A. Corporate Organi ation
1. Introduction to 351
351(a), (c), (d)(1)-(2); 358(a), (b)(1); 362(a); 368(c); 1032(a); 1223(1), (2); 1245(b)(3).
N ec g a f a da ce f a ab e c e e ce f a g b e ca a f e
e change doesn t substantiall alter the nature of the transferor s investment. Normal nonrecognition
c c de a a f a f c a a f f e e , e e defe a
acc a ed a e a a ed e e e e a ed f e g b a a
d ffe e f . 351 b ade c b ec g f b a ce c a ge e c age
b e e e . T e e e ce f 351 a ce a e e a a fe a a ff c e
c ea e e a fe ed a c a f ec g
ea e , e e a a fe a e e ed e e a e a fe ed e , e eb

C a e Ta a O e
f g ec g f a ga . T ee e e e f ec g be ef : 1) a fe f
e , 2) e c a ge e f c , a d 3) a fe c fc ed a e e c a ge.
The corporate partner to 351

1032 c ae ec g a e a ce f c b c a a a a ec g
a fe . 362 c e e ba f ec g b ec he an fe o ba i a el i h he
a fe ed e , a e e FMV. T ec f e be I e a L be ,
f a, e e e a fe a ec g a d ed a e a e , b ec a a d
he a en ck i h a lo e ba i han FMV (and canno e dep ecia ion of he mo e al able FMV
fg ea a e ff c e a e ).
P e an fe ed e ain i an fe o ba i hile no in he con ol of he co p. An gain o lo

a e be ea ed f e a fe ed ba . Sa e dea a fe ee . If a a fe ee
e c a ge e a ba f $10 a d FMV $100 f $100 c , e ae f e c
(a $100) a fe ee ec g e $90 ga (a $100 ga $10 g a ba ).
1. N ec g 351, ba f ec g 358.
2. Be a a e f b de f a ac ( a fe a d a fe ee a c e e ce )
Problem 46
Rea ed ga / 1001(a)
Rec g ed ga / 1001(c), 351
Ad ed ba e ece ed 1012
C a ac e f e ece ed 1221
H d g e d 1223
Holding pe iod de c ibe he a a ha d ffe e a e ca a ga f LTCG. If a
a fe ed e a ca a a e de 1221 (a ed a c e e ), e e e d
fo hich he an fe o held ha p ope p io o an fe ma be acked on o he ock ecei ed in
e e c a ge. U a e f e ece ed c , e a d g e d de e e e e e
ea ed ga f a ec g ed ea ed a - e ca a ga , e e b ac e ed LTCG.
(a) D b c a
A Ca c a e= a e a c a ge. 1012 a ba ca c ae c
B W ea e $5K ga ae f c , e ec g ed. C a ac e f e ece ed c a ge
f e ( c d a e bec e eg a c e a a e) c b e efe e a
a ea e de RE c e e
C M eali e p e io l n eali ed $5K lo immedia el , on ecogni e n il ock i old
D $25K eali ed, 0 ecogni ed. Capi al a e nle D i eal o . Won be able o clam a $5K lo
beca e D a a ead a ed $5K de ec a e a fe ed e . L e D ee
d g e d. 1245(a)
E $18K ea ed ga , ec g , $2K ba a fe c . P e bec e ca a
a e de 453B(a), 1223(1) ac g e a e . 453B(a) a da e ed a e ec g f ga
d f a e b ga beca e eE d a e e 351 ec g
a a ce beca e e c ga e a e e c a ge f e e , e ed
a da d d f a d ca .
(b) D b ee c a
F a ca e co p didn con ib e an hing ( he ock co no hing, o he con ib ed ilch
eac a fe ), e ea e f $100K f a a ac . B ba ca e e
c e d g a ac 358(a), a d ac g a e 1223(2).
A c ee ec g
B M ec g e $5K ga e e d
C Ma ec g e $5K ae f a d
D M ec g e $20K ga f e e d.
E-
(c) D b e a . J f ca ? T e a fe c ea ed e ea f $10K, d f e a cce f d b e
d .

C a e Ta a O e
2. Requirements of nonrecognition of gain or loss under 351
A. Con ol immedia el af e he e change 351(a)

351 a e f e a fe a a group control the corporation immediatel after the
e c a ge. M c de d ec e f a ea 80% f a g c a d 80% f a
g c . 368(c). 318 constructive ownership rules don t appl .
Intermountain Lumber 48 (Ta Ct. 1976)

S c a ed a d a fe ed e e c a . A a f e c a
a , e ag eed e 50% f ae W . Af e e a fe , e ed c a 351
he d avoid taxes as nonrecognition of gain, and Wilso ed a g e a e c ag ee e a
a ae e c d ec d a g e ba e a d a a ge ded c g e de ec a . T ec
a d , a e ag ee e e 50% a a c d f e c a ,a d S ad
e f a a g e 80% c ece a f 351 a cab . I e a ad
ec d e ga a d de ec a e e a .
E e a c , a be -c ac a ag ee e , fa de e e f e e -
a ac d c e. E f ce e f c e, g , b b e a c.
H c d a e bee c c ed c ea e a g ec g ? W a a
c b ,a d e d a e bee . Had e c b ed a a , b W a dS d
a e bee a fe c g 100% f e a e .
O :
1. Ca c b b a e. W c b e ca ($91K) d ec e
a ,S c b e e ca a a e . U f ae ,S d -c b e
W 2:1 ($182:$91), a d e a e d ea a e b ea d acc d g
a a .
2. P e- c a a a a e. S e af ee e e W
( f ga a e ), a d e c ae a db e . U f ae ,S
be ed a e a ed a f e e ea ed a ec a e e e e
a e ee W ( a f f a ec a ac a a ed beca e S
e af e a e ). O a fe e be ,W ga a FMV ba f
c b beca e f a ca c ae f e a e e e be g a FMV.
3. Ca b . S c b e a e ,W c b e ca . S ece e 182 a e f
stock, $91 cash boot back. Wil c b e e a ea f ca a d c ece ed.
H e e, ee a e a ac a c e a e c aef e g
S f c .
4. Le de a c . Ba a e $91K a S . He a fe e e (e c be ed)
e a e e be ,W c b e $91K. B ge 182 a e ,
e ec e . T e be a ff e a . T e deb a fe d e e e 351
nonrecognition, and the constructive boot is ignored for tax purposes (357(a)) ONLY IF e
a f e a db e e (357(b)).
5. P - c a d b . S a fe a e be . La e , d b e
$91K a e de (S ) a a 301(c)(2) e f ca a ( a d de d beca e e e
a bee f ec e ). W c b e $91K a d ece e 182 a e .
N ec g e 1, a f ee e f ca a e 2, ec g e 3, b
a a e - a ac d c e be .
6. Rede . I a a fe f a e f S ($182K FMV), $91K ca f W ,
a dc d b e 364 a e S a d 182 W . C e edee 182 a e
a d gf S f $91K.
B. T an fe of p ope and e ice

Propert has been broadl constr ed c de ca , ca a a e , e , AR, a e , a d
in certain circumstances, intangible assets like patents and process knowledge. Services can t be

C a e Ta a O e
c de ed e f 351 ea e , c e. 351(d). If a a fe ece e c f
b e a d e ce , a f e c ca c aga e 80% e e e . S c a
c e a c ed de 83(b).
C. Solel fo ock
S c ea a e e e ec a .
Problems 53-5
1. Q a f de 351?
(a) Ye A an ac i n ( eali ed b n ec gni ed). C d e n a a beca e f 1032.
B ge a e ed b ea a a d ec g ,e e g B ece ed a f e
n n ing ck, beca e B ain g n c n l.
(b) Ye e a ac d c e. A a d B a e b a fe ec ,a dc e ed
Ma c 2 af e B a fe .
(c) If c n l i e ed ma ch 5, c n l i de ed. D ha n c n ib ed an hing. B if
e e a (b), a d a cce f a g ed, e e ec g a d a d e
gif i n ela ed. Pa e b h na and b ad in e e a i n f e - a ac d c e,
e e beca e e g f a c ac a b d g ( a ), beca e e g f a deed a g f
a d a a e a ac a e .
(d) N
2. Ta e a a
Va a 61(a)(1), 83(a)
(a) N ec 351, beca e Ma age ffe g e ce ead f e e c a ge f

c .
(b) Ye , 351 a f ca f Ma age a g f he ck. A f he ec nd a , I i
e ? A mi n e, if e , a i fie he c n l e . The al ec n mic effec i
a e ac e a ea e a (a), b ca e ead f ece g c a a
c e a ackage, Manage i e en iall di c n ing he ala again a cha e
a e e f e c e d a e ece ed e (a) ce a .
(c) N , beca e f e de a e f e e c a e c ece ed,
a e a a f e ce c e a . 1.351-1(a)(1)( ). Rec g e e de
a e a c a e fe ae c , e a Ma age e e a g $149K a c e.
O c .
(d) Ma age c e a 10% f e a e f c e e a a l ca ed a e ice
c m en a i n, he an ac i n i n de minimi .
(e) Re c ed - d c e a . A fc e a ba ed e e - d
c e a bec e a fe ab e b ec b a a f f fe e. 83(a). Ba g
Manage lea ing, he al a i n and a a i n ld ma e hen he e ic i n n he ha e
a e lif ed. Then he e he 83(b) e ec a d e a defe a a d a f ( b
a ce aga a e a a ae f c a e c e ). Pa ega d f
. Ta ed a d a c e f . If d, ea ed a a e a ec a (LTCG).
W a ab (e) de 1.83-1(a)? Un il a a , ck i n ned b e ice ide .

C e? If Ma age 83(a) a f , e. O e e, f a e e
d be e e e e ad a e e . b ee d ea be ea a ,
ce e e c d ea a . T e c , f Ma age 83(b) e ec , ba ca
ed ea c , effec e 100% f ec c ed b e e a g a e
e c a .
Al e na i e acc m li h he b ine bjec i e and Manage e i ake:

I e ca e f c ,c a d efe ed, e ec e a d g a e
Ha e efe ed e e e f e ca a c de a f ec
D b e efe ed e ca a e

C a e Ta a O e
D b ec ( g) a $1 a , 51% Ja a a d e e a g 49% be ee Ve e
a d Ma age . Ma age bec e ca a c b .
D de? Ta f e b ca e ec S c beca e f ca e f c .
A e a e 2 (S c Va e )
O eca f c
Wa a e ce de
D b ec Ja a a d Ve e, e Ma age
G e a age a a ( )f f ec c ae
1.351-1(a)(1) a a a a ae c ded e c ec e , c
e
3. Treatment of Boot 351(b), 358(a), (b)(1); 362(a)
351 N ec g
358 S a e de ba e
362 C a e ba e
1032 C ae ec g e
A. In general
P c : Ta a ga ea ed f a fe ea f b , beca e a fe defea g
e c a ged f e e g d f 351 ec g .
N a B R e: Rec g ed ga = a f b ; ba a fe c 358. Re
f Ca a La R e
C a ba : T a fe ba + a fe ec g ed ga f b . 362.
A e a e:
Pa a a e a ac : bd de e e e f a fe e c a ge f 100% c ( e
e); e e a g ee f - c c de a ( e ).
E a e:
$100 FMV
$ 10 Ba
C b e 80%, ba e c a ged e 8. T a fe c e ba , ec g ed
ga e a g ea ed ga (72 c de 351).
Se 20% e e f $20 FMV b d. Rea ed ga $8 f a fe ,b d be $20 (face
a e f b d). C ba $20, a d c ba a e e d be g 28
( a fe 8 ba g e c de 362)
$10 f b d ece ed a ed a fe ( e $10 ec e ed a g a ba 301(c))
Re Rea ed ga Rec g ed SH Ad ed C AB
ga Ba c e
N a b e 90 20 10 30
351(b) Re f
ca a a
Pa a 351(a) a e 90 18 8 28
1001(c) ea e P aa
e f
ca a
C b 90 10 (LTCG) 0 N/A
351(a)/ Re f
d b 301(c) ca a f
ea e
T ee b ef a e ga a (721(a)), c a a a ae
ea e beca e f e e a b a ce f e a ac .

C a e Ta a O e
Other propert not stock that is gi en b a corporation in e change for transferred propert .
351(b) e e a fe ece gb ec g e a ea ed ga e a ac
ee e f e e FMV f a a f g e ece ed. Re e
ec g f ga bef e ba ca be ec e ed, a b ca be ab ed.
W e e e a e a fe ed, eac e ea ed a a e a a e a ac .
E a e:
$200K e $20K ba a fe ed c f $170K c a d $30K ca .
T ee a $180 ea a ,b e ed ec g e a ga ee e f eb
ece ed. S a fe ec g ed $30K ediatel , b t doesn t mess ith the remaining $150
e c d c e ed a e ,c ae e a ed a e . T e ba e
f ec e ed f e $30K f b ( a a e e a g $10K af e e ba
ded c ), a d e e f e FMV defe ed e c age c ae e e .
B. Timing of 351(b) gain

Deb e f ec a e c a ged e a fe e f e ca a
c b d a f f 351 nonrecognition, b t the aren t f ll recogn ed ed a e .
T e a e ea ed a a e a e de 453.
The transferor s basis is first set off against the stock (non-b e c a ge e ) FMV. If e
basis doesn t e ceed the FMV, then there is no immediate charge. If it does, then e e ce ba
a ca ed e a e f e a fe . 453 e a ed aga e a e
f ec ac . f e e a e a g ba , ff e e face a e f e b ga .
N e: ga f e e e c a ged f a e a SALE, a d be ec g ed
ed a e .
E a e:
Problem 63
A g e $22 FMV e ($15K ba ); ge 15 c ($15K), $2K ca , 100 efe ed ($5K)
B g e $20K FMV e ($7K ba ), $10K FMV a d ($25K ba ); ge 15 c ($15K),
$15K ca
C g e $50K FMV a d ($20K ba ); ge 10 c ($10K), $5K ca , c f $35K/
ea
Ta c e e ce (ga ea ed a d ec g ed, ba a d d g e d)?

A
T a E e
FMV $22K $22K
FMV c. . $15K $15K

FMV . . $ 5K $ 5K
Ca $ 2K $ 2K
Rea ed $22K $22K
Ad . ba $15K
Ga / $ 7K
Ca e ba $ 5K (AB c f f e ec g )
Rec g ed $ 0 ($7K ba $7K b ec g )
C
AB e . $15K (362(a) ca e ba f a fe )

C a e Ta a O e
+ 2K (Ca a e )
$17K (C ba e - $5K a ec a eca ef
f e ec g )
B
T a I e La d
FMV $30K $20K $10K
%T a 66.7% 33.3%
FMV c $15K $10K $ 5K

Ca $15K $10K $ 5K
Rea ed $30K $20K $10K
Ad . ba $ 7K $25K
Ga / $13K ($15K)
Ca e ba ($ 2K)
Rec g ed $ 0 ($13K ba – ($15K) b ec g )
– OR –
Ca e ba $13K
Rec g ed $13 ($13K ba –0( ec g f ))
A c a ed ba f c :
$ 7K I e
+ $25K La d
+ $10K Rec g ed ga
– $15K Ca b
$27K Ba c
$15K S c a e
$27K Ba
–12K
C
AB . $ 7K (362(a) ca e ba f a fe )
+$10K (Ca a e )
$17K (C ba e e )
AB a d. $25K (362(a) ca e ba f a fe )
+$ 0K (O c ea e ba b b a fe ed e a
ge e a ed e ec g ed ga f a fe – a ead added
e , a)
$25K (C ba a d)
P.S. W e a f c a fe f e ac g e d, e ac g e d a be
a ed a ae a a ( e a e 2/3:1/3 a ).
C
T a fe ed:
La d $50K (FMV; $20 ba )
Rec g ed ga $30K (FMV – ba )
Rece ed:
C $10K
Ca $ 5K
N e $35K (T ea e)
T a b $40K (N e + ca ece ed)

C a e Ta a O e
Q a f f 453(a) a e a e ? La ge fb a e e, a d a
ece f e a ae f a fe ed g d a f e f 453(a).
H d e ba ge a ed? A g f c ( ec g e ) FMV, e
e a de ( f a ) b .
AB c $10K (FMV f c e ed b ba )
AB b $10K ($40K a a e , eac a e ea ed a ba ,
eac a e ea ed a ga )
W a ab e a $5 = 3,752, $40K e = $26,250.
C
AB a d. $20K (362(a) ca e ba f a fe )
+$ 3.752K (Rec g e ga e a fe ec g e ga f
a e )
$K (C ba a d)
W a f C ad g e $50K FMV -ca a a e ?

C o ldn t q alif for 453(a) a e ea e , a d e $30K ga d a be a ab e
f . W a ab eca e e ee a a e e? 453( ), e d g 453(a) g
1245(a), a a a -ca a a e eca e c e be ec g ed acc d g e
a , .e. e ac e e a e ..
4. Assumption of liabilities 357, 358(d)
357 C aea f ab
358 Ba d b e ( a e de ba e)
1031/1031(d) L e-kind e changes: ...s ch ass mption [of ta pa er liabilit ] shall be considered as
e ece ed b e a a e [and s bject to ta immediatel ].
Ca e :
357(a) Whoa, ait! Liabilities aren t boot for p rposes of immediate recognition, so o aren t
a ed f . S , a e f e ce , 358(d) c b ed c g ba .
M c f a ec a f deb , c a c de ed b f e
a fe . B a g a c c f a df a e 351. S 357 a e a
e ce , a d 358(d) comps for that immediate ta able loss b adj sting the transferor s ba d
ee c be ed e . If e d f ba g 357 (a) d e a ega e
ba , e e a fe e ed ec g e a ega e a a a ga a e e f a fe .
357(c).
Lessinger 68 (2nd 1989)

A iding he 357(c) a . Le ge c b ed a e f e e c a ,
b e SP a e a d $200K e ed. He a c b ed a e e SP (ba ca a
c bb e, a acc ge a a c bb ed the ledger b Lessinger s acco ntant (and possibl
e Le ge a a a e )) a face a e f e e a a a e ega e a e SP,
c a a a fe ed. Le ge a ded e ega e ba 357(c) a e g ega e ba
ga ec g ed ag a fe f e . IRS ba ed. C e a a ed e d gf a
b ad ead g f 357(c) a d 362 together. Cr is legall enforceable obligation to contrib te mone
in the f t re.
Also, if Lessinger asn t allo ed c b e e e a d e SP a e ed e a
a fe ed, e eF a d e C e a ce Ac . O c .
S d a ega e f ceab e b ga a ca ef e e ee a ca a e ?
Co rt doesn t reall ans er it, b t seems to indicate that the d sa es.

C a e Ta a O e
Peracchi (9th 1998)

A e a e Le ge , Pe acc a a ed c a ba e a e
c a (a eg ae e, d ffe e a e Le ge c bb e [a e a e f a e da ce]).
C ea ed a e e d be e f ceab e ba c , ee be e ba beca e
of Peracchi s increased e posure to risk in pledging the note. Therefore, he s entitled to an upped
ba ee e f bee e d ec a . T ec ed
a a ce e a ae e face a .
N e: Y d a a be ab e bea IRS a g e b b g e e f ,a d e
edg g f e c . S e e b a ce f ea ab g e a g a a g
basis-up strateg legitimate.
T e ea e b f e e ca e : TIMING. N ge a ba c ea e, b e e ba
c ea e d cc . S ce a deb b ca e , d be a e e d
ec g ???
Problems 80
1. Ac b e : I , $10K FMV ($20K ba ); a d, $40K FMV ($20K ba , $30K gage).
A ece e : 20 a e ($20K a e), c a e gage.
a) $20K AB I e
+ $20K AB La d
$30K L ab a fe ed (f 358(d))
$10K Ba c
Assuming that A isn t a realtor, the holding period of the land transferred will be tacked pro rata
ac a f e c ece ed. T e e d g e d ac g f e ventor , as it isn t a
ca a a e .
C ba be $20K.
b-d) L ab e be e ce f ba , ee be a $5K ec g ed ga (357(c)). W

e d $0 ba :
$25K AB ba b a d a d
+ $ 5K Rec g ed ga
$30K L ab
$ 0 Ba
C ba be a fe ed ba ,b 1.357-2(b) a ae e ba ac eg a e f
a c b ed a e .
W ede bec a e a ca d be ec g ed acc d g e a ec a

a e f e e ec e e , acc d g g FMV a c bed 1.357-2(b).
2. Bc b e : B d g, $400K FMV ($100K ba ), f gage f $80K ( a d b e )a d

ec d gage f $10K ( e a , e e f a fe ).
B ece e : $310K c , a f ab e.
a) B ge a e ed b 357(b), beca e a a a da ce ec b e a ab
a ed (a da ce AND a d b e e), a d ea ef a be a ca b .
b)
Polic : Don t fuck around with 35 s graciousness. We ll wallop ou with recognition

ed a e .
3.

C a e Ta a O e
5. Incorporation of a going business
Hempt Brothers, Inc. 81 (3rd 1974)

A e c e. AR a be c de ed e f a c a e ONLY WHEN
e e e c f 351. Acc ece ab e a e a fe ab e, b e AR ca e e e ge e a ed
f e ce . T e e ce de a a ee a ed, a e e e e AR g e . S ce
351 o e can be e ice (351(d)), e e e ac f c a be e ed g f e
c ge a e f 351 ( f dde a e f e ce , e c., c e e e
E a :A a f e a ac ,a e a e , e c., e a a g ca e .
L ab e de 357(c)(3)
482 Reallocation
If a e e e a ed b e , e e a be a ea ca e. Se ce a d c e a
ab ea ca e a b de . T e Se ce f e de ce f e ea ca f
a ac c ea d a c e e ce .
Revenue Ruling 95–47

W e e ab e e e a ca a e e d e. T a fe f e e a ab . C
c b ed a d a a e c be ed b e e a ab e . P e a a ca f 357(c).
ee e a e ab e o ld be con ide ed o dina e ai o land and e i men , he co
d a f . B ee a d a a e f e e c ea c ae g ,a d be
c de ed ca a e e d e , c a e ec f ca e a ed f 357 e ce a f ca .
Problem 90
a)
b) De g .
c) Ye .
d)
e)
f)
6. Collateral issues
A. Contributions to capital 118(a); 362(a)(2), (c)

W e a a e de a fe e e a ca ece ga g e , e
a e ade a c b ca a a d ca c ea e e ba a ead e d c ef ec e
a fe . T e a fe ed a e c dab e a g c eb e c . T an fe o ba
ca e .
Fink 92 (1987)
N -aa e de f c ca a . N ddF a a e a AB ded c e
e de ed a d ca ce ed a e , b e a a ed c a a a 165(f) d a . T e
ca a e , e c a a ca a a e , b e a c ed g a ae
e c a ge. I a a e de , ec e e ca a ga / e e e e f 1223.
C g e e ed e 1224A. B e ea e f f US a a e e ea ed ?
IRS a , beca e e e e a a e de -c b . Se ce a e
d a e ed e ba e e a g c b e ba f ea f e c
e de ed. US ag eed.
Wa a d: Ha e e c b ae f a e de g , e a e de a e
e ceed f aea dc b e e ec a a d ec c b ca a . N
e c a ge a e , b ec b e bec e a ea c b ca a .
302 d a e e ed def

C a e Ta a O e
B. Intentional avoidance of 351
C. Organi ational e penses
P be 100
B. Capitali ation
1. Introduction
W a d ffe e ce d e a e f e d c ,b d , e ? Ta ea deb a d e
d ffe e ,a d e e fa ab e a ea e deb . I g deb a d e d b e a ;
e a e f deb a f ee c a a d ca a ga f e ce d ffe e ce, e e c b bac
(e e a deb e a e e a e de ) a be a ed a d de d f e a e de e a
e c . See a e 351 c /b d ffe e ce a ec g .
2. Debt v. equit
P be Ded c f ee , f d de d
I ce e
P c S b a ce . F
Ca e 1: GM S c
GM B d S ae de 0.000001% GM c , eb d ea c f c.
Ca e 2: C e e c
A B C
60 30 10 D ffe e e e f e c ea e e b
30 b d 10 b d 60 b d f fa d b fc ea a gb ae
a d deb .
Xc
Ca e 3: P b d e b d ae de e de c a . W a ce e eef e
b d de ac a e c ed ?
T e IRS ca a a e b a ce e f de e e e e c a e b ga a e deb
e . T e e a ec ca e a a a e , e e d be g e ( e e
e e a f a ed f )a d e e be g deb (f ed ef c e a c a
e e a a f ed a da e). T e e ea ea e e dd e, ef ec
dec de e e a a c a e e fa . S e a a ed a ae e ec a e
created a smell test for either debt or equit . The principal factors of the smell test are:
F f e b ga While labels aren t controlling, a proper label ma ard off a
c a e ge a deb ac a e .
T e deb /e a Ra of compan s liabilities/shareholder s equit . The more thin the
ca a a , e be e a f e Se ce c a f a e a e de e a ae
a e de e g d d a a e ee de ca a ed b e .
Ho e er, the bar of hat is and isn t thin capitali ation has been amorphous in the case la .
I e Gleaned b an objecti e look at criteria such as lender s reasonable e pectation of
epa ment in light of the compan s financial condition, and the corp s abilit to pa the
c a a d ee .
P a I c e edc , deb e d b e a e de e a e a
c a e e eb e Se ce. If c e e a e e aged, b a ce e
d e a e de /deb de e f ce / e deb ?
o Stock o erlap : Assume that stock o nership and debt holdings are proportionall
e a a g e e . T ea a c a e% c ed a d % f e
e . If e e c a f eac e added ge e 50%, e e

C a e Ta a O e
( . ., 20%,
31%, >50%, b =e )
S b d a Fe e , de c ed e e a ae de deb be b d a ed
e ca .
H b d e
T e b g ba a e ed e c e a e- - e- e c a f ca b g d c a e
b d c a ac e c a e ca a f e e ded c ea gf e ea e
ba a ce ee . T e Se ce a ade a ce e d ca g a ed e
c b d a a e ea ab g a da e e ab e a c a c ae
c . A a , a g a a ea. B 385(a) a a e ded add a a e e ca a a e
Se ce ea b d a c a b ed a ac a c ,a d a deb ed e .
I a ad g, d e e g a d b d f e e c ce ab deb . e . A
,
e ,a d a c a a ded.
3. The Section 385 saga

T e e a a da ce g e e f e ce e deb , 385 a e T ea c ea e eg
de e g e e a ee ac c deb b a ce, ega d e f ec
abe . 385(b) e fac be a e acc e de e g e e a deb -c ed
ea e :
F
S b d a ( a e de deb e a g e a de e de )
Deb /e a
C e b
P a
T e 385(c) a ac e a f e ee a e e f
, S . T
; .
Problems 123
1. A, B, a d C f C e . Ac b e : $80K ca ; B c b e : b d g, $80K FMV ($20K
ba ); C c b e : $40K ca , $40K g d . Eac ece e 100 a e C e c .
C e e e $1.8M add a ca a . G d Ba a $900K a e ef
gage e a ed b d g.
L f c a f a d D:E e
a) A e A, B, a d C c b e e e a g $900K e a ef f $300K, 5- ea
e a a ab e a e f e 1%. Pa e 385(b)(1) beca e e e a f ed de e a f deb ,
f ed e. B a 100%, a d e de D:E 1.8M:240K, 7.5:1 (a d 12.9:1 f
AB ). T D:E 900K:240K, 3.75:1 FMV (6.4:1 AB). S
, . ( . .,
be f afe a b a e c e, a e a d b e a e ade e a e d f a , e c.).
B c d ea a e c de g e c eca ade a e e e a e?
b) A e (a), b a e e a 10%, 20 ea debe e a ab e f e f .

D ffe e ce f ab e a a b d, a d e e e e e f e
.
c) S ( ), B ( ).
S $300K , C D:E?
U de e c a ac e a ,
ca a ? W a ab e C e da e ded c a ee a e Ba ? C e d
a e d b e e ee ef f a d de d e ae de , d e a e
. S
. W , , D:E . B

C a e Ta a O e
c a ac e a , ec b ca a bec e ee beca e e a C e d
ha e been made b fo he ha eholde g a an ee.
d) A e a A a ee e $900K e a e e a (a). Bec e ag deb ,

beca e ee a . U e , fc e, A e a ed e e B C.
e) Deb in fo m a an ncondi ional obliga ion. Che o a ing in e e , o if A doe n e fo

a e , e ee a bab e ea e deb e e a e deb .
Ma be ec a f ed a e f e e fa e ef c a e b ga .
4. Character of loss on corporate investment
If eed ee c c de a a a a e g de 1244 f ec a ac e g f a
b e a e de , CB 131-33.
165 - e
Deb e ec e 165(g) A c de 165( ), 163(f) ( eg a e ed e

. bad deb b e ( d a c e ded c ) 166 1) e < e ea ,
. -b e (ca a ded c ) 166 Ge e e 2) ae aced a )
301(c) 1. a da d
C. Operating (Nonliquidating) Distributions

243(a), (b)(1); 301(a), (c); 316(a); 317(a).
Reg : 1.301-1(c); 1.316-1(a)(1)-(2).
1. Earnings and profits

F c : D g d b e b ec d be a f e f ae de
e ed ca a .
C ce : C a e d b ed af e - a ea g.
Ca a a e ee c a ge f f do no inc ea e co ne a e n il he changed a e gain

ee .
Ea g a d P f (E&P): A e ab e SH ca a c b = RE
Tec ca def 312.
. Sa i h co o a e TI [co o dina me hod of acco n ing; a la eali a ion and
ec g a g e ]
. Ad e f :
- Ta -f ee c e
- N ded c b e c e e e e (162, b be , bb g e e e , f e , e c.) a d
e ( e a ed a e 267(a), e c.)
- T g ad e
De ec a ACRS (312( )(3))
I a e a e (312( )(5); 453)
316(a) def e a d de d a a d b f e ade b a c a a e de

o of (1) ea ning acc m la ed af e Feb. 28, 1913 ( acc m la ed ea ning and ofi ), o (2)
ea g a d f f e c e a ab e ea .
Ma e eb ab e e : (1) e e d b ade f ea g a d f
ee e a e e , a d (2) e e d b dee ed be ade f e
ece acc a ed ea g a d f .
I e g f d de d a , a e ea g a d f a ec e f e a ab e ea c
ed b a ade. A d de d f c e ea g a d f a ab e, ega d e f
ca def c .

C a e Ta a O e
Problem 140
G f f ae $20K
D de d ece ed f IBM 5K
LTCG 2.5K
T a g c e $27.5K
Ded c
Sa a e 10.25K
D de d ece ed (70%) 3.5K
LTCL a e 2.5K ( ed b 1211)
De ec a 2.8K
T a $ 8.45K
Ad e :
Ta e e ee $ 3K
D de d ece ed ded c 3.5K ( a ed c g ea g a d f ;
E ce e de ec a 1.8K c g a ab )
T a $ 8.3K
Dec ea e :
E ce f LTCL a e $ 2.5K
E a ed a e .8K
T a $ 3.3K
T a A&D $ 8.45K
T a $13.45K
2. Distributions of cash
301(a), (b), (c); 312(a); 316(a). Reg 1.301-1(a), (b); 1.316-2(a)-(c).
D b a a e de ece e . E e d b a d de d ee e fc e
E&P. D b abo e P&E ed ce ha eholde ba i . If ba i i f ll ed ced, hen emainde i
c ed a ga f a e e c a ge.
N e: ca d b a e ca ab e e e f acc a ed E&P a bee ed ced e . A

a ec a ed a e a a c a e a a e ca be b ed aga de a ca d b , e
be g e ed ea a E&P c a .
Problem 144
a. ... a d E&P ed ced e acc d g 312(a) ($17.5 ed ced o he e end of Pelican
a a ab e $5K E&P 312(a) ca f ce a ega e E&P)
b. All $10K i a di idend, ega dle of he fac ha he e an acc m la ed di idend. E e
d b c e f f c e E&P. 316.
c. A ca e a ea -e d E&P aa a d b ade d gc e ea (2 d b ,
$2K e ). 316. N a a a acc a ed E&P (316 o ), g e e a g $8K f
ef d b (acc a ed E&P a ed e a d b e c e E&P) a d
ea g $2K be ee e a d b ( afg e eac ). Lea e $1K acc a ed E&P
e a e de , a d c b ed e $2K c e E&P e $3K ef e. T e a de
applied o ed ce he ha eholde AB.
d. $7.5K d de d beca e e c e ff e b ca E&P. A g a c e E&P
dec e ead d g ec e ea , $10K/4 (d b ea ) = $2.5K.
1.316-2(b) c e E&P def c ( ee . 1274) If e e a def c e E&P, ca a e ead

dec e a ea g e a g, e c ca ec f c e a ca ed e E&P . If , e
E&P ca be a ca ed ea - e acc d g ee e a ca ed e e a g .

C a e Ta a O e
3. Distributions of propert
Ge e a U e d c e: 311(a). D b da ed c d b e a ec a ed e
a e de a dc -e e a a e. SH d e e a d ea e ga beca e f
301(d) FMV ba e. C g e f g ed a d ba ca ( a ) e ea ed d c e
311(b).
Problem 148
a. C e E&P g e $9K ea a f FMV d b . 311. Ga a ed, c ed ce
E&P. Ne c e e ce $6K (a g 1/3 a ) c ea e c e E&P. SH ece e FMV ba
e ece ed. 301(d). D b bec e d de d e e f E&P (b acc a ed a d
c e ),
b.
c. F , c a e a c e e ce . $9K ga . 311(b). C e e E&P e e a g e e
af e c ga a . S e 2: SH c e e ce . A fd b = FMV erty s associated
ab e . 301(b)(2). $20K - $16K = $4K d b . C c e ea g ( ca e, a ea e
e ea ed $6K) c e , a $4K a d de d. 312 (a), (b). T e e c E&P c ea e f
$2K ($6K e a gf a ga $4K d de d = $2K). SH ba = FMV, ega d e f e
e c b a ce ( e e ed deb e a a ded c ee f e ec e ). Sc S c c
Ra W gg .
d. A e AB a d = $30K. If c d b e a d, e ea ed f $10K (301(b)
a FMV ed ca c a e ). E&P ge a f AB, $25K acc a ed a d $15K
c e E&P $30K, e $10K ed e acc a ed E&P e ea . 312(a)(3). C
d a e d e a da d e d b ed e f .
e. 1016(a)(2) de ec a a a ded c .
4. Distributions of a corporation s o n obligations

311(a), (b)(1); 312(a)(2). Reg 1.301-1(d)(1)( )
Gain recognition rule doesn t apply to distributions for corp s own deb b ga . N a , E&P
ed ced b e c a a f e b ga a b ab e a ea . B ca e ee ee
a e c e a e e deb b ga a face a e, a c c d e ade ea g a b
e a gb ea g a ce f a fac a e a ed deb b ga , g e ea g
a fa f e e e d de d a . I e ca e f a b ga a g a ed c , e
c ca ed ce b a d c ed a .
Problem 151
312(a)(2). Somewhere in here there s a $5K return of capital. Corp can lower E&P $5K (current
d c ed a e f e deb b ga ), a d e ed ce c a e $100K ( g a E&P a d
a g $5K f ca a a e ). E a e f $5K d de d. P , ec e e a e
ee c e ( ce e e a $100K a d e b g f $5K, e e be e e a $95K
e e acc a ed e e fe f e b ga ).
5. Constructive distributions
Reg 1.301-1( )
H g e , fa a a e , e c. a e c e a d d de d which they aren t able to
ded c . Re a ed, e IRS ee g , e e f e ca e , a d ge e
g. See N c (Ta C 1971) (c c e d de d f e a e fc a e ac
d de d a d dad, g f f e . W a ab ca g c c ec e a
Ja e e a ?). See a 482, Re e e R g (c de g f c ed c , ee e
e e e a e a ag de a e, a g e e a d E&P c ea e a d g e
c c e a ).
6. Anti-avoidance limitations on the dividends received deduction (DRD)

243(a)(1), (3), (b)(1), (c); 246(a)(1), (b), (c); 246A; 1059(a), (b), (c), (d), (e)(1)
C a e a e de (c , f g d a e ) ece e a ded c d de d c a a d
e a a . 243 ded c :
Ge e a : 70%;

C a e Ta a O e
If ec e c > 20% f d b g c : 80%;
If b c a ec ed de a b e a e ec ed aff a g : 100%.
246(c) d g :W a fac b c ed a e e-d de d a c + d de d

ce, ece e e d de d, e e e c f face a e? C c d ec d d de d a
c e (a 30%), a d e c a e ed ced a e ce a a STCL e e e d ffe e ce
be ee e c a ea d ae ce ff e e c e e e e e.
7. Use of dividends in bootstrap sales
TSN Liquidating Corp. 163 (5th 1980)

N e: A a d b e e e e ed de d ec e ed ca e f bec g
e d eaded a a ac .
D. Redemptions and Partial Liquidations

302, 317(b)
302(a) a e ea e : f fa e f ef ca eg e f (b), ge a e ea e (a d
LTCG/LTCL a ea e ). If d fa (b), e (d) a d a e ea ed a a d de d.
E ample: A a C , 100 a e : X, 60; Y, 20; Z, 20.

If Y e ae A a, e (b)(3) a e . Ge a e ea e , b ac a e a ac
e a ea a e beca e (dec ea e c a e ed b f ca a a e , c ea e X & Z
e e ce age ).
W a f X e 15 e c ? Red ce a d g ae 85, b X a a c f a
a e . S d de d ea e , e e g e e d ffe e effec ( f d de d d b ,
e e ce a e a d ROI e e e a e ed, e c.). N a d de d d d a.
A ec e e ede f Y. X e ce age e c ea e 75% (60/80); Z 25% (20/80).

If e e a a a d b f 20% f A a , e X d ece e 12% f a a ; Y,
4%; a d Z, 4%. B a e a e g e , 20% g g Y a e.
W ede bec a e e ede a a ede a d a a a e beca e f e d ed

e effec f e a g a e de . C c ed de d cc e a e de ae
ac e a c a g e a ac .
1. Constructive o nership of stock

302(c)(1), 318 (C c e e )
F ca e e f a b e ( e c e a c e a b ab e e ae de
a d a ac e )
i. Famil attribution
A d d a c de ed a g c edb e, c d e , g a dc d e ,a d a e .
I -a d c . N a b f a a d ae a a dc d.
ii. Entit to beneficiar attribution
S c ed b f a a e e ae c de ed a ed b e a e
be ef c a e e be ef c a ee .
iii. Beneficiar to entit attribution
S c ed b a e be ef c a e f a e a e c de ed a ed b e a e
e a e. A c ed b a be ef c a a b ed e e ce ee e
be ef c a ee e e a d c e .
iv. Option attribution
A e d ga b c c de ed a g a c . Ta e ecede ce
e fa a b fb a .

C a e Ta a O e
Problems 182
. W a , 100 a e : G a dfa e , 25; M e , 20; Da g e , 15; Ad ed S , 10 (M e
option on five); Grandmother’s Estate, 30 (Mother 50% beneficiary). Apply 318 a d de e e
e a f :
G a dfa e 85 (a – 15 f e a g 50% e e E a e [(a)(2)(a),
(a)(5)(a) - e a b a ])
Da g e 55 (15 + Mother’s 20 + Mother’s option 5 + Mother’s Estate
e e 15)
Grandmother’s Estate 100 (30 + Mother’s 20 [B2E (a)(3)(a)] + Grandfather’s 25 + 25
S /Da g e )
. Xe e , 100 a e : Owned by Partnership in which A, B, C, D all equal partners. A’s wife W
a 100 Ya c C .
a. How many, if any, of Xerxes owned by A, W, and M (W’s mother)?
. A, 25; W, 25; M, 0 ( fa d bea b [(a)(5)(B)]).
b. H a , f a , f Xe e ed b Ya c ?
. 25 [(a)(3)(C) B2E a b + (a)(1) fa a b ;d bea b b ed
beca e a d b e-fa c c ]
. W a fW ed 10% f Ya c ? E e f e f gge g e 50%
e d f (a)(2)(C) E2B a d (a)(3)(C) B2E, c c e e e ae
a ed.
c. H a , f a , f Ya c a e ed b Pa e , B, C, D, a d Xe e ?
. 100 [((a)(1) e + (a)(3)(A) B2E Ya c ) = A c c e g 100 Ya c +
(a)(3)(C) B2E Pa e Xe e 50% e d = Xe e e f a Ya c ]
2. Redemptions tested at the shareholder level
A. Substantiall disproportionate redemptions

302(b)(2); Reg 1.302-3.
If a shareholder’s reduction in voting stock as a result of a redemption satisfies three mechanica
e e e , e ede be ea ed a a e c a ge (a d e d eaded d de d). T
qualify as “substantially disproportionate,” a redemption must satisfy the following requirements:
. I ed a e af e e a ac , e a e de (ac a a d c c e ) e
a 50% f e a c b ed e fa g c ,
. T e e ce age f a a d g g c ed b e a e de ed a e af e
e ede be e a 80% f e a g c ed b e a e de
ed a e bef e ede ,a d
. The shareholder’s percentage ownership of common stock after the redemption also must be
e a 805 f e c c ed bef e e ede . If e e e a e
ca fc , e e 80% e a ed b efe e ce FMV.
A b e a ee e .
Revenue Ruling 85-14

S e a ac a g d de d a e c a ge . W a f a a a e de X e c a ged
ae a f ed de 302(b) a a g X a , e edge a e c d be
redeeming another shareholder’s shares in the near future, thus making X the majority again? See
(b)(2)(D) f ec g f g, a g f c e e f fac f de e a f
302(b)(2) ea e .
Problems 186
1. Y C , 100 c , 200 NV efe ed; A ce, 80 c , 100 efe ed; Ca , 20

c , 100 efe ed. De e e f 302(b)(2) a e?
a. Y redeems 75 of Alice’s preferred
. N . N g c e e a f e f 302 ea e . A a a d de d.
b. Same as (a), except Y also redeems 60 of Alice’s common.

C a e Ta a O e
. Fa (b)(2)(B), be < 50% g e af e ede a f . Ca a
20 a , 50/50.
c. Sa a (a), c Y a 70 A c c .
. Pa e (b)(2)(B), b ca e e efe ed c a be a f ed f 302 ea e
ded a e efe ed c 306 a c . S 1.302-3(a).
d. W a c a (c) D c. 1 a a Y 10 Ca
c ?
. O A c a Ca a b . (b)(2)(D). B e a
e a ac a a a ca e ( edge ), beca e 80% e e
e e a def f b a a d a 50%. (b)(2)(C). IRS
dc e a e - a ac a a a e, e e C ge e d
f e a c a ec .
2. Z C , 100 V c , 200 NV c , $100 FMV eac ; D , 60 V c , 100 NV

c . Je , 40 V c , 100 NV c . I Z 30 D Vc ,
ede a f ?
N .
B. Complete termination of a shareholder s interest

302(b)(3), (c)(2)
U :
- Rede f g c
- Wa e f fa a b (c)(2)
-R 306 a c
W e e a a e f fa a b ?
i. Waiver of famil attribution

A b a e e a c e edc . If a a e c ec aec da d
c g e a c d, e c., e a e d be c c b ca
a b . 302(c)(2) de a afe a b f fa a b ded e f g
c e aa e e:
I ed a e , ed b ee a ee ec e a a a c ed ,
T ed b ee d e eac e ee 10 ea , a d
If e d b ee a e f e Id ... ead e a e f g e e .
F e , 302(c)(2)(B) a a a b ca b a , 10 a ,
e e
T e edee ed a e de ac a c a S c 318
e a e,
A c c e e a e ac ed c f e edee ed a e de .
Revenue Ruling 77-293 e ce : Ne e f e e e ce a e f a a da ce a
e f e c a e f e a fe .
S : A a f e a ac !
P c ? If a e ea c g e , e a ede a dgf f e a ga e c e
e g a da a ea da ece a a c a bee
e ed ded a e e a aff a e g a e ARE c b ed b ee.
L nch 188 (9th Cir. 1986)

I L c a 302(c)(2) a e f a b , e d a e bee f a ed
e ede beca e f e d a c c e e f ee ec a b a d
ac a 100% L c C .
G a c , c a ( ca , ).
IRS a ca e, e (c)(2)(A)( ) e c e d ec e ec e
a e a e ee e c e .
A e a e ba e f a d g:

C a e Ta a O e
- Deb :e a Fa he c c e ed ha e , a d fa he a e e f
e. D b e c e age, a d IRS d a e ca ed e e e e ce efe ed c .
P edge f ha e See 1.302-4(d), (e). T e edge f c a OK, b e f c g e
edge (f ec e e c ) d be b e a c f fa e .
- 302(c)(2)(B)( ) 10- ea -bac e a d Revenue Ruling 77-293 - a -a da ce e.

F ec
Sec d ec F c a e a d ee e e e ee c d g a g age
aga a f ef .
T d ec U c ec ed d c e a e e e a d a c ae c . Bad!
F (c)(2)(B) -bac a d b ad d e a a da ce e ce be ead?
ii. Waiver of attribution b entities

W a f e edee ed a e de a , e a e, e e a c ee e ae
ac a ee ec ,b c e a e a b ed a be ef c a ee ?
Wa e f a b b e, b f e be ef c a e a ea b a dc
e 302(c)(2) e c a e .
C. Redemptions not essentiall equivalent to a dividend

302(b)(1), Reg 1.302-2
Davis 204 (1970)

Da b g c f c a a ec a c d ec e a a , e e
edee e c ce e a a a d ff. He b g 1945 a $25/ a e a d e c
edee ed e 1960 f e a e ce. He c a ed e a ac f a e ea e a a e
f ca a , b e IRS ba ed. CA9 e d f Da , US e e ed. Da ad c a ed a e c
a a f a a db e e, a d he ef e a a d de d ( h ch a RE
d b e f ca a ). US d d b , a g ha he b e e e
ee a de e g d de d a . T e ea ed a 302(b)(1) e ae
d de d e ea ha : ce Da e e cha ged f a c f he
c e e d c , e ede a e a d de d. I de a f a e e a
e ae a d de d, a ede e a ea gf ed c f he ha eh de
ae ee ec a .
N e: c c e e e a de (b)(1).
Dd a f f a e f fa a b afe ha b beca e Da d bac e

efe ed, a d ad c c a d g. T e (b)(3) afe ha b d a , e he ,
beca e e c a g efe ed, a a ac c ca e e a a e f (b)(3)
ec .

W a e ea gf ed c f ha eh de e e c ed f Da ?
H e (2 d C . 1964) a ha eh de ee c de :
T e g e a d e eb e e c e c -V e
T e g a c a e c e ea g a d acc a ed ,a d -
F a ca
T e g ae e a e da . -
F a ca
I e a e, b g e a e f ee aea e d e e a f f e (b)(3) afe
a b . F (b)(2), e e a e 1000 f 1750 a d g a e . Af e ede ee ae
c c e 50% a d (b)(2) e e < 50% ed a e af e ede . (b)(1)
, h gh, beca e a 50/50 a d ff c g de gh ca a ea gf
ed c beca e he e e aea c e ec .
H e e f h h d he he 50% f he c . If ca e ed, he he e
a be effec e c f ed b ee.

C a e Ta a O e

I e a e, e a e ab a b e a e ,b e
- -a d . Th , fa he (b)(2)(C)( ) 80% e , . B ba e (a b ab e 24. %
f - -a ch d e ). S he IRS a ba ca , C e e gh, ge 302(a) a e
ea e .

C ah he ca he h c ab a h A a d B, h e C 18% a
, a fac g . T ad de d.
Problems 219
1. Z c , 100 a e . A, 28; B, 25; C, 23; D, 24. D de d de (b)(1)?
(a) Nea (b)(2)(C)( ) 80% e (80% f A g a 28% e e 22.4%; af e
ede 93 a e a d g, c a 22.6%). 0.2% ff, ea
a d ea gf ed c a e ea e OK.
(b) Sa e a (a), b f e a e edee ed a d A&D a e e a ed. O e bef e a
52% ( /a b ). Af e ( /95 a e a d g) 49.4%. Pa e (b)(1).
(c) Sa e a (b), e ce A&B a e e a ed ead. O e bef e a 53% ( /a b ).
Af e ( /95 a e a d g) 50.1%. Fa (b)(2)(B) < 50% e .
(d) Sa e a (c), b A&B a e eac e. A a a a b , ega d e f fa
.
Yc , 100 C, 100 NVP.

S a e de C S ae P efe ed S a e
A 40 0
B 20 55
C 25 10
D 15 15
E 0 20
2. W ef g a f f 302(b) e c a ge ea e ?
(a) Y edee 5 efe ed a e f E. N (b)(1) b a a d a ea e
beca e g c edee ed, b eg a e a a ge e c a ge
ea e .
(b) Y edee a f a d g efe ed c . Rede d e affec A. E ge
(b)(3) afe a b f c ee e a f ee . N ac e, bab
a d de d ha c a a e. V e e fac , b de e a e fac ? S
ea g a d da g fac a d g. B g be d e, a a e
e ec c g f e a e de a d a e e affec ed?
1. B ge a ed g g f a f ea g a e e. B d a f f
a e ea e de (b)(1).
2. C a ec c ac , ea gf ee . D de d ea e .
3. D a e a C.
3. I d d a 10 c a $15K ba . W a a e f ba ff e a e a e
edee ed a a ac c a f ed a a d de d?
S d he ba f d d a e a g ha e ca f a d he a d g ba
a a ec g ed a a e ca a e .
W a f a 10 a e e e edee ed a d de d a ac beca e e fa a b
a e a a a ab e?
See Reg 1.302-2 E a e 2. Ba a fe e a ed a . O c .
3. Redemptions tested at the corporate level: Partial liquidations

I d ceed 311(b) (Ge e a U e d c e e ea )

C a e Ta a O e
E&P ed c
. 301 ea e
N a 312(a) a d (b) e f ed c f E&P d b ed a
. Sa e ea e 312( )(7)
Red ce E&P b a d b ed, b e a ae aec b
E&P ( ed c a )
A. Partial liquidations
302(b)(4), (e)
A redemption q alif ing as a partial liq idation nder 302(b)(4) a e a ed ed b ee
a e de a a 302(a) e c a ge. 302(e) a da e a e f c fe a a f e e a
ede a a a da ec ae e e.
1. E ceptional features
M be c a e a e de . Ye , e ece e 301 a d 243 DRD ea e ; b
1059(e)(1)(A) a e a e a d a d de d a d ed ce e ba c ea g ca a
ga a d e a . HOWEVER, 302(e)(4) a a ede a f f ae
ea e .
2. Definition
. I ge e a a c b e c ac
. Safe a b 302(e)(2), (3)
3. Polic – 331(a), (b)

If e e a ede a ee be c ec ed a a c aeb e c ac ,
e a e de ca g a ead a d ea a a a da f a e ea e . C e
e Da meaningf l red ction credo, beca se the distrib tion in this instance o ld be pro
rata ( ith no meaningf l red ction across the board) and et still get sale treatment. This is
a e c e c aef c .
4. Disposition of controlled subsidiar

332 c ed b d a da e e e . If f da e, e IRS a ea
the parent as if it had been operating independentl . The s bsidiar s time can tack e
ae e ee e f e- ea e d f e a e da e a d d b e e ceed .
B t hat if parent j st sells s bsidiar s stock instead of liq idating? No special treatment,
beca e 332 da a cc ed. T e g ace doesn t carr if there is no transfer of
a ab e a e .
Note: If corporation simpl distrib tes s bsidiar s stock, then corporate di ision r le in
355(a), (b) a a a -f ee a b a e de a d c ae e e f e e ae
e (a e e e e a a a da afe a b 302(e)(2))
Problem 223
(a) Sa e ea e f M & P f afe a b e ce ;c ge 301, 243 DRD, 1059
e . P aad b , e a c e e d .
(b) R e f e- ea e e e f e afe a b .
(c) 302(e)(1) e f e eeab e e e ca e de c ,a d e ceed f a ce
d b a ed b ed a e de . Q a f e a a e ea e de ge e a
e.
(d) Sa e ea e a a a a da .
(e) I ac , a d de d. Pa a da f -c aed b ee .
O d a f f a e ea e f I fe de e f ef 302 c e a. I
ca e, 302(b)(3) e a f ee a e, ae ea e OK.
(f) W n t q alif nder safe harbor beca se of fi e- ear e istence test. Also doesn t
beca e ad b fb e a e a d a a a da . See Reg 1.346-
1(a).

C a e Ta a O e
(g) See RR 79-184. Parent attrib tion for s bsidiar s operation and b siness .
( ) See RR 79-184. Parent attrib tion for s bsidiar s operation and b siness histor .
B. Redemption planning techniques

1. Bootstrap sales
Zen 229 (6th Cir. 1954)
I eg a ed, ea a ged a ac a IRS , a d da d fa de a e ea e
ec f 302(b)(3). W a , e d g e d e e ee c , d a f e
c a d a a d e ad e c edee e e a de a ea c f
s bstantiall all of the corp s acc m lated earnings and prof . IRS c a ed a e a e
f ec a a d de d, Ze c a ed a a 302 ede . Led Revenue
Ruling 75-447 the order of the steps doesn t matter, b t e recogni e that e lost nder
Ze , e a ac (Ze ede a d e ae f c , e e ed de f
e [ a e f c a d e ede ]) be ea ed a a d de d. 302(b)(2) be
applied hen all the d st has settled b c a g c e e- a d -
a ac .
2. Bu -sell agreements: Constructive dividend issues

Arnes 250 (9th Cir. 1992)

McDonald s franchise redemption prompted beca se of di orce. Wife characteri ed that the
c ede a ac a d e ba d a ad ce dec ee, a d d
a e 1041 e e e e ec g . Se 1 e ge 1041 e e e . S e 2
c a edee ae f ba d (ba ca a e ed ff e c f e
c a e ce f e a e ). H ba d ge a e ed 302(d) a d 301 beca e
c c e ede a 100% a e de e e a a d de d. S e ea c e ed
e e .
N e: IRS a e ed def c e c aga ba d c e aef e $450K f
e - fe, b beca e e e c aea e e be ee e ceed g ( e
a a a e ceed g , e a a a ceed g ).
Grove 256 (2nd Cir. 1973)

C a ab e ba . G e, a a e de f c , c a ed c a ab e c b
ded c de 170(e) for the FMV of his stock in corp donated to RPI. Corp redeems RPI s
stock, and RPI doesn t care abo t their classification beca se the re ta e empt. What if
G e ad edee ed e c f , a d e d a ed e ceed RPI? W d a e bee
a ede f G e. IRS a G e a c e, b a g a ge ded c . S
IRS a a a a e a ac ,a d a e e e a e a a ged, d be
termed a redemption that doesn t pass 302 e . G e a RPI asn t nder obligation to
edee ae, d be fa ea e a ac a a fa eg a ed a .
Co rt bo ght it, regardless of Gro e s life interest in the donated stock and s stematic
c b e a e e RPI.
170(f) has remedied Gro e in f rther defining hat can and can t q alif for charitable
c b ea e .
C. Redemptions through related corporations

304 (e ce (b)(3)(C), (D), (b)(4)). Reg 1.304-2(a), (c) E a e (1), (3), a d (4).
304 Labe ed a a ede e, b ea ab ede ( ead: e eg a e
e )? L e ad f a ca a e c ga / e a ac . What s
d ffe e 304 a a ea ede a c e c ? A e ea e e c e f c ae
ce, b c ge b ea e e c a ge.
W a ab ae / b da a ac ? S b ec e g e ed c . W e a ed
settles in the transaction, look at the shareholder s o nership interest in the pare c .

C a e Ta a O e
J a e a ea ae f c b ac g a e de a e c a
c ed, 304 ma appl if there hasn t been a change in control sufficient to a ard sale
ea e .
Niederme er 268 (Ta Court 1974)

304(a), (c)(3) A e a ge . Sa e f c be ee c a . 302(b) e
e f g c . c a ge e a AT&T, a d g f 91%
ac a a d a b ab e e- a ac , 0% ac a a d 68% a b (f a e f 72%
e e c a ge a f a d g c eca c a ed). M a d e
a 302(b) beca e e a ed c ee e ae e ee a fa a b
a e (a d e a ac d a f f 302(c)(2) immediatel because the transaction as
a f a g e, eg a ed a ). N c c e e ea a e e g ee
d be 0%. P b e : e a e d f a d g c ; a d ed
efe ed c - a ac ( b ec agf c a ). N fa e ce ,e e.
Problems 275
1. I ead g N ede e e , a e e a e ab e a e ef g:
(a) W d d 304 a e aeb e a a e f e AT&T c c Le ?
(b) Gi en that 304 applies, ho do ou test the redemption to determine if the ta pa ers ha e a
d de d?
(c) W ee e a a e ab e a e fa a b ?
(d) H c d e a e a ded f ae e ?
A e ed ge e a e ca e c e ab e.
2. Ba C , 100 a e , acc a ed ea g E&P. O C , 100 a e , $5K

acc a ed, E&P. C a de, 80 Ba (ba = $500 e /$40K a ), 60 O (ba = $150
e /$9K a ). Re a g ae ed b e a ed d d a . Ta c e e ce e :
(a) C a de e 20 O Ba f $4K ($1K e ba )?
(b) Sa e a (a), e ce C a de ece e $3K a d e Ba a e (FMV $1K)?
(c) Sa e a (a), e ce C a de ece e e Ba a e, a d Ba a e e 20 O ae b ec
a $3K ab a C a de c ed b e 20 a e f O ?
(d) C a de e O ae Ba f $12K?
D. Redemptions to pa death ta es
303(a), (b)(1)-(3), (c). S 6166.
O e-time e emption from ta es for redemption of a decedent s stock. Decedent s redeemable
c c e e 35% f e e e e a e, agg ega a be a ed f e
corps if at least 20% of the corps total outstanding stock is in the estate. For the latter test, stock
ed a a e a be c ded e ca c a .
E. Stock Dividends and 306 stock

305, 306, 317(a)
1. Ta ation of stock dividends under 305
305(a)-(d); 307; 312(d)(1)(B), (f)(2); 1223(5).
Ge e a e: S c ece ed a -f ee de 305(a) ea ed a a c a of the recipient s old
c . Acc d g , e ba e d ae d ded a ga ae a ea e
FMV.
E . If B 100 C a e a $20 ba , a d C d b e 1 f 1 c d de d, e B
e d 200 C a e a d ba ead d $10 e .
E ce : 305(b)
(1) O a c ca T e e c ce: ced ece e c , ece e c ?
O ega e e a -f ee a fe .
(2) D aed b ! N b d a a e a c ce, b f e effec a e a e
e c ea e e a e e , e e a a e ca
e , e e e d de d a ab e.

C a e Ta a O e
(3) C efe ed I d ca e f e c a ge a e de e d g
co p f e pe fo mance (diffe en lice d ing liq idi /liq ida ion).
(4) S c d de d ON efe ed E a d ca f e a e a d ea g
da e de e fc a e de .
(5) C e b e efe ed Ba ca (3) a ade f be a e aga .
(6) C c e c d de d 305(c) e e e ede a a ec c e d de d
a d a ab e.
Problems 289
1. Ta con eq ence on he e edemp ion in ligh of 305?
(a) N a .
(b) B Fa a d J ce a e a ed, beca e B c d de d a ed. F a a ed beca e
p efe ed holde had op ion ( ee a o lang age an ).
(c) N a A d de d; B d de d a ed a a c e de 301. 1-305.3(b)(4).
(d) E a d he p efe ed b cke , and n in o (2). C a ge f a ee . T a e :
add a ee , e e a a a a e e . T a
ha n eall happened he e, ho gh, b he a o pa en he ica b ad e g e c a
a e f eg a d de d c . S fa a f e e a e .
(e) F ank ill ge e e hing, e en ho gh he e a ne p io i . The ne p io i doe n ma e iall
change an one p opo ional in e e , beca e P efe ed A ea f efe e ce E&P
bef e e b d a ed efe ed c .
(f) Debe e de a e c de beca e e debe e a e c e b e, a d fa de e
305(d) def a a e de . Bec e d aed b .
(g) T e c e a e efe ed c de g ed a a e f ee a
e ed de e d f ed a . S d be ad e e a c e e ce beca e e
ha eholde igh don change, and F ank c - -c a fe e 305
c i e ia. Ho e e , ha abo he di ib ion o Fa and Jo ce on p efe ed ock? Well, an
d de d efe ed d a be a ab e, b (b)(4) allo an e cep ion ha on
e f ce a a f he di ib ion of a con e ion a io change i impl o p e e e he in e e
f e efe ed a e de g fa c .
( ) S a da d a d b a a ab e de 301.
( ) P efe ed c e b e c . O aga , ce ba ca a - e c c
d b a e ead a c a ge a a eca e . Ta ab e e
e IRS a e a d a e (b)(5). Te c de g f ce e f
c e . I ca e, beca e f e 20 ea fe a f e c e , e bab a
c e f eb e a ea e cce f ( ded a e ce e a e
c e a ac e). If e e ec e , e e ee be a.
b a ea a Fa a d J ce a e a ab e de (b)(5) a d F a a ab e de (b)(3)(B).
2. 305(c) be fZc ag ee a a ede f 50 a e a e e ec f eac

a e de , a d A (500 a e ) a e c a e ec c ec e ea ? B (300) a d C (200)
d e ec .
T a d de e d e e ZC a a c e E&P. A a , f a c d de d,
b ce ain ha eholde in e e inc ea e a hi plan p og e e . Redemp ion i ce ed de
302(a)(1) (303 304 b e, b ca e). We , 20% e a f g e,
e e hing el e... So look o meaningf l ed c ion in o ne hip acco ding o Da . Af e e f
ede , B a d C ca c b e e pec i e o e o o e n an hing A doe he e he co ldn
bef e. A ge a e ea e , B a d C a e c c e c d de d ONLY f a ede
c 301 a e. I ca e, B a d C a Y1.
B Y2, e ede f Ad e mee he afe ha bo , and A ge hi i h 301 a a
ea edemp ion. No 305(c) f B a d C. T e ee a ec c e, a ab e d de d
e e ede ae a ed. T e e ede a e a f a e d c ede a , e
be Y2.
2. Section 306 stock

C a e Ta a O e
A. The preferred stock bailout
Chamberlin 290 (6th Cir. 1954)

D b f efe ed c a a f e ded be ed a e edee ab e b ce a a e
a d a e. C OKed a ac ,e e ac edg e f e a a da ce e ,
beca e e f rm hadn t violated the la . T ee- e a ac a ade e e e a -d de d
a e g e a ce c a e (S e 1: efe ed c d de d C a be ; S e 2: a e
f e efe ed c a ce c a e ; S e 3: ede f efe ed f a ce
c a e ).
B. The operation of 306
i. 306 stock defined

Tainted 306 c a c e a c c d b ed b a c a f
ece ed b e a a e a -f ee de 305(a). A c de c ece ed a a -f ee
e ga a f e ece f a c ad e effec f a d de d. Add a , c
e c a ged f 306 c a be 306 c f ece ed a ca e ba a ac .
T e a -ba c e e ac a d b e c ,a d e edee ae
f e ae de a d g e 301 a ab e d de d a .
Of course, that leaves the question, What is common stock? T ca , e IRS def e
a a c , e e g , a a c ae b a a e c
c aeg .
RR 76-383 a a c ed af g f ef a ec ,b e e
c ee ec c ( ea g a f ee g )
c c beca e e g ae be a a e de e e dec ed ce
e .
RR 79-163 a a a c ed a e c g a a ed g
dividends or limited rights upon liquidation aren t common stock.
ii. Dispositions of 306 stock

T d ead d ffe e e:
Ta ab e: A a ab e d f 306 c ge e a d ce d a c e e
a fe . If 306 c edee ed, e a ea ed e ede ea ed a a
d b , ge e a g 301 c e. T e ede f 306 c a be ea ed a a
d de d ee e f E&P a e e f e ede . O e e, d b
e ed a e ea ed a a a e ca a (c)(2).
S d: M ec e look back e. Se e ge e a e d a c e e
e e a e ae d a e bee a d de d a e e f e a d b .
So the seller has to look back to the corp s E&P a the time of distribu ca c a e
c d a c e e ea e e c e a e, a d a e ce ea a
ea ed a a ed c ba f e 306 c . E ce be d a a ga f ae
f c . T e d a c e ca be c a ed a a 243 DRD, and the issuing corp can t
ed ce E&P e 306 c d.
iii. Dispositions e empt from 306

Ta a da ce a d e eg a e C a be . O c e e de g ed a
a e ec a e b ec 306 a . T e ef e, 306 a e e a e de
e e c ea d a a fc a e ea g e ea g e a e ea e f c ae
c . A bef e, e e a e:
C ee e a f e e ( ea g d a f c a b
a f ca ),
302(b)(3) e a f ee ,
302(b)(4) a a da ,

C a e Ta a O e
Rede f 306 c c ee da ,
N ec g a fe (351 a fe , c b ca a , e c.),
A d b a dd ede f db e IRS be a fa a
a da ce a .
Fireoved 302 (3rd Cir. 1972)

T ea e C a be . F e ed edee ed efe ed a e ac a e c a ed
de 306 e ce a ca a ga . C d a ed, a g a ede e
a d a e e efe ed c f e 306 e ce . B e dg e e ca
be ed a a defe e f e e a d ac ca f ca be d a a da ce.
Problems 309
1. I Y1, A g a C d b ed c e b e, g efe ed c $1K
Ja a d Ve a, e a ed 50/50 c a e de . C ba f $2K
d b a d $3K ed a e af e . A e fd b ,A g a ad $2K E&P. I
Y3, A g a ad $3K E&P.
(a) Y1 a c e e ce ? Ta -f ee de 305(a) d b ,b a ab e ba ?
307(a) f a c a ed ba d de d a a f a -f ee d de d , a e e ba f
e g a c a dd b e a g e c b ed d a d e c a .
I ca e, efe ed + c $1K + $3K = $4K FMV. T e a e c
ea dd b e a acc d g e c e FMV ($4K). Beca e $3K
f $4K, $1.5K ba f e $2K c e a ca ed c ; e
e a g $.5K ( f $4K) a b ab e efe ed.
(b) 306(a)(1)(A) a a Ve a a $1K d a 301 income, limi ed onl b he ra able
hare e cep ion and in oking he (a)(1)(A)( ) -bac e c ec Y1 f ad bee
ca ead f e c d b ed. Limi doe n come in o pla here beca e ca h
d b Y1 d a e bee $1K.
(c) I ca e, e $1K- d- a e-bee -d de d a a ca d a c e a a (b),
a. Add a , e -bac e a a e e $750 e ce e e d-
a e-bee d b . (a)(1)(B) a add e a ab e a e ($1K) e
a c a ed ba ($500 f (a), a) ea e $250 a ge ca a ga ea e . T a
ea e $500 f a -f ee e f ba . If Ve a ad d f e e a ab e a e
, e e e ce ba d a e bee a b ed e e a g ae .
(d) All ran ac ion are OK. No ain if di idend a n po ible in he fir place (c)(2).
(e) A d (d a) f c a n a rede a ab e. (a), (a)(1).
H e e , ce e e ec g ed ga , (b)(3) a a a Ja (a)
doe n appl . B a a fe f 306 c , e a 306 a ed e C a de
e e (c)(1)(C). T e a e bec e d a c e ee e f e -
bac . T e ba ca e e f Ja . B C a de c ee e a g
ee Ag a ,a d e e ga d ae g a dc d a b , 306(b)(1)
a C a de a d 306 a d e ece e LTCG ea e .
If Ja ad d ed, e 306 doe n appl and he ock i n ain ed.

(f) Redemp ion of Ja on preferred for $1.5K and a f f c f $5K?
C c ge e c a ge ea e de 302(b)(2) beca e f e b a a
ed c c . P efe ed a ed, ede a Y3, Y3 A g a a $3K
E&P, a d a f e efe ed ede a d de d. (a)(2). T e c bec e a
$4.25K ga af e ba ($750) ec e ed, a ab 306(b)(4)(B)? N
a ce f a c a f a a da ce, b Ja d ed f a f e
c c , (b)(4) doe n appl . So ha abo ha e ra por ion? I imm ni e
a lea half of he common beca e here i n an bail- fea e f c c .
O ee e a d e f e de gc c a ca ed e 306
a ...
(g) N e d a f f e (b)(4) e ce beca e e b a d ca e a e
a a a da ce e, ca g 306 a a d a g a $1.5K ece e 301 ea e .

C a e Ta a O e
( ) Ye , 306 c ; e , ede b ec 306(a)(2); b a f ee e ca a beca e
a d de d b a e ca a .
2. Za c C , 100 c (a ed b Sa S f ), e a e g E&P.
(a)
(b)
F. Complete Liquidations
1. Complete liquidations under 331
A. Consequences to the shareholders
331, 334(a), 346(a) 453( )(1)(A)-(B); Reg 1.331-1(a), (b), (e).
N a ea ed a f a e de ad d e c ec a e c a ge f e
co a e . 331(a). T ca , e da g c ec g e ga a f ad d e
d b ed a e e a e de a FMV. Eac a e de ec g e ga e
d ffe e ce be ee e ad ed ba e c a d ea . Eac a e de a e a
FMV e - ba e a e ece ed.
C ae fa e a a e e d e e a e ea a ae de
ec e ba bef e e g ga .
Shareholder level ta on corp earnings:

P c
T g Sha eholde a e a ed on co E&P onl if and hen he co i e a di idend.
W ede bec a a e g g beca e f ed.
Ta a e W g
Ra e 301(c)(1) d a c e W ede bec a g aga . Sa e f da , ee
331 e ca a ga ea e
C a e:
A) C ae fa e a dc da ;
B) I - d da a d ae de a e f a e .
B2 - A e a e
$$ e c a ge
S ae de
T d
Pa
B1 - d B e
da
A2 ca
da
A1 - A e a e
$$ e c a ge
C
A) S e 1 c a e f a e a ed de 1001 a c e e ga / ec g ; S e 2 SH
ec g de 331. D b e a effec , g e .

C a e Ta a O e
B) S e 1 - d da c ea e SH- e e a c a ec a de 331(a), b he e
c e e a a ec a ed a e ( e-Ge e a U e )a d ae de a e 334(a)
FMV ba .
Seg e e ec : C g e e ed ed d ce a c a e e d e /d ffe e a
eg e be b f g g ec ae a ef e a e. I 1986, C g e e ed
e e a d e ac ed 336 e gc a e- e e ec g .
Problem 315
A, 100 a e H d , $10K ba . H d a $12K acc a ed E&P. H d
da e ; a c e e ce A?
(a) H d d b e $20K A e c a ge f c ?
(b) W a f (a) ab e a a $10K d b Y1 a d a e $10K Y2? A be
f a a fc ee da ?
(c)
(d)
(e)
B. Consequences to the liquidating corporation

336(a)-(d), 267(a)(1), (b), (c).
i. Background
Court Holding Co. 317 (1945)
Cumberland PSC 318 (1950)
ii. Liquidating distributions and sales

336(a) a d ec g ec
iii. Limitations on recognition of loss

336(d)(1) ela ed pe on ecogni ion di q alifica ion a d (d)(1)(B) di q alified p ope :
D b e a ed e , .e. c g a e de ( ee 267 f def ),
a f ec g f f e e (1) e d b -aaa g e
a e de , (2) e d b ed e a ac ed b e da gc a 352
a ac a ac b ca a e f e- ea e d e d g e da e f e
d b .
P c e -aa e e e ? C ge e ab e ded ge
a e ea a a e de ece e a ee e a
d ae e c ee ec .
P c d a a ce f 351 ec g e c a ge e ?
336(d)(2) a a da ce b lo ffing :
Pe e e d b g f e-c b b - e. O a e fd b gc
ac ed e a 351 a ac ac b ca a a a f a
c e e ec g e e da . L e ae ed a f
acc ed -c ac . P e-c b e a e ded c ed aga e ba , b
ca fa be e . Add a , e a be ec g ed a e b a ed
b ec ea f e ad fa da a T ea a a.
L a e ab e d ag a ed a ac . W a f ee a d , e e a e de
e e c d ec e d a b e (S e 1), a d e eb e - d da e
(S e 2)? T gge 1001 ga / a a e de e e ; - d a e e c a ge e 336
a e e e ga / . A f ef ee a e a e ac .
W a ab af ? S e 1, c a e f a e ; S e 2, da . 1001
a e g/ , e ae ceed S e 2, b ee e e b. A acc a ed,

C a e Ta a O e
d b ed e e c e b g a a aa c e f e a fee a d ea g
a e (531, 541).
Fifth option: 1. SH sale of stock to 3PB; 2. 3PB doesn t liq idate. 1001 c g/ ; a d
336 c e e a e ga .
S : 1. SH a e f a ea 80% c ; 2. 3PB c a d da e . 1001 g/ ; b

- d da defe c a e a e de ae f e a e . 336
337, 334(b), 381(a)(1).
Se e : 1. SH a e f c ; 2. 3PB e ec 338. T e K be -D a d ca e
e a ac , b a ce a d ec a e ac . E ec g 338 c de e c
a e a a e ac . W d a e e ec ee c c a ce : f a e
a e e dec ed a e; f a e a e a ec a ed, b f a ge c a e ea g
ca e ;a d
Eg : 1. SH a e f c , SH c g a e c ; 2. 338(a) AND
338( )(10) e ec . Pa e da e b - d, a e e c 3PB. O g
338 a ac c e e a a e ga .
L f a cab f 338 e a .
Problem 328
2. Liquidation of a subsidiar
332, 334(b)(1), 1223(1); Reg 1.332-1,-2,-5.
George L. Riggs, Inc. 331 (Ta Court 1975)
Pa e c 3PB
332 331
334(b) ca e ba 336, 336(d)(3) ec g. a a dec ed a e
381(a)(1) E&P ca e
S b da
337
B. Consequences to the liquidating subsidiar

336(d)(3), 337(a), (b)(1), (c), (d); 381(a)(1), (c)(2), (3); 453B(d), 1245(b)(3), 1250(d)(3); Reg
1.332-7.
No triggering of corp ta to the parent to the e tent that the liq idated s bsidiar s assets are going
e a e . T e a e a e g e a 334(b) ca e ba , a d e a be ca g ae
hen shareholder sells stock ( hich ill reflect parent s al e ith additional liq idation
ceed ).
III. Transfer of a Corporate Business
A. Ta ab e Ac
B. O e e f Ac e Re ga a

C a e Ta a O e
IV. Limits on the Retained Earnings Strateg
A. Pe a Ta e

Corporate Taxation Outline
I. Overview of Enterprise Taxation
How is corporate income federally taxed?
Three categories in the Code:
1. Sole proprietor (individual owner)
2. Partnership
3. Corporation
A. Conduit v. Entity Taxation
Business directly owned by proprietor
Taxed under §1, Schedule C – normal income tax
Business tax information reported with personal statements
Joint owners may be treated individually as sole proprietors for tax purposes
o Joint owners may individually elect to use different accounting methods, etc. on their tax
forms
o Cf. Partners, who are bound by joint firm decisions
2. Partnerships
Pass-through or Conduit taxation
Calculated as a business, but taxed to the individual partners
701 – not taxed as income of the firm directly, but as income to the partners.
702 – in determining income tax, each partner is taxed according to their interest in the business
on a pro rata basis of business income or loss. See also 703, 704.
Key: Allocation to partners of distributed share
Partners have to report distributive share of profit income, even if not actually distributed. If
partnership retains earnings, partners are still taxed.
3. Corporations
11(a) – corporation computes its profit or loss and is taxed as an entity
11(b) –“progressive” tax schedule, but most taxable corporations (except the largest ones) are subject
to a flat rate of 34%
The flip side of §11
61(a)(7) – dividends and the double tax. Corporation is taxed once, and earnings taxed again when
distributed as income to individual shareholders
A. C Corporations
“Regular corporations”
i. Corporate earnings are subject to “double tax,” once on corporate earnings, and once more
when earnings are distributed to shareholders through their income taxes.
Models of double tax. Assume TP owns all shares of Corp X, which made $100 in profit this
year. Assume applicable tax rates are corporate, 46%; individual, 70%; LTCG, 40%:
o Dividend Distribution – all after tax profits distributed to shareholder
Simplest form – a.k.a. “double tax”
CIT 46
Dividend 54
PIT 37.80 (.7 x 54)
TP’s after tax proceeds 16.20 (54 – 37.80)
Combined effective tax rate (sum of total taxes as percent of original income) – 83.8%
o Deductible Distribution – X distributes all $100 to TP as rent paid (deductible under
162(a)(3)) for premises leased from TP – still paid out to shareholder, but colored as a
business expense instead of a dividend. Most common in closely held corps, tends to be
self-policed by unrelated shareholders in large and widely held corps
Disguised dividend – modified pass-through when business pays expenses to shareholder
CIT 0
Distribution as rent 100
Wiedenbeck Spring 2002 RJZ 1

PIT 70
TP’s after tax proceeds 30
Combined effective tax rate – 70%
Are there any limits on the DD strategy? Only if closely held corp.
Reasonableness – “rent” in this situation would be subject to a substance test in
review. Tax consequences are not controlled by title, so if the corporation were to
distribute a gross over amount to an interested shareholder for any otherwise legit
purpose, they would be improper as to the amount of excess distribution. Substance
over form question.
o Retained Earnings – X retains and reinvests the $100; TP sells all stock in X at end of
year
Capital gain bailout
CIT 46
RE 54
Price paid for add’l assets 54
PIT 15.12 (.7 x .4 x 54, applying LTCP tax preference)
1001 – realized gain/loss – sales proceeds go up by the amount of reinvestment, but the
individual basis is the same as the amount she paid for the stock when originally bought.
Combined effective tax rate – 61.12%
Note: the one year mark is only required of the stock. In basic tax, the determinative
factor is whether the property sold is a capital asset. In this case, the asset is the stock
and not the $54 in RE.
Key to profitable following of RE strategy is based SOLELY on higher/lower
Are there any limits on how long may the RE strategy be taken advantage of?
o Penalty taxes (accumulated earnings tax 531/532/535(a),(c)(1)/537(a)(1), personal
holding company tax AET/541/)
AET: Congress encourages retention to foster “reasonable anticipated” (from 537(a))
internal growth (includes internal expansion and acquisitions according to Treasury
regulations), but excessive abuse of RE will result in massive tax consequences
through the AET formula above
Note – subjective test in 532 applicable only to corporations purposely formed
or availed to avoid tax liability!
PHCT: No subjective test as in AET. Two part test (% of income that is PHC
income, 5 or fewer controlling stockholders test)
o Corporate redemption of sock (another distribution, but not as a dividend)
o Liquidation of corporation – exchange stock for assets
Because of the retained earnings model, corporations have traditionally been used as tax reduction
vehicles. Shareholder nets value form sales of stock (1001 capital gain), and not in the more
highly taxable form of dividends. Less tax than if she had been sole proprietor, less tax than the
other two strategies.
Consequences of a corporate tax regime: tax rates. Unlike the S corporation, the C corp may
screw up vertical equity because it disproportionally taxes equity holders not according to their
respective stake, but unilaterally. This may disadvantage small stakeholders (like geriatrics
holding a few shares of stock).
B. S Corporations
If there is no corporate expectation of advantageous RE scheme, then may elect to incorporate as S
corp. Avoids tax liability on corporate earnings, but earnings must be reported. Shareholders are
then taxed on their pro rata share of the corporate earnings no matter the income’s disposition
(distributed to shareholders or not). The character of the monies reported (loss, gain, deduction,
credit) is retained in the taxpayer’s hands.
Limitations

o Eligibility – Cannot incorporate as S if more than 75 shareholders, one or more is foreign,
any shareholder is not an individual, more than one class of stock exists. All
shareholders must approve the S structure. 1361(a)
o Losses – shareholders cannot deduct losses in C corp because corporation is separate
entity, but S corps materialize losses as personal losses against unrelated income. 172.
Limited losses allowable as offset to percentage ownership. 1366(d)(1). Less generous
than partnership loss allowances, though.
o Special allocations – bars allocations because of only one class of stock. 1361(a).
o Owner-firm transactions – still controlled by C rules, while partnerships aren’t. 1371(a).
Conduit tax regime ensures that you pay a rate that is proportionate to your overall income,
unlike the note above showing the frustration of vertical equity.
4. Partnerships and Limited Liability Companies
A. Partnerships
B. Limited Liability Companies

Personal service corporations (PSCs) generally follow deductible distribution strategy to the
hilt
5. Policies
A. The double tax – treating corporations as separate entities form their shareholders. Central theme
in corporate taxation. Critics say it is inefficiently biased 1) against corporate as opposed to
noncorporate investment, 2) in favor of excessive debt financing for C corps, and 3) in favor of RE
at the corporate level rather than dividend distribution.
B. Higher personal rates create incentive for corporate investment
C. Favorable capital gains rates create incentive for long-term investment
D. Nonrecognition – gains or losses not taxable until realized in sale, exchange, or other event that
makes them easily measurable
6. Common law
A. Sham transaction – transaction that never occurred but is represented by the taxpayer as having
occurred. Usually reserved for more egregious cases, typically defined where court finds that
taxpayer was motivated by no business purpose other than obtaining tax benefits, and there is no
substance to the transaction because no reasonable possibility of profit exists
B. Substance over form – a business’ definition of a disputed transaction is not determinative. What
the transaction accomplishes, rather than what it portends to be, if the common law key to review
C. Business purpose – no valid business purpose but to create tax savings
D. Step transaction doctrine – combination of formally distinct transactions to determine tax
treatment of the integrated series of events. Interrelatedness of events to allow this test is a gray
area (some courts require binding legal commitments enforcing the whole of the transactions,
others simply look for “mutual interdependence”)
B. The Corporation as a Taxable Entity 1-27
1. Corporate income tax

A. Rates 11(b)(1)
Taxable income Rate
0 to $50K 15%
$50,001 to $75K 25%
$75,001 to $10M 34%
* $100K to 335K add 5%
* $15M+ add lesser of 3% or $100K
$18,333,333 35% flat rate

* - Rate “bubbles” to wipe out the advantages of the first $75K in income at the earlier rates. See
11(b).
B. Determination of taxable income 63(a)

Computed similarly to personal income taxes, with following exceptions:
No personal or dependency exemptions, medical expense, spousal support, etc., deductions
No standard deduction
70-100% deduction allowed to corporate shareholders for subsidiary dividend distribution to
parent corp
o Effect of 70% dividends received deduction is that corps are subject to 10.2%maximum
tax rate on dividends (34% rate x 30% includable portion of dividends). 243(a).
10% deduction limit to charitable contributions
$1M per year limit to publicly traded corps for executive compensation
Corp losses only deductible to extent of corp gains 1211
o Excess may be carried back three years or forward five

Lower brackets of §11. PSC taxed at 35% - not eligible for graduated rates. 11(b)(2), 1561.
Restricted accounting methods. 448. C corps generally not allowed to use cash method
accounting – must use accrual method accounting. C corps can generally afford to pay
someone the extra money for accrual, and it’s more accurate.
C corp can pick fiscal year, PSCs have to use calendar years. 441(i).
Distributions from subsidiaries – see above, 243(a). Only available to C corps.
D. Fairness and CIT

The breakdown of horizontal and vertical equity arguments for scaled taxes
Large corp with thousands of shareholders retains all earnings – violates verical equity
Two individuals, A & B, own all stock of corp A and corp B, respectively. Corps A & B have
equal revenue and operating expenses
o Additionally, need to know what each corp is doing with its earnings
o Assume that both corps distribute all after tax profits as dividends. Would still provide
horizontal equity.
o Assume A capitalize din stock exclusively; B partly in stock, but mostly in corporate
debt. B will see some deductible to the extent of corporate debt, while seemingly
economically identical A will not. Violates horizontal equity
E. Incidence of CIT
Short run – burdens shareholders if industry is perfectly competitive (commodity) or
unregulated monopolies
Long run – shifting of burden to owners of ALL capital
o X corp current dividend distribution
Y partnership
Differential will occur until after tax implications equalize and the cost of capital is
resultantly increased because of higher supply of capital (less tax, more in pocket, less
need for financing, more cash in bank stockpiles, lower interest rates)
F. Economic neutrality and inefficiencies in allocative resources

CIT favors unincorporated over incorporated businesses
CIT favors RE over current distribution
CIT favors debt rather than equity capitalization
Net result is estimated 25% deadweight loss in total CIT tax revenues
2. Alternative minimum tax 55, 56(a)(1)(A), (c), (g)(1-3; 4(A-Cii)), (5), (6); 57(a)(5-6)
Flat rate tax imposed on a broader income base than the taxable income yardstick used for the
regular corporate tax. Payable only to the extent that it exceeds corp’s regular tax liability.

AMT income (AMTI) taxed at 20% after initial $40K exemption. AMTI = CTI + tax preference
items – certain timing benefits from regular taxation
Adjusted current earnings (ACE)
Reread pp. 16-17. Confusing.
Ownership tests prevent splitting corporate profits among smaller corporations to minimize tax
liability. 11(b)(2).
Avoids ACE/AMT maze by passing corporate tax through to personal shareholder level. General
forms:
Problem 19
(a) Boots, Inc.’s taxable income $900,000
Regular tax liability $
(b)
(c)
(d)

Possible integration of corporate and individual tax systems into single, coherent, and equitable
system.
a. Dividends paid deduction to corporations (like interest payments). Would neutralize debt
capitalization favorableness. Eliminates CIT
b. Dividends received exclusion – Eliminates SH tax
c. Imputation-credit system – CIT remains, dividends taxed on SH, but dividend is increased to
comp for the CIT and CIT is treated as a credit against SH’s tax liability (i.e. $100 profit * .35
= $65 dividend, but “gross up”/impute dividend by CIT, so SH reports $100 dividend on
which they can claim the CIT as credit. SH at 40% taxable will have $35 credit, then simply
pays $5 difference)
d. Distribution relief alternatives:
Corp and SH taxes equal,
All shareholders taxable, AND
No corp tax preferences, then all three forms above yield same result.
Conduit tax treatment, but difficult to determine appropriate allocative tax treatment because of
disparate stock class treatment. General view is that unless different classes of stock are outlawed,
current complex capital structures prevent this type of integration. “Best in principle” winner,
Cannes 2002.
C. General capital tax

Treasury’s 1992 Comprehensive Business Income Tax (CBIT) proposal. Addressed bias between
distribution and RE strategies. As follows:
a. Deny deduction for any payments to capital owners (interest/dividends),
b. Interest and dividends received excluded from second round of taxation
c. Apply system to all business, regardless of business form
1. In general
Federal classification of business entities does not hinge on state law labels. However, state law
governance of legal relationships provides the criteria that the federal classifications are based on.

These federal adaptations of the “overall resemblance” test are contained in Reg. 301.7701-1 through -
3. It lists six characteristics normally found in a “pure” corporation:
Associates (two or more persons in shared control and ownership)
An objective to carry out the business and divide the gains therefrom
Continuity of life
Centralization of management
Limited liability
Free transferability of interest (shareholder ability to dispose of their shares)
A business will thus be treated as a corporation under federal tax laws if it more closely resembles this
organization than it does a partnership. This process of distinguishing between the two has caused
problems.
Absence of first two characteristics will prevent organization from classification as an association.
When distinguishing between associations and partnerships, the last four are considered and
weighted equally. Classification as an association will only occur if three of the remaining four
are present.
B. Limited liability companies

IRS classified as partnerships. Principal benefit of LLC over limited partnerships and S corps
(other pass-through entities) is that owners have limited liability, but may participate in business
management. Also, no strict eligibility requirements like S corps, and flexibility in taxation under
Subchapter K. Looks to be the dominant organizational form for the foreseeable future.
C. “Check the Box” regulations

Because of thinning lines between state law definitions of corps and partnerships, IRS chucked the
four-factor system in favor of default tax classification as partnerships unless electively “checking
the box” to be taxed as a C corp. This is only for businesses that have not incorporated under
some state incorporation law, because to change the regulations governing them would free them
from the statutory definition of “corporation” in 7701(a)(3) and frustrate the tax code. IRS regs
have no authority to revise statutes, but as a matter of policy are probably indicating that they’d
like Congress to change the statute itself.
Businesses may make this election after functioning as an S corp in the startup phase for loss pass-
through purposes. See 301.7701-3.c.iii – iv.
D. Publicly traded partnerships

Temporary loophole around double tax regime was amended quickly by congress when interest
began to be traded often like stock. 7704. PTPs are reclassified as corps when interests are either
1) traded on an established securities market, or 2) readily tradable on a secondary market.
Exceptions from reclassification on 90% or more of gross income is from passive income items
(dividends, rent, etc.).
301.7701-4. No double tax on trust income. Distributions are taxed to the recipient to the extent of the
trusts “distributable net income.” If trust income is accumulated, then it is taxed at §1(e) rates, and
normally not taxed again if the accumulated earnings are distributed later. If the trust becomes an
active trade or business, it is taxed as a normal corporation.
Two classes of trusts: 1) Conserve property (301.7701-4.a), and 2) “Active business” trusts
(301.7701-4.b). Regs suggest that ultimate test is whether state law trust is a state law “business
entity”.
Other considerations for trusts v. corporations: 1) active conduct of business, and 2) voluntary
association of business partners = corporate tax levied against trust. Spendthrift trusts are stuck in
this conundrum. See Estate of Bedell, 86 T.C. 1207 (1986).

Problem 36
(a) No double tax on the recipients. Trust was already taxed.
(b)
(c)
D. Recognition of the corporate entity

Ambiguity in relationships between agents and corporations examined.
Bollinger 37 (1988)
Shell corporation used as agent for partnership to avoid state usury laws and allow acquisition of bank
financing. When losses were incurred, Bollinger applied the accelerated depreciation deductions from the
real estate to his personal taxes (like a partnership) on income from other sources. IRS disallowed because
of state law formation as partnership, saying that losses must be attributed to corp. Tax court overturned,
US affirmed. If a corp is legitimately formed for reasons other than specifically avoiding tax
consequences, and the corp is acting as an agent for certain asset purposes as clearly indicated in corp
charter, no abusive avoidance scheme exists.
Why not an S corp? Severe limitations on pass-through for losses (not for gains, though).
II. Taxation of C Corporations
Quick taxable income overview

Income measurements –
Realization, look to intro language in 61, then 61(a)(3), 1001(a). Tax reckoning only when investment is
terminated.
Recognition, 1001(c)
Definition of 1001(c)*: Amount realized 1001(b) + case law
- Adjusted basis 1011 1012, plus or minus adjustments in 1016
Gain/loss Cost of property to extent you received
more than you put in.
Definition of gross income: Amount spent in consumption + change in taxpayer’s wealth.
* – Even though there is a realized gain, congress may choose to pass on taxing it. Most commonly because
gain is realized in technical sense, but investment continued in similar form. See e.g. 1031(a) (lifetime
exchanges), 351 (transfer to corporation nonrecognition). Every nonrecognition rule has an associated basis
rule. See e.g. 358 (associated basis rule for 351).
In corporations, 351 nonrecognition may occur if a transferor exchanges capital assets (as defined in 1221,
minus enumerated exceptions) for stock that is in essence merely a change in form of the initial investment in
the transferred property. The catch is when the transferor’s basis in the property is different than its FMV, and
is contingent on what the disposition of that property is after the transfer (i.e. transferor immediately sells the
received stock and must realize and recognize the FMV gain before he/she can recover their basis).
A. Corporate Organization
351(a), (c), (d)(1)-(2); 358(a), (b)(1); 362(a); 368(c); 1032(a); 1223(1), (2); 1245(b)(3).
Nonrecognition allows for avoidance of taxable consequences for raising business capital if the
exchange doesn’t substantially alter the nature of the transferor’s investment. Normal nonrecognition
policy consideration is that if swap is for such a similar form of investment, then the deferral in
accumulated value is warranted until this new investment is terminated for something substantially
different in form. 351 broadens this policy by nonrecognition of substance changes to encourage
business investment. The essence of 351 is to ascertain whether a transferor has a sufficiently
continuous relationship with the property transferred to a corporation to justify nonrecognition
treatment, or whether that transfer has severed the relationship with the transferred property, thereby

justifying recognition of a gain. Three requirements for nonrecognition benefits: 1) transfer of
property, 2) in exchange solely for stock, and 3) transferor control of corp immediately post exchange.

1032 is corporate nonrecognition statute – issuance of stock by corporation always a nonrecognition
transfer. 362 covers the basis for recognition by the corp – the transferor’s basis travels with the
transferred property, no matter the FMV. This is the crux of the problem in Intermountain Lumber,
infra, where the transferor wants recognition to avoid immediate taxes, but the corp wants to avoid so
they aren’t stuck with a lower basis than FMV (and cannot use depreciation of the more valuable FMV
figure as a tool to write off current taxes).
Property transferred retains its transferor’s basis while now in the control of the corp. Any gain or loss
on that property will be realized from the transferred basis. Same deal with transferees. If a transferee
exchanges property with a basis of $10 and FMV $100 for $100 in stock, then upon sale of the stock
(at $100) transferee must recognize $90 gain (as in $100 gain – $10 original basis).
1. Nonrecognition in 351, basis for recognition in 358.

2. Be aware of both sides of transaction (transferor and transferee tax consequences)
Problem 46
Realized gain/loss 1001(a)
Recognized gain/loss 1001(c), 351
Adjusted basis in property received 1012
Character of property received 1221
Holding period 1223
“Holding period” describes the tax status that differentiates capital gains from LTCG. If a
transferred item is a capital asset under 1221 (as opposed to normal income property), then the period
for which the transferor held that property prior to transfer may be “tacked on” to the stock received in
the exchange. Upon sale of the received stock, the total holding period will determine whether the
realized gain finally recognized is treated as short-term capital gains, or the lower bracketed LTCG.
(a) Distributor computations

A – Cash purchase = no material change. 1012 says basis in cash purchase is cost
B – Will realize $5K gain on sale of stock, none recognized. Character of property received changes
from inventory (which would have become regular income at sale) to stock with possible preferential
tax treatment under RE scheme
C – Must realize previously unrealized $5K loss immediately, won’t recognize until stock is sold
D – $25K realized, 0 recognized. Capital asset unless D is realtor. Won’t be able to clam a $5K loss
because D has already amortized $5K in depreciation on the transferred property. Looks like D meets
holding period. 1245(a)
E – $18K realized gain, no recognition, $2K basis transfers to stock. Promissory note becomes capital
asset under 453B(a), so 1223(1) tacking rule applies. 453B(a) mandates immediate recognition of gain
or loss on disposition of installment obligations because while E would have the 351 nonrecognition
allowance because the corp only gave him a promissory note in exchange for the property, he turned
around and sold it for hard cash.
(b) Distributee computations
Formalistic answer – corp didn’t contribute anything (the stock cost nothing, so they contributed zilch
to each transfer), so they realize full $100K of all transactions. But basis carries over with
corresponding transactions in 358(a), and tacking applies with 1223(2).
A – complete nonrecognition
B – Must recognize $5K gain when inventory is sold
C – May recognize $5K loss on sale of land
D – Must recognize $20K gain if equipment is sold.
E-
(c) Double tax. Justification? The transfer created new wealth of $10K, kind of like a successful double
down.

A. “Control” immediately after the exchange 351(a)

351 only applies if the transferors as a group “control” the corporation immediately after the
exchange. Must include direct ownership of at least 80% of all voting stock and 80% of all
nonvoting stock. 368(c). 318 constructive ownership rules don’t apply.
Intermountain Lumber 48 (Tax Ct. 1976)

Shook incorporated and transferred his mill to the new corporation. As part of the incorporation
plan, he agreed to sell 50% of his shares to Wilson. After the transfer, he tried to claim 351 so
he’d avoid taxes as nonrecognition of gain, and Wilson tried to argue that the stock agreement was
a sale so he could record a higher base and a larger deduction on higher depreciation. The court
said no, that the agreement to sell 50% was a condition of the incorporation, and thus Shook had
no intention of maintaining the 80% control necessary for 351 applicability. Intermountain had to
record the gains and depreciate them normally.
Even an implicit, albeit non-contractual agreement, will fall under the purview of the step-
transaction doctrine. Enforcement of this principle, though, is obviously problematic.
How could this have been constructed to still create a right to nonrecognition? Wilson was not a
contributor, and he should have been. Had he contributed at all, both Wilson and Shook would
have been transferors controlling 100% of the assets.
Options:
1. Cash contributions from both parties. Wilson contributes cash ($91K) directly to the
sawmill, Shook contributes the capital assets. Unfortunately, Shook would out-contribute
Wilson 2:1 ($182:$91), and the shares would more appropriately break down according to
that ratio.
2. Pre-incorporation partial sale. Shook sells half interest in his sole proprietorship to Wilson
(thus forming a partnership), and then incorporate it and buy the mill. Unfortunately, Shook
will be immediately taxed on all of the previously unrealized appreciation when he sells the
partnership interest to Wilson (only half of appreciation actually taxed because Shook only
sells half the partnership). On transfer to the lumber mill, Wilson will gain a FMV basis for
his contribution because of his initial cash purchase of the partnership interest being at FMV.
3. Cash boot. Shook contributes assets, Wilson contributes cash. Shook receives 182 shares of
stock, $91 cash “boot” back. Wilson contributes the same amount of cash and stock received.
However, this merely masks the transaction as contemporaneous corporate funneling to
Shook for control.
4. Lender financing. Bank makes $91K loan to Shook. He transfers the sole (encumbered)
proprietor assets to the lumber mill, Wilson contributes $91K. Both get 182 shares,
respectively. The lumber mill pays off the loan. The debt transfer does not prevent 351
nonrecognition, and the “constructive boot” is ignored for tax purposes (357(a)) ONLY IF the
loan is for some valid business purpose (357(b)).
5. Post-incorporation distribution. Shook transfers assets to lumber mill. Later, mill distributes
$91K to shareholders (Shook) as a 301(c)(2) return of capital (not a dividend because there
has been no profit in the corp yet). Wilson contributes $91K and receives 182 shares.
Nonrecognition on step 1, tax free return of capital on step 2, nonrecognition in step 3, but
still may run into a step-transaction doctrine problem.
6. Redemption. Initial transfer of assets from Shook ($182K FMV), $91K cash from Wilson,
and corp distributes 364 shares to Shook and 182 to Wilson. Corp then redeems 182 shares
outstanding from Shook for $91K.
B. Transfers of “property” and services

“Property” has been broadly construed to include cash, capital assets, inventory, AR, patents, and
in certain circumstances, intangible assets like patents and process knowledge. Services can’t be

considered property for 351 treatment, only income. 351(d). If a transferor receives stock for
both property and services, all of the stock can count against the 80% requirement. Stock as
compensation is computed under 83(b).
C. Solely for “stock”

Stock means normal equity investment with the company.
Problems 53-5
1. Qualify under 351?
(a) Yes to A’s transaction (realized but not recognized). Corp doesn’t pay tax because of 1032.
B gets hammered with both realization and recognition, even though B received all of the
nonvoting stock, because B ain’t got no control.
(b) Yes – step transaction doctrine. A and B are both transferors to the corp, and control is tested
on March 2 after B transfers.
(c) If control is tested post march 5, control is destroyed. D hasn’t contributed anything. But if
the test is as in (b), and that is successfully argued, then the nonrecognition still stands and the
“gift” is unrelated. Passes both narrow and broad interpretations of step-transaction doctrine,
either because the gift was not contractually binding (narrow), or because the gift was indeed a gift
and not a sale transaction in tax terms.
(d) No
2. Tax evaluations
Valuation in 61(a)(1), 83(a)
(a) No protection in 351, because Manager is offering service instead of property in exchange for
stock.
(b) Yes, 351 qualification if Manager is paying for her stock. As for the second part, “Is it
property?” A promissory note, if property, satisfies the control test. The total economic effect is
almost exactly the same as the situation in (a), but in this case instead of receiving stock as a
compensation package, Manager is essentially “discounting” her salary against a purchase
payment system for the stock she would have received in the (a) scenario.
(c) No, because of the de minimis value of the property in comparison to the stock received, in
what looks like a mask for service compensation. 1.351-1(a)(1)(ii). Recognize the de minimis
payment as purchase of equivalent stock, then tax Manager on the remaining $149K as income.
Ouch.
(d) Manager kicks in more than 10% of the value of stocks essentially allocated as “service
compensation,” so the transaction is not de minimis.
(e) Restricted in-kind compensation. Amount of compensation is based on time when in-kind
compensation becomes transferable or not subject to substantial risk of forfeiture. 83(a). Barring
Manager’s leaving, the valuation and taxation would mature when the restrictions on her shares
are lifted. Then there’s the 83(b) election to avoid the tax deferral and pay up front (possibly
insurance against massive taxation later if stock value skyrockets). Pays without regard to risk of
loss. Taxed as ordinary income up front. If sold, treated as market appreciation (LTCG).
What about (e) under 1.83-1(a)? “Until you pay tax, stock isn’t owned by service provider.”
Control issue? If Manager 83(a) pays up front, no issue. Otherwise, for tax purposes no one
would be the owner until someone paid taxes on them. but there should really be no issue at all,
since there is no control dispute at all. The stock, if Manager 83(b) elects out, is basically
unissued treasury stock, so effectively 100% of the corp is controlled by the remaining two parties
to the incorporation.
Alternatives to accomplish the business objective and Manager’s equity stake:

Issue two classes of stock, common and preferred, with respective low and high values
Have preferred represent most of the capital considerations of the corp
Distribute preferred to the capital investors

Distribute common (voting) at $1par, 51% to Java and the remaining 49% between Venturer
and Manager. Manager now becomes capital contributor.
Downside? Tax flexibility – can’t elect S corp because of two classes of stock.
Alternative 2 (Silicon Valley)
One class of stock
Warrants to service providers
Distribute common to Java and Venturer, none to Manager
Give manager warrant (pull option) for future common purchases
1.351-1(a)(1) says that warrants aren’t included in term “stock or securities”, so no control
issue
351 – Nonrecognition
358 – Shareholder basis rule
362 – Corporate basis rule
1032 – Corporate nonrecognition rule
A. In general
Policy: Tax all gain realized from transfer up to the amount of boot, because transferor is defeating
the “changed form investment” grounds for 351 nonrecognition.
Normal Boot Rule: Recognized gain = amount of boot; basis in transferor’s stock in 358. “Return
of Capital Last Rule”
Corporation basis: Transferor’s basis + transferor’s recognized gain from boot. 362.
Alternatives:
Partial sale approach: subdivide interest in property for transfer in exchange for 100% stock (step
one); sell remaining interest for non-stock consideration (step two).
Example:
$100 FMV
$ 10 Basis
Contribute 80%, so basis in exchanged property is 8. Transfer covers basis, so no recognized
gain on remaining realized gain (72 to corp under 351).
Sell 20% interest for $20 FMV bond. Realized gain $8 for transferor, but should be $20 (face
value of bond). Corp’s basis is $20, and corp’s basis in total property ends up being 28
(transferor’s 8 basis goes to corp under 362)
$10 of bond received is taxed to transferor (other $10 recovered as original basis – 301(c))
Results Realized gain Recognized SH’s Adjusted Corp’s AB

gain Basis stock property
Normal boot rule 90 20 10 30
351(b) Return of
capital last
Partial 351(a) sale 90 18 8 28
1001(c) treatment Pro rata
return of
capital
Contribution 90 10 (LTCG) 0 N/A
351(a)/ Return of
distribution 301(c) capital first
treatment
There is no boot rule for partnership organization (721(a)), so courts apply partial sale
treatment because of the literal substance of the transaction.

“Other property” not stock that is given by a corporation in exchange for transferred property.
351(b) requires transferor receiving boot to recognize any realized gain on the transaction to
the extent of the money or FMV of any nonqualifying property received. Requires
recognition of gain before basis can be recovered, so that boot cannot be abused.
When multiple items are transferred, each one is treated as a separate transaction.
Example:
$200K property with $20K basis transferred to corp for $170K stock and $30K cash.
There is still a $180 realization, but only required to recognize that gain to the extent of the boot
received. So transferor recognized $30K immediately, but doesn’t mess with the remaining $150
until the stock is sold or converted into another, corporately unrelated asset. The basis is then
fully recovered from the $30K of boot (with a tax on the remaining $10K after the basis
deduction), and the rest of the FMV is deferred to encourage corporate investment.

Debt instruments of the corporation exchanged to the transferor in return for the capital
contribution do not qualify for 351 nonrecognition, but they aren’t fully recognized immediately.
They are treated as installment payments under 453.
The transferor’s basis is first set off against the stock (non-boot exchange item) up to FMV. If the
basis doesn’t exceed the FMV, then there is no immediate charge. If it does, then the excess basis
is allocated to the installment portion of the transfer. 453 is then applied against the installment
portion of the contract. if there is any remaining basis, it offsets the face value of the obligation.
Note: gain from inventory property exchanged for a note is a SALE, and must be recognized
immediately.
Example:
Problem 63
A gives $22k FMV inventory ($15K basis); gets 15 common ($15K), $2K cash, 100 preferred ($5K)
B gives $20K FMV inventory ($7K basis), $10K FMV land ($25K basis); gets 15 common ($15K),
$15K cash
C gives $50K FMV land ($20K basis); gets 10 common ($10K), $5K cash, corp not for $35K/two
years
Tax consequences (gain or loss realized and recognized, basis and holding period)?
A
Total Equipment
FMV $22K $22K
FMV c. st. $15K $15K

FMV p. st. $ 5K $ 5K
Cash $ 2K $ 2K
Realized $22K $22K
Adj. basis $15K
Gain/loss $ 7K
Carryover basis $ 5K (AB in stock for future recognition)

Recognized $ 0 ($7K basis – $7K boot recognition)
Corp
AB equip. $15K (362(a) carryover basis from transferor)

+ 2K (Cash payment)
$17K (Corp basis in property - $5K in appreciation recapture for
future recognition)
B
Total Inventory Land
FMV $30K $20K $10K
% Total 66.7% 33.3%
FMV stock $15K $10K $ 5K

Cash $15K $10K $ 5K
Realized $30K $20K $10K
Adj. basis $ 7K $25K
Gain/loss $13K ($15K)
Carryover basis ($ 2K)

Recognized $ 0 ($13K basis – ($15K) boot recognition)
– OR –
Carryover basis $13K
Recognized $13 ($13K basis – 0 (no recognition of loss))
Associated basis for stock:

$ 7K Inventory
+ $25K Land
+ $10K Recognized gain
– $15K Cash boot
$27K Basis in stock
$15K Stock value

$27K Basis
–12K
Corp
AB inv. $ 7K (362(a) carryover basis from transferor)
+$10K (Cash payment)
$17K (Corp basis in inventory property)
AB land. $25K (362(a) carryover basis from transferor)

+$ 0K (Only increase basis by boot on transferred property that
generated the recognized gain for transferor – already added to
inventory, supra)
$25K (Corp basis in land)
P.S. While only a portion of this stock qualifies for the tacking period, the tacking period may be
applied to all shares pro rata (the same 2/3:1/3 ratio).
C
Transferred:
Land $50K (FMV; $20 basis)
Recognized gain $30K (FMV – basis)
Received:
Common $10K
Cash $ 5K
Note $35K (Two year note)
Total boot $40K (Note + cash received)

Qualify for 453(a) installment payment option? Large portion of boot is installment note, and any
receipt of promise to pay later for transferred goods qualifies for 453(a).
How does basis get applied? Assign it first to stock (nonrecognition property) up to FMV, then
remainder (if any) to boot.
AB stock $10K (FMV fully covered by basis)
AB boot $10K ($40K total payments, so ¼ each payment treated as basis, ¾
each payment treated as gain)
Works out to taxable amount on $5k = 3,752, on $40K note = $26,250.
Corp
+$ 3.752K (Recognize gain only when transferor recognizes gain from
payments)
$K (Corp basis in land)
What if C had given $50K FMV non-capital assets?

C wouldn’t qualify for 453(a) installment treatment, and the $30K gain would all be taxable up
front. What about recapture when there is an installment note? 453(i), overriding 453(a) through
1245(a), says that any non-capital asset recapture income will be recognized according to the
payouts, i.e. exactly like the installment option..
357 – Corporate assumption of liability

358 – Basis to distributes (shareholder basis rule)
1031/1031(d) – Like-kind exchanges: “...such assumption [of taxpayer liability] shall be considered as
money received by the taxpayer [and subject to tax immediately].”
Carve out:
357(a) – Whoa, wait! Liabilities aren’t boot for purposes of immediate recognition, so you aren’t
taxed up front. So, to make up for this exception, 358(d) comps by reducing basis.
Most corp formations involve corp assumption of debt, which is normally considered boot for the
transferor. But applying that strictly to corp formations would frustrate 351. So 357 makes an
exception, and 358(d) comps for that immediate taxable loss by adjusting the transferor’s basis down
in the encumbered property. If the diminution of basis through 357 (a) would result in a negative
basis, then the transferor is required to recognize that negative amount as a gain at the time of transfer.
357(c).

Avoiding the “357(c)” trap. Lessinger contributed assets of his sole proprietorship to his corporation,
but the SP was insolvent and $200K in the red. He also contributed a note to the SP (basically a
scribble, an accounting entry that was scribbled into the ledger by Lessinger’s accountant (and possibly
while Lessinger was unawares)) with a face value of essentially that same negative amount to the SP,
which was also transferred. Lessinger avoided the negative basis 357(c) trap requiring negative basis
gains recognized on straight transfer of property. IRS balked. Court extrapolated their holding from a
broad reading of 357(c) and 362 together. Crux is “legally enforceable obligation to contribute money
in the future.”
Also, if Lessinger wasn’t allowed to contribute the note and the SP was in the red when it was
transferred, he runs into the Fraudulent Conveyances Act. Ouch.
Should that legally enforceable obligation to pay cash in the future represent a cash payment now?
Court doesn’t really answer it, but seems to indicate that they’d say “yes.”

Peracchi (9th 1998)

Alternatively to Lessinger, Peracchi was allowed to claim basis in his personal promissory note to his
corporation (a legitimate note, different than the Lessinger scribble [also the name of a new dance]).
Court reasoned that the note would be enforceable in bankruptcy, so there must be some basis because
of Peracchi’s increased exposure to risk in pledging the note. Therefore, he’s entitled to an upped
basis to the extent of his possible exposure to loss should the corp tank. The court limited this
allowance to notes worth approximately their face amount.
Note: You should always be able to beat this IRS argument by borrowing the money first, and then
pledging it in full to the corp. Some semblance of real liability goes a looong way to making this
“basis-up” strategy legitimate.
The real issue in both of these cases: TIMING. Not if you get a basis increase, but when the basis
increase should occur. Since this is a debt in both cases, should it be installment method
recognition???
Problems 80
1. A contributes: Inv, $10K FMV ($20K basis); land, $40K FMV ($20K basis, $30K mortgage).
A receives: 20 shares ($20K value), corp assumes mortgage.
a) $20K AB Inventory
+ $20K AB Land
– $30K Liability transferred (from 358(d))
$10K Basis in stock
Assuming that A isn’t a realtor, the holding period of the land transferred will be tacked pro rata
across all of the stock received. There is no holding period tacking for the inventory, as it isn’t a
capital asset.
Corp basis will be $20K.
b-d) Liabilities will be in excess of basis, so there will be a $5K recognized gain (357(c)). Will
end up with $0 basis:
$25K AB basis both inv and land
+ $ 5K Recognized gain
– $30K Liability
$ 0 Basis
Corp basis will be transferred basis, but 1.357-2(b) says prorate the basis across the gross value of
all contributed assets.
Wiedenbeck thinks that the allocation should be recognized according to the appreciation in
value of the respective items, not according to gross FMV as proscribed in 1.357-2(b).
2. B contributes: Building, $400K FMV ($100K basis), with first mortgage of $80K (valid business) and
second mortgage of $10K (personal, eve of transfer).
B receives: $310K stock, assumption of liabilities.
a) B gets hammered by 357(b), because a tax avoidance purpose combines total liability
assumed (avoidance AND valid business purpose), and treats the final number as cash boot.
b)
Policy: Don’t fuck around with 35’s graciousness. We’ll wallop you with recognition
immediately.
3.


Assignment of income. AR may be considered property for tax computation purposes ONLY WHEN it
serves the policy of 351. Accounts receivable are transferable, but the AR in this case were generated
form services. The service provider is always the entity taxed, no matter where the AR goes. Since
351 property can’t be services (351(d)), then there is a conflict that must be resolved in light of the
congressional purpose of 351 (look for hidden payment for services, etc., schemes to use
Exam tip: Always look for step transactions, alternative solutions, etc., when analyzing cases.
Liabilities under 357(c)(3)
482 Reallocation
If you have multiple related business, there may be a reallocation issue. Service has discretionary
ability to reallocate tax burden. The Service will look for evidence of improper reallocation of
amounts to mismatch income and split tax consequences.

Where liabilities give rise to a capital expenditure. Transfer of environmental liability. Corp
contributed land that was encumbered by environmental liabilities. Potential application of 357(c). to
the extent that the liabilities would be considered “ordinary repairs to land and equipment,” the costs
would qualify. But the extraordinary nature of these cleanup costs are too high, and must be
considered capital expenditures, which are specifically eliminated from 357 exception qualification.
Problem 90
a)
b) Design.
c) Yes.
d)
e)
f)

When a shareholder transfers property other than cash without receiving anything in return, they
have made a contribution to capital and can increase their basis in already held stock to reflect the
transfer. The transferred amount is excludable as gross income by the corp. Transferor’s basis
carries.
Fink 92 (1987)
Non pro-rata surrender of stock to capital. Not only did Fink want to take an AB deduction on the
surrendered and cancelled shares, but they also wanted to claim it as a 165(f) ordinary loss. They
claim that yes, the stock was a capital asset, but the loss was not incurred through a sale or
exchange. It was a surrender, so it eschews the capital gains/losses requirements of 1223.
Congress remedies this with 1224A. But the real issue in front of US was was there realized loss?
IRS says no, because they were still majority shareholders post-contribution. Service says they
should have upped their basis in the remaining stock by the basis of the amount of the stock
surrendered. US agreed.
Ways around: Have the corp buy shares from shareholders outright, then shareholders take
the proceeds form sale and contribute those to the corp as a direct contribution to capital. No
net change in assets, but the contribution then becomes a real contribution to capital.
302 would have helped this definition

C. Organizational expenses
Problem 100
B. Capitalization
1. Introduction
What difference does it make if investors hold stock, bonds, or notes? Tax treats debt and equity
differently, and the more favorable tax treatment is with debt. Issuing debt avoids the double tax;
repayment of debt is tax free on principal and capital gains for excess difference, where stock buybacks
(essentially debt repayment to the shareholder) may be taxed as dividends if the shareholder retains
some stock. See also the 351 stock/boot differences in tax recognition.
2. Debt v. equity
Problem – Deductions for interest, not for dividends
Incentives –
Policy – Substance v. Form
Case 1: GM Stock
GM Bonds Shareholder owns 0.000001% GM common, some bonds – so no real conflict.
Case 2: Closely help corp

A B C
60 sh 30 sh 10 sh Different levels of ownership will create equilibrium
30 bonds 10 bonds 60 bonds for fair distribution of corp wealth among both shares
and debt.
X corp
Case 3: Priority bonds over subordinate outside lender claims. What incentive is there for the
bondholders to act as proper creditors?
The IRS can analyze substance over form to determine whether corporate obligations are debt or
equity. There is a spectrum in case law that may help, with one end being equity (risk investment with
the potential of shared profits) and the other being debt (fixed promise from corp to repay principal
with interest at a fixed maturity date). Then there are all the spots in the middle, left to the courts to
decide where a particular investment falls. Some say that the disparate results in the courts have
created a “smell test” for either debt or equity. The principal factors of the smell test are:
Form of the obligation – While labels aren’t controlling, a proper label may ward off a
challenge that debt is actually equity.
The debt/equity ratio – Ratio of company’s liabilities/shareholder’s equity. The more thin the
capitalization, the better ammo for the Service to classify an item as equity under the rationale
that no lender in their right mind would loan out to a severely undercapitalized business.
However, the bar of what is and isn’t thin capitalization has been amorphous in the case law.
Intent – Gleaned by an objective look at criteria such as lender’s reasonable expectation of
repayment in light of the company’s financial condition, and the corp’s ability to pay the
principal and interest.
Proportionality – In closely held corps, debt held by the shareholder in the same proportion as
stock raises eyebrows with the Service. If close to equally leveraged, by what incentive
would the shareholder/debt holder enforce his/her own debt?
o “Stock overlap”: Assume that stock ownership and debt holdings are proportionally
equal among investers. Treasury says compare % stock owned and % of instrument in
question. If the lowest comparison from each investor added together tops 50%, then the

debt instrument will be considered equity (i.e., one shareholder’s relative stock is 20%,
another’s relative debt holdings are 31%, combined >50%, then debt = equity)
Subordination – Frequently, outside creditors require that shareholder debt be subordinated to
their claims.
Hybrid instruments
The big banks have tried to eschew a one-or-the-other classification by issuing products with massive
hybrid characteristics that they claim allow for interest deductions while allowing for equity treatment
on balance sheets. The Service has made announcements indicating that it will pursue disputes on
such hybrids that have unreasonably long maturity dates or the ability to repay principal with corporate
stock. Anyway, this is still a gray area. But 385(a) was amended to add a parenthetical that allows the
Service to treat hybrids as scrambled transactions – in part stock, and in part indebtedness.
In tax advising, do everything to avoid hybrids if there is concern about debt v. equity. Also
make sure capitalization of corp isn’t too thin, that client adheres to the terms of the debt
instrument, and that strict proportionality is avoided.

To prevent tax avoidance through the use of excessive debt, 385 allows the Treasury to create regs on
determining whether an interest in a corp is stock or debt in substance, regardless of how the corps
label it. 385(b) sets out factors to be taken into account when determining whether a debtor-creditor
relationship exists:
Form
Subordination (shareholder debt equal to or higher than outside lenders)
Debt/equity ratio
Convertibility
Proportionality
The 385(c) obligation of consistency locks the issuer’s characterization of the interest at the time of
issuance, but doesn’t restrict the Service from the reclassification endeavor listed above. The rule only
applies to the issuers; it doesn’t apply to the holders and how they apply the interests to their taxes.
Problems 123
1. A, B, and C form Chez. A contributes: $80K cash; B contributes: building, $80K FMV ($20K
basis); C contributes: $40K cash, $40K goodwill. Each receives 100 shares Chez common.
Chez requires $1.8M additional capital. Goodwill Bank loans $900K at two points over prime for
mortgage on renovated building.
Look to flowchart for aid in D:E question
a) Assume A, B, and C will contribute the remaining $900K equally in the form of $300K, 5-year
notes at variable rate of prime –1%. Passes 385(b)(1) because there is a fixed determination of debt,
fixed time. But proportionality is 100%, and the outside D:E is 1.8M:240K, or 7.5:1 (and 12.9:1 if you
use AB for equity). The inside D:E is 900K:240K, or 3.75:1 FMV (6.4:1 AB). So this doesn’t pass
safe harbor, but it’s not necessarily considered debt. You’d have to make a case that it wasn’t (i.e.,
numbers for safe harbor are close, another party would possible have made the same kind of loan, etc.).
But could this really pass when considering the commercially inadequate interest rate?
b) Assume (a), but that the note is a 10%, 20 year debenture payable only out of net profit.
Difference from above is that this is a hybrid, and then the instrument loses one of its only positive
aspects in the “it’s debt” argument.
c) Same as (a), but the investors will personally guarantee the Bank’s loan (which is now unsecured).
Should this be treated as the bank loaning $300K to each shareholder, and thus reduce Chez’s D:E?
Under this two step characterization, would this then be considered a shareholder’s contribution to
capital? What about when Chez would attempt to deduct an interest payment to Bank? Chez would
have to distribute the interest in the form of a dividend to the shareholders, who would then pay the
bank as interest on a personal loan and deduct it themselves. So shareholders wouldn’t care because
there’s no tax repercussion. Well, as mentioned above, the D:E is substantially lowered. But in this

characterization, the contribution to capital becomes true equity because the loan to Chez would not
have been made but for the shareholder’s guarantee.
d) Assume that A will loan the entire $900K with the same terms as (a). Becomes straight debt,
because there is no proportionality. Unless, of course, A is related to either B or C.
e) Debt in form as an unconditional obligation. Chez stops paying interest, so if A doesn’t sue for
payments, then there was probably no intention to treat the debt instrument in question as true debt.
May be reclassified as equity if there is failure to perform corporate obligations.
If you need to see policy considerations or a narrative guide to 1244 for recharacterizing loss for small
business shareholders, look in CB 131-33.
165 - losses
Debt – worthless securities 165(g) Also consider 165(j), 163(f) (registration required unless
v. bad debt business (ordinary income deduction) 166 1) term < one year, or
v. non-business (capital loss deduction) 166 Generes 2) privately placed loans)
301(c) – 1. mandatory d

243(a), (b)(1); 301(a), (c); 316(a); 317(a).
Regs: 1.301-1(c); 1.316-1(a)(1)-(2).

Function: Distinguish distribution properly subject to double tax from return of shareholder
invested capital.
Concept: Cumulative undistributed after-tax earnings.
Capital assets merely change of form – do not increase corp’s net assets until the changed asset gains
interest.
Earnings and Profits (E&P): Assets – liabilities – SH capital contributions = RE

Technical definition in 312.
ii. Start with corporate TI [corp’s ordinary method of accounting; tax law realization and
recognition laws govern]
iii. Adjustments for:
- Tax-free income
- Nondeductible current expenses (162, bribes, lobbying expenses, fines, etc.) and
losses (related party losses 267(a), etc.)
- Timing adjustments
Depreciation – ACRS (312(k)(3))
Installment sales (312(n)(5); 453)
316(a) – defines a dividend as any distribution of property made by a corporation to its shareholders
out of (1) earnings accumulated after Feb. 28, 1913 (“accumulated earnings and profits”), or (2)
earnings and profits of the current taxable year.
Makes two irrebuttable presumptions: (1) every distribution is made out of earnings and profits
to the extent that they exist, and (2) every distribution is deemed to be made out of the most
recently accumulated earnings and profits.
In testing for dividend status, look at the earnings and profits at the close of the taxable year in which
the distribution was made. Any dividend out of current earnings and profits is taxable, regardless of
historical deficits.

Problem 140
Gross profits from sales $20K
Dividends received from IBM 5K
LTCG 2.5K
Total gross income $27.5K
Deductions
Salaries – 10.25K
Dividends received (70%) – 3.5K
LTCL sale – 2.5K (limited by 1211)
Depreciation – 2.8K
Total $ 8.45K
Adjustments:
Tax exempt interest $ 3K
Dividends received deduction 3.5K (not allowed in computing earnings and profits; only in
Excessive depreciation 1.8K computing tax liability)
Total $ 8.3K
Decreases:
Excess of LTCL sale $ 2.5K
Estimated taxes .8K
Total $ 3.3K
Total A&D $ 8.45K

Total $13.45K
301(a), (b), (c); 312(a); 316(a). Regs 1.301-1(a), (b); 1.316-2(a)-(c).
Distribution is amount shareholder receives. Every distribution is a dividend to the extent of current
E&P. Distribution above P&E reduces shareholder’s basis. If basis is fully reduced, then remainder is
computed as gain from sale or exchange.
Note: cash distributions are capable even if accumulated E&P has been reduced to zero. Any
appreciated asset that has collateral value can be borrowed against to provide a cash distribution, while
not being reported on the annual E&P computation.
Problem 144
a. ... and E&P is reduced to zero according to 312(a) ($17.5 reduced to the extend of Pelican’s
available $5K in E&P – 312(a) cannot force a negative E&P)
b. All $10K is a dividend, regardless of the fact that there’s an accumulated dividend. Every
distribution comes first out of current E&P. 316.
c. Allocate all year-end E&P pro rata to all distributions made during current year (2 distributions,
$2K per). 316. Now apply pro rata to accumulated E&P (316 “or”), wiping out the remaining $8K of
the first distribution (accumulated E&P not prorated over all distributions like current E&P) and
leaving $2K to split between the last distribution (half goes to each). Leaves $1K accumulated E&P
per shareholder, and combined with the $2K current E&P results in $3K left over. This remainder is
applied to reduce the shareholder’s AB.
d. $7.5K dividend because the current loss is offset by historical E&P. Assuming that current E&P
declines steadily during the current year, $10K/4 (distribution on ¼ year) = $2.5K.
1.316-2(b) current E&P deficit (see p. 1274) – If there is a deficit in the E&P, you can assume steady
decline as year goes along, unless corp can show specific items that caused the E&P loss. If so, then
E&P can be allocated in real-time according to the events that caused the operating loss.

3. Distributions of property
General Utilities doctrine: 311(a). Distribution in kind allowed corp to distribute appreciated property
to shareholders to avoid corp-level tax on sale. SH would then sell and not realize gain because of
301(d) FMV basis rule. Congress figured it out and basically (with limitations) repealed doctrine in
311(b).
Problem 148
a. Current E&P goes up $9K on realization of FMV distribution. 311. Gain is taxed, which reduces
E&P. Net consequence is $6K (assuming 1/3 tax) increase in current E&P. SH receives FMV basis in
property received. 301(d). Distribution becomes dividend to extent of E&P (both accumulated and
current),
b.
c. First, corporate tax consequences. $9K gain. 311(b). Corp level E&P rises to remaining level
after corp gain tax. Step 2: SH consequences. Amount of distribution = FMV – property’s associated
liabilities. 301(b)(2). $20K - $16K = $4K distribution. Corp current earnings (in this case, at least the
newly realized $6K) covers, so all $4K is a dividend. 312 (a), (b). The result is corp E&P increase of
$2K ($6K remaining from initial gain – $4K dividend = $2K). SH basis = FMV, regardless of the
encumbrance (the inherited debt will equal a deduction on interest for the recipient). Scott Szcorczik is
Ralph Wiggum.
d. Assume AB land = $30K. If corp simply distributes land, the it will realized loss of $10K (301(b)
says FMV is used to calculate loss). E&P gets hit at full AB, so with $25K accumulated and $15K
current E&P – $30K, result is $10K rolled over into accumulated E&P next year. 312(a)(3). Corp
should have sold the land and then distributed the profits.
e. 1016(a)(2) – depreciation as a deduction.
4. Distributions of a corporation’s own obligations

311(a), (b)(1); 312(a)(2). Reg 1.301-1(d)(1)(ii)
Gain recognition rule doesn’t apply to distributions for corp’s own debt obligations. Normally, E&P is
reduced by the principal amount of the obligation attributable to that year. But in cases where there is
a lower current value on the debt obligation that face value, a corp could evade earnings tax by
eliminating book earnings with issuance of a facially overvalued debt obligation, skipping the earnings
tax in favor of the lesser dividend tax. In the case of an obligation with an original issue discount, then
corp can only reduce by that discounted amount.
Problem 151
312(a)(2). Somewhere in here there’s a $5K return of capital. Corp can lower E&P $5K (current
discounted value of the debt obligation), and then reduces corp assets $100K (wiping out all E&P and
paying out $5K of capital assets). Equals net of $5K dividend. Plus, recipient will owe taxes on
interest income (since the note will pay $100K and he bought it for $5K, there will be essentially $95K
in interest accumulated over the life of the obligation).
Reg 1.301-1(j)
High rent, family salaries, etc. are tools corps use to avoid dividends – which they aren’t able to
deduct. Rest assured, the IRS will hunt these things out, smoke them out of their caves, and get them
running. See Nicholls (Tax Court 1971) (constructive dividend for personal use of corporate yacht –
dividend to mom and dad, gift from them to son. What about calling it constructive compensation to
James the sailor?). See also 482, Revenue Ruling (considering two fully controlled corps, where one
sells the other an item at a gross undervalue, allowing the other to avoid E&P increases and higher
corp income tax).

243(a)(1), (3), (b)(1), (c); 246(a)(1), (b), (c); 246A; 1059(a), (b), (c), (d), (e)(1)
Corporate shareholders (corps, for godsakes) receive a deduction on dividends to corporations to avoid
triple taxation. 243 deductions:
General: 70%;

If recipient corp owns > 20% of distributing corp: 80%;
If both corps are controlled under an umbrella elected affiliation group: 100%.
246(c) holding provisions: What of a corp buys stock immediately pre-dividend at stock + dividend
price, receives the dividend, then sells the stock post for its face value? Corp could record dividend as
income (at 30%), and then claim the reduced sale price as a STCL to use the “loss” on the difference
between their purchase and sale price to offset other income elsewhere.

Note: A valid business purpose will prevent the dividend technique used in this case from becoming
the dreaded “sham transaction.”

302, 317(b)
302(a) sale treatment: if you fall into one of the four categories of (b), you get sale treatment (and
LTCG/LTCL tax treatment). If you don’t fall in (b), then you go to (d) and are treated as a dividend.
Example: Alpha Corp, 100 shares: X, 60; Y, 20; Z, 20.

If Y sells its shares to Alpha, then (b)(3) applies. Gets sale treatment, but in actuality the transaction is not
like a real sale because (decreases corp value through the distribution of capital assets, increases X & Z’s
ownership percentages).
What if X sells 15 to the corp? Reduces outstanding shares to 85, but X still maintains control of majority
shares. Still dividend treatment, even though there is different effect (no uniform dividend distribution,
ownership percentages and ROI entitlement altered, etc.). Normal dividend wouldn’t do that.
Assume complete redemption of Y. X percentage ownership increases to 75% (60/80); Z to 25% (20/80).
If there was a straight distribution of 20% of Alpha’s worth, then X would receive 12% of that amount; Y,
4%; and Z, 4%. But as this example goes, 20% is going to Y alone.
Wiedenbeck thinks that every redemption is in part a redemption and in part a sale because of the diluted
positive effects for remaining shareholders. Constructive dividend occurs to those shareholders who are
not actively participating in the transaction.
1. Constructive ownership of stock

302(c)(1), 318 (Constructive ownership)
Four categories of “attribution” rules (when close party’s stock ownership is attributable to the shareholder
and transaction in question)”
i. Family attribution
An individual is considered as owning stock held by spouse, children, grandchildren, and parents.
In-laws don’t count. No attribution from a grandparent to a grandchild.
ii. Entity to beneficiary attribution
Stock owned by or for a partnership or estate is considered as owned by the partners or
beneficiaries in proportion to their beneficial interests.
iii. Beneficiary to entity attribution
Stock owned by partners or beneficiaries of an estate is considered as owned by the partnership or
estate. All stock owned by a trust beneficiary is attributed to the trust except where the
beneficiary’s interest is “remote” and “contingent.”
A person holding an option to buy stock is considered as owning that stock. Takes precedence
over family attribution if both apply.

Problems 182
i. Wham, 100 shares: Grandfather, 25; Mother, 20; Daughter, 15; Adopted Son, 10 (Mother
option on five); Grandmother’s Estate, 30 (Mother 50% beneficiary). Apply 318 and determine
ownership amounts for:
Grandfather 85 (all – 15 from remaining 50% interest in Estate [(a)(2)(a),
(a)(5)(a) two-step attribution authority])
Daughter 55 (15 + Mother’s 20 + Mother’s option 5 + Mother’s Estate
interest 15)
Son/Daughter)
ii. Xerxes, 100 shares: Owned by Partnership in which A, B, C, D all equal partners. A’s wife W
owns all 100 Yancy Corp.
i. A, 25; W, 25; M, 0 (no family double attribution [(a)(5)(B)]).
b. How many, if any, of Xerxes owned by Yancy?
i. 25 [(a)(3)(C) B2E attribution + (a)(1) family attribution; double attribution not prohibited
because not a double-family construction]
ii. What if W only owned 10% of Yancy? Even for purposes of triggering the 50%
threshold of (a)(2)(C) E2B and (a)(3)(C) B2E, constructive ownership ties are still
applied.
c. How many, if any, of Yancy are owned by Partnership, B, C, D, and Xerxes?
i. 100 [((a)(1) spouse + (a)(3)(A) B2E Yancy) = A constructively owning 100 Yancy +
(a)(3)(C) B2E Partnership to Xerxes 50% threshold = Xerxes ownership of all Yancy]
A. Substantially disproportionate redemptions

302(b)(2); Reg 1.302-3.
If a shareholder’s reduction in voting stock as a result of a redemption satisfies three mechanical
requirements, the redemption will be treated as an exchange (and not the dreaded dividend). To
i. Immediately after the transaction, the shareholder must own (actually and constructively) less
than 50% of the total combined power of all voting stock,
ii. The percentage of total outstanding voting stock owned by the shareholder immediately after
the redemption must be less than 80% of the total voting stock owned by the shareholder
immediately before redemption, and
iii. The shareholder’s percentage ownership of common stock after the redemption also must be
less than 805 of the common stock owned before the redemption. If there is more than one
class of common, then the 80% test is applied by reference to FMV.
Attribution rules apply to these tests.

Step transactions masking dividends as exchanges. What if a majority shareholder X exchanged
shares qualified under 302(b) as making X a minority, on the knowledge that the corp would be
(b)(2)(D) for recognition of this ruling, making focus entirety of facts for determination of
302(b)(2) treatment or not.
Problems 186
1. Y Corp, 100 common, 200 NV preferred; Alice, 80 common, 100 preferred; Cathy, 20
common, 100 preferred. Determine if 302(b)(2) applies?
i. No. Nonvoting stock never qualifies for 302 treatment. Always a dividend.

i. Fails (b)(2)(B), must be < 50% voting power after redemption to qualify. Cathy still has
20 shares, so they’re split 50/50.
c. Same as (a), except Y also redeems 70 of Alice’s common.
i. Passes (b)(2)(B), but in this case the preferred stock may be qualified for 302 treatment
provided that the preferred stock is not 306 “tainted” stock. See §1.302-3(a).
d. What difference would it make in (c) if on Dec. 1 of same year Y redeems 10 of Cathy’s
common?
i. Only if Alice knew that Cathy’s shares would be redeemed. (b)(2)(D). But the statutory
step transaction may not apply in any case (knowledge or not), because 80% rule is the
test in the statutory definition of substantial disproportionality – not 50%. (b)(2)(C). IRS
would counter that step-transaction always applies, whether or not Congress reminds us
of it in one particular section or not.
2. Z Corp, 100 V common, 200 NV common, $100 FMV each; Don, 60 V common, 100 NV
common. Jerry, 40 V common, 100 NV common. If Z redeems 30 of Don’s V common, will
redemption qualify?
No.
B. Complete termination of a shareholder’s interest

302(b)(3), (c)(2)
Utility:
- Redemption of only nonvoting stock
- Waiver of family attribution – (c)(2)
- Redemption of 306 “tainted” stock
Why is there a waiver of family attribution only?
i. Waiver of family attribution

Attribution laws pose serious harm to closely held corps. If a parent cuts the corporate cord and
control goes to a child, etc., the parent would still be considered “in control” because of
attribution. 302(c)(2) provides a safe harbor from family attribution provided the following
criteria are met:
Immediately post, the distributee has no interest in the corp other than as a creditor,
The distributee does not reacquire interest within 10 years, and
If the distributee attempts to files I dunno...read the statute to figure this one out.
Further, 302(c)(2)(B) provides that family attribution can’t be waived if, in the 10 years prior,
either
The redeemed shareholder acquired any of the redeemed stock from a “Section 318”
relative, or
Any such close relative acquired stock from the redeemed shareholder.
Revenue Ruling 77-293 exception: Neither of these exceptions applies if tax avoidance was not
one of the principal purposes of the transfer.
Still: Always look for step transactions!
Policy? If you are really cutting ties, then a redemption and gift of operating assets is close
enough to a liquidation that real liquidation is not necessary to show that control has been
relinquished – provided that there is an affirmative showing that ties ARE cut by the distributee.
Lynch 188 (9th Cir. 1986)

If Lynch didn’t qualify for the 302(c)(2) waiver of attribution, he would have been fully taxed on
the redemption because of his residual constructive ownership of the entire corporation by and
through his son’s actual ownership of 100% interest in Lynch Corp.
Given the statutory silence on definition of “employee,” look to common law (in this case, torts).
IRS says it doesn’t care, the (c)(2)(A)(i) list is not exclusive to simply directors or executives – it
applies to all employees nonexclusively.
Alternative bases for similar holding:

- Debt:equity ratio – Father constructively owned son’s shares, and father was sole owner of
promissory note. Double coverage, and IRS would have called the note in essence preferred stock.
Pledge of son’s shares – See §1.302-4(d), (e). The pledge of stock was OK, but enforcing the
pledge (foreclosure on the stock) would be problematic for father.
- 302(c)(2)(B)(ii) 10-year look-back rule and Revenue Ruling 77-293 no-tax-avoidance rule.

First prospect –
Second prospect – Focus on waiver and interest requirement – “no interest including” language
again at forefront.
Third prospect – Unchecked discretionary veto power on extraordinary corporate policy. Bad!
Fourth – (c)(2)(B) look-back and how broadly should the tax avoidance exception be read?
ii. Waiver of attribution by entities

What if the redeemed shareholder is a trust, estate, or other entity that completely terminates its
actual interest in the corp, but continues to own shares attributed to a beneficiary to the entity?
Waiver of attribution is still possible, but only if the beneficiaries waive attribution and comply
with the 302(c)(2) restrictions as well.
C. Redemptions not essentially equivalent to a dividend

302(b)(1), Reg 1.302-2
Davis 204 (1970)

Davis bought stock from his company so that the company could secure a loan, with the intention
to redeem the stock once the loan was paid off. He bought in 1945 at $25/share and the corp
redeemed in the 1960s for the same price. He claimed the transaction for sale treatment as a return
of capital, but the IRS balked. CA9 held for Davis, US reversed. Davis had claimed that the stock
plan was for a valid business purpose, and therefore wasn’t a dividend (which is simply a RE
distribution or return of capital). US didn’t buy it, saying that the business purpose test is
irrelevant in determining dividend status. They reasoned that 302(b)(1)’s “not equivalent to
dividends” rule meant just that: since Davis never lost or changed in form any control of the
closely held corp, the redemption was like a dividend. In order to qualify as not essentially
equivalent to a dividend, a redemption must result in a meaningful reduction of the shareholder’s
proportionate interest in the corporation.
Note: constructive ownership rules apply under (b)(1).
Didn’t qualify for waiver of family attribution safe harbor because Davis only sold back the
preferred, and still had common stock outstanding. The (b)(3) safe harbor wouldn’t apply, either,
because the stock was nonvoting preferred, a transaction which can never avail itself to (b)(3)
protection.

What is the “meaningful reduction of shareholder’s interest” credo of Davis?
Himmel (2nd Cir. 1964) says “shareholder interest” includes:
The right to vote and thereby exercise control - Vote
The right to participate in current earnings and accumulated surplus, and -
Financial
The right to share in net assets on liquidation. -
Financial
In this example, buying out the shares of the estate alone would never satisfy for the (b)(3) safe
harbor. For (b)(2), the estate owns 1000 of 1750 outstanding shares. After redemption the estate
still constructively owns 50% – and (b)(2) requires < 50% immediately after redemption. (b)(1)
works, though, because a 50/50 standoff in control is good enough to call a “meaningful
reduction” because there is no more unilateral control over the corp.
However – look for who holds the “other” 50% of the stock. If it’s scattered, then there
may still be effective control of the distributee.


In this example, the trust will not have to worry about attribution to the parents, but it will to the
son-in-law’s kids. Thus, it fails the (b)(2)(C)(ii) 80% test, too. But just barely (attributable 24.x%
from son-in-law’s children). So the IRS says basically, “Close enough, you get 302(a) sale
treatment.”

C ahs the opportunity to call the shots in collaboration with A and B, so while C’s 18% is a
minority, it is still part of a control group. This is a dividend.
Problems 219
1. Z corp, 100 shares. A, 28; B, 25; C, 23; D, 24. Dividend or not under (b)(1)?
(a) Near miss on (b)(2)(C)(ii) 80% test (80% of A’s original 28% interest is 22.4%; after
redemption with only 93 shares outstanding, control was 22.6%). 0.2% off, so near miss
and “meaningful reduction” sale treatment OK.
(b) Same as (a), but only five shares redeemed and A&D are related. Ownership before was
52% (w/attribution). After (w/95 shares outstanding) 49.4%. Passes (b)(1).
(c) Same as (b), except A&B are related instead. Ownership before was 53% (w/attribution).
After (w/95 shares outstanding) 50.1%. Fails (b)(2)(B) < 50% test.
(d) Same as (c), but A&B hate each other. Always apply attribution, regardless of family
hostility.
Y corp, 100 C, 100 NVP.

Shareholder Common Shares Preferred Shares
A 40 0
B 20 55
C 25 10
D 15 15
E 0 20
2. Will the following qualify for 302(b) exchange treatment?

(a) Y redeems 5 preferred shares from E. No (b)(1) substantially disproportional treatment
because no voting stock redeemed, but legislative history says that it gets exchange
treatment.
(b) Y redeems all of its outstanding preferred stock. Redemption doesn’t affect A. E gets
(b)(3) safe harbor from complete termination of interest. No impact on vote, so probably
a dividend on that claim alone. Vote is “key factor,” but is it determinative factor? Still
earnings and liquidation rights factors outstanding. But looking beyond vote, what are
the economic rights of the shareholders and how are they affected?
1. B gets walloped going from majority of earnings stake to none. B should qualify for
sale treatment under (b)(1).
2. C has minor economic impact, so no meaningful interest. Dividend treatment.
3. D same as C.
3. Individual owns 10 common at $15K basis. What happens if to basis of five shares are
redeemed in a transaction classified as a dividend?
Should up the basis of individual’s remaining shares to carry forward the outstanding basis
that was not recognized as a return to capital yet.
What if all 10 shares were redeemed in a dividend transaction because the family attribution
waiver was unavailable?
See Reg 1.302-2 Example 2. Basis transfers to related party. Ouch.

In kind proceeds – 311(b) (General Utilities doctrine repeal)

E&P reduction
i. 301 treatment
Normal 312(a) and (b) rules for reduction of E&P distributed apply
ii. Sale treatment – 312(n)(7)
Reduces E&P by amount distributed, but not more than shares proportionate contribution to
E&P (reduction limitation)
302(b)(4), (e)
A redemption qualifying as a “partial liquidation” under 302(b)(4) are taxed to the distributee
shareholder as a 302(a) exchange. 302(e) mandates that the focus of examination for whether a
redemption is a partial liquidation is on the corporate level.
1. Exceptional features
Must be noncorporate shareholders. Yes, they receive 301 and 243 DRD treatment; but
1059(e)(1)(A) will make it an extraordinary dividend and reduce the basis – creating capital
gains and more tax. HOWEVER, 302(e)(4) pro rata redemptions will qualify for sale
treatment.
2. Definition
i. In general – major corp business contraction
ii. Safe harbor – 302(e)(2), (3)
3. Policy – 331(a), (b)

If there is a redemption that seems to be connected to a major corporate business contraction,
then shareholders can go ahead and treat as partial liquidation for sale treatment. Controverts
the Davis “meaningful reduction” credo, because the distribution in this instance would be pro
rata (with no “meaningful reduction” across the board) and yet still get sale treatment. This is
an exclusively corporate focus.
4. Disposition of controlled subsidiary

332 controlled subsidiary liquidation requirement. If you first liquidate, then IRS has to treat
the parent as if it had been operating independently. The subsidiary’s time can tack on to the
parent to help meet the five-year period if the parent liquidates and distributes the proceeds.
But what if parent just sells subsidiary’s stock instead of liquidating? No special treatment,
because no 332 liquidation has occurred. The grace doesn’t carry if there is no transfer of
taxable assets.
Note: If corporation simply distributes subsidiary’s stock, then corporate division rule in
355(a), (b) may apply – tax-free at both shareholder and corporate level if these provisions are
met (same requirements as partial liquidation safe harbor in 302(e)(2))
Problem 223
(a) Sale treatment for M & P from safe harbor exception; corp gets 301, 243 DRD, 1059
mess. Pro rata distribution, so no other tax schemes would work.
(b) Ruins the five-year requirement for the safe harbor.
(c) 302(e)(1) – when unforeseeable event causes destruction, and then proceeds of insurance
distribution are distributed to shareholders. Qualifies as sale treatment under general
rule.
(d) Sale treatment as a partial liquidation.
(e) Iris is a corp, so it is a dividend. Partial liquidation only for non-corporate distributees.
Only would qualify for sale treatment if Iris fell under one of the four 302 criteria. In this
case, 302(b)(3) termination of interest applies, so sale treatment OK.
(f) Won’t qualify under safe harbor because of five-year existence test. Also doesn’t
because it is a distribution of business assets and not a partial liquidation. See Reg 1.346-
1(a).

(g) See RR 79-184. Parent attribution for subsidiary’s operation and business history.
(h) See RR 79-184. Parent attribution for subsidiary’s operation and business history.

1. Bootstrap sales
Zenz 229 (6th Cir. 1954)
Integrated, prearranged transaction that IRS lost on, and today would fall under sale treatment
protection of 302(b)(3). Woman, intending to sell divest her interest in corp, sold part of her
stock to a third party and then had the corp redeem the remainder as treasury stock for
substantially all of the corp’s accumulated earnings and profits. IRS claimed that the payment
from the corp was a dividend, Zenz claimed it was a 302 redemption. Led to Revenue
Ruling 75-447 – the order of the steps doesn’t matter, but we recognize that we lost under
Zenz, so the two transactions (Zenz redemption and then sale of stock, or reversed order of
steps [sale of stock and then redemption]) will not be treated as a dividend. 302(b)(2) will be
applied “when all the dust has settled” – by simply comparing stock ownership pre- and post-
transactions.
2. Buy-sell agreements: Constructive dividend issues


McDonald’s franchise redemption prompted because of divorce. Wife characterized that the
stock redemption was actually sold to her husband pursuant to a divorce decree, and should
have 1041 property settlement nonrecognition. Step 1 – she gets 1041 settlement. Step 2 –
corporation redeems shares from husband (basically that he ripped off the corp for the
purchase price of her shares). Husband gets hammered on 302(d) and 301 because
constructive redemption to a 100% shareholder is essentially a dividend. She really screwed
her ex.
Note: IRS asserted deficiency against husband to compensate for the $450K lost from
ex-wife, but lost because there is no collateral estoppel between the two proceedings (he
was not a party to her proceedings, she was not a party to his proceedings).

Charitable bailouts. Grove, majority shareholder of corp, claimed charitable contribution
deduction under 170(e) for the FMV of his stock in corp donated to RPI. Corp redeems RPI’s
stock, and RPI doesn’t care about their classification because they’re tax exempt. What if
Grove had redeemed the stock first, and then donated the proceeds to RPI? Would have been
a redemption for Grove. IRS says Grove has no income, but is making a huge deduction. So
IRS says look at it as a step transaction, and no matter how the steps are arranged, it should be
termed a redemption that doesn’t pass 302 muster. Grove says RPI wasn’t under obligation to
redeem shares, so it would be unfair to treat the two transactions as part of an integrated plan.
Court bought it, regardless of Grove’s life interest in the donated stock and systematic
contributions in the same style to RPI.
170(f) has remedied Grove in further defining what can and can’t qualify for charitable
contribution treatment.

304 (except (b)(3)(C), (D), (b)(4)). Reg 1.304-2(a), (c) Examples (1), (3), and (4).
304 – Labeled as a redemption issue, but is it really about redemptions (read: other legislative
intentions)? Look more towards financial stake or control gain/lost with the transaction. What’s
different in 304 than a real redemption in a close corp? Assets leave the corp in terms of purchase
price, but corp gets substitute assets in exchange.
What about parent/subsidiary transactions? Subject to heightened scrutiny. When all the dust
settles in the transaction, look at the shareholder’s ownership interest in the parent corp.

Just know that when you have a sale of stock by a controlling shareholder to another corp that is
controlled, 304 may apply if there hasn’t been a change in control sufficient to award sale
treatment.
Niedermeyer 268 (Tax Court 1974)

304(a), (c)(3) – As messy as it gets. Sale of stock between corporations. 302(b) tests look to
ownership of issuing corp. change in ownership is as to AT&T, so mom and pop go from 91%
actual and attributable pre-transaction, 0% actual and 68% attribution post (for a net of 72%
ownership when change in amount of outstanding stock is recalculated). Mom and pop think they
pass 302(b) because they planned to completely terminate their interest with a family attribution
waiver (and the transaction would qualify for 302(c)(2) “immediately” because the transaction was
part of a single, integrated plan). No constructive ownership meant that their resulting interest
would be 0%. Problems: more than one kind of outstanding stock; mom and pop still held
preferred stock post-transaction (subject to a gift to charity). No family hostility exception, either.
Problems 275
1. In reading Niedermeyer, make sure you are able to answer the following:
(a) Why did 304 apply to the sale by the taxpayers of their AT&T common stock to Lents?
(b) Given that 304 applies, how do you test the “redemption” to determine if the taxpayers have a
dividend?
(c) Why were the taxpayers unable to waive family attribution?
(d) How could they have avoided this unfortunate result?
Answered generally in the case comment above.
2. Bail Corp, 100 shares, no accumulated earnings or E&P. Out Corp, 100 shares, $5K
accumulated, no E&P. Claude, 80 Bail (basis = $500 per/$40K total), 60 Out (basis = $150
per/$9K total). Remaining shares owned by unrelated individual. Tax consequences when:
(a) Claude sells 20 Out to Basis for $4K ($1K over basis)?
(b) Same as (a), except Claude receives $3K and one Bail share (FMV $1K)?
(c) Same as (a), except Claude receives one Bail share, and Bail takes the 20 Out shares subject to
a $3K liability that Claude incurred to buy the 20 shares of Out?
(d) Claude sells his Out shares to Bail for $12K?
D. Redemptions to pay death taxes

303(a), (b)(1)-(3), (c). Skim 6166.
One-time exemption from taxes for redemption of a decedent’s stock. Decedent’s redeemable
stock must comprise over 35% of the entire estate, or aggregation may be allowed for two or more
corps if at least 20% of the corps’ total outstanding stock is in the estate. For the latter test, stock
held jointly in any manner may be included in the calculation.

305, 306, 317(a)
1. Taxation of stock dividends under 305
305(a)-(d); 307; 312(d)(1)(B), (f)(2); 1223(5).
General rule: Stock received tax-free under 305(a) is treated as a continuation of the recipient’s old
stock. Accordingly, the basis in the old shares is divided among all shares total in relation to their
FMV.
Ex. If B owns 100 Corp shares at $20 basis, and Corp distributes 1 for 1 stock dividend, then B
ends up with 200 Corp shares and basis is spread down to $10 per.
Exceptions: 305(b)
(1) Optional stock or cash – The test is choice: forced to receive stock, or opt to receive stock?
Opting negates the tax-free transfer.
(2) ¡Disproportionate distribution! Nobody may have a choice, but if the effect is that some have
the opportunity to increase their stake in ownership, while others may just take cash or
property, then the whole dividend is taxable.

(3) Common or preferred mix – Indicates future change in proportional ownership depending on
corp’s future performance (different slices during liquidity/liquidation).
(4) Stock dividend ON preferred – Expands priority claim on future assets and earnings upon
liquidation to the detriment of common shareholders.
(5) Convertible preferred – Basically (3) parade of horribles all over again.
(6) Constructive stock dividends – 305(c) repetitive redemption plans are constructive dividends
and thus taxable.
Problems 289
1. Tax consequences on these “redemptions” in light of 305?
(a) No tax.
(b) Both Fay and Joyce are taxed, because B stock dividend was optioned. Frank is taxed because
preferred holders had option (see statutory language “any”).
(c) No tax on A dividend; B dividend taxed normally as income under 301. 1-305.3(b)(4).
(d) Expands the preferred “bucket,” and runs into (2). Change of proportional interest. Two part test:
in addition to proportional interest, someone has to walk away with money or property. That
hasn’t really happened here, though, but the statutory parenthetical is broad enough to encompass
that type of regular dividend stock. So fails part two of the test as well.
(e) Frank still gets everything, even though there’s a new priority. The new priority doesn’t materially
change anyone’s proportional interest, because Preferred A still retains its full preference to E&P
before the subordinated preferred stock.
(f) Debenture holders are stockholders because the debentures are convertible, and thus fall under the
305(d) definitions as shareholders. Becomes disproportionate distribution.
(g) The conversion ratio on the preferred stock is designed to maintain the proportions of interest that
existed under the unmodified plan. Should be no adverse tax consequences because the
shareholder rights don’t change, and Frank’s common-to-common transfer is not in the 305
criteria. However, what about the “distribution” to Fay and Joyce on preferred stock? Well, any
dividend on preferred should normally be taxable, but (b)(4) allows an exception that won’t
enforce taxation if the “distribution” of a conversion ratio change is simply to preserve the interest
of the preferred shareholders in light of a stock split.
(h) Standard optional distribution that is taxable under 301.
(i) Preferred convertible into common. Option again, since this is basically a two-step common stock
distribution that will likely lead to a change in proportional share class ownership. Taxable unless
the IRS passes it as not disproportionate – (b)(5). Test includes showing of incentives for
conversion. In this case, because of the 20 year lifespan of the conversion, they will probably all
convert if the business is in any measure successful (provided that other incentives make
conversion unattractive). If everyone converts, then ownership interests will still be proportional.
but it appears that Fay and Joyce are taxable under (b)(5) and Frank is taxable under (b)(3)(B).
2. 305(c) problems if Z corp agrees to annual redemption of 50 shares at the election of each
shareholder, and A (500 shares) makes such an election two consecutive years? B (300) and C (200)
do not elect.
That would depend on whether Z Corp has any current E&P. Anyway, not in form a stock dividend,
but certain shareholder’s interest increase as this plan progresses. Redemption is processed under
302(a)(1) (303 or 304 possible, but not in this case). Well, not 20% termination of voting power, no to
everything else... So look to “meaningful reduction in ownership” according to Davis. After the first
redemption, B and C can combine respective vote to overturn anything A does where they couldn’t
before. A gets sale treatment, B and C have constructive stock dividend ONLY if it is a redemption to
which 301 applies. In this case, B and C pass Y1.
But in Y2, the redemption for A doesn’t meet the safe harbors, and A gets hit with 301 tax on that
year’s redemption. Now 305(c) looms for B and C. They seem to have constructive, taxable dividend
unless the redemptions are isolated. These redemptions are part of a periodic redemption plan, so they
be sunk in Y2.


Distribution of preferred stock that was fully intended to be immediately redeemable by certain parties
to avoid taxes. Court OKed transaction, even with acknowledgment of the tax avoidance intent,
because the firm hadn’t violated the law. Three-step transaction that made the essentially-dividend
payment go to the insurance companies (Step 1: preferred stock dividend to Chamberlin; Step 2: sale
of those preferred stocks to insurance companies; Step 3: redemption of preferred from insurance
companies).

“Tainted” 306 stock is any stock other than common stock distributed by a corporation if
received by the taxpayer tax-free under 305(a). Also includes stock received in a tax-free
reorganization if the receipt of that stock had the effect of a dividend. Additionally, stock
exchanged for 306 stock will also be 306 stock if received in a carryover basis transaction.
The tax-bailout hook comes when a company distributes this stock, and then redeems it later
from the shareholder – avoiding the 301 taxable dividend status.
Of course, that leaves the question, “What is ‘common’ stock?” Typically, the IRS defines it
as any stock, whether voting or not, that participates without substantial restriction in
corporate growth.
RR 76-383 says that stock issued with a first right of refusal to the corp, but otherwise
completely like common stock (meaning without limitation on future equity rights) is
common stock because the right to sale will be a shareholder level decision to reduce
equity.
RR 79-163 says that any stock issued in a restructuring that has limited rights to
dividends or limited rights upon liquidation aren’t “common” stock.

Two dispositions lead to different rules:
Taxable: A taxable disposition of 306 stock will generally produce ordinary income to the
transferor. If 306 stock is redeemed, the amount realized on the redemption is treated as a
distribution, thus generating 301 income. The redemption of 306 stock may be treated as a
dividend only to the extent of E&P at the time of the redemption. Otherwise, distributions in
the red are treated as a normal return to capital – (c)(2).
Sold: More complex “look back” rule. Seller will generate ordinary income to the
extent that those shares would have been a dividend at the time of their original distribution.
So the seller has to look back to the corp’s E&P a the time of distribution to calculate how
much ordinary income they will realize on the current sale, and any excess realization is
treated as a reduction in basis of the 306 stock. Excess beyond that is normal gain from sale
of stock. The ordinary income cannot be claimed as a 243 DRD, and the issuing corp can’t
reduce E&P when 306 stock is sold.
iii. Dispositions exempt from 306

Tax avoidance and the legislative solution to Chamberlin. Only schemes designed to thwart
tax repercussions are subject to 306 taint. Therefore, 306 only applies when shareholders
exercise a withdrawal of corporate earnings while retaining their same measure of corporate
control. As before, exemptions are:
Complete termination of interest (meaning disposal of stock with no attribution
ramifications),
302(b)(3) termination of interest,
302(b)(4) partial liquidations,

Redemptions of 306 stock in complete liquidations,
Nonrecognition transfers (351 transfers, contributions to capital, etc.),
Any distribution and disposition or redemption found by the IRS to not be part of a tax
avoidance plan.

The answer to Chamberlin. Fireoved redeemed preferred shares in a corp that he claimed
under 306 exceptions as capital gain. Court disallowed, saying that redemption solely to
avoid taxes took the preferred stock out of the 306 exceptions. Business judgment test cannot
be used as a defense if there is no valid practical justification beyond tax avoidance.
Problems 309
1. In Y1, Argonaut Corp distributed nonconvertible, nonvoting preferred stock worth $1K to
Jason and Vera, unrelated 50/50 common shareholders. Common basis of $2K prior to
distribution and $3K immediately after. At time of distribution, Argonaut had $2K E&P. In
Y3, Argonaut had $3K E&P.
(a) Y1 tax consequences? Tax-free under 305(a) on distribution, but what about their basis?
307(a) for associated basis on dividends says that for tax-free dividends, take the basis of
the original stock and distribute it among the combined old and new stock proportionally.
In this case, preferred + common post is $1K + $3K = $4K FMV. Then take common
pre and distribute it proportionally according to the current FMV ($4K). Because $3K is
¾ of $4K, $1.5K basis of the $2K common pre is allocated to common post; the
remaining $.5K (¼ of $4K) is attributable to preferred.
(b) 306(a)(1)(A) says that Vera has $1K ordinary 301 income, limited only by the “ratable
share” exception and invoking the (a)(1)(A)(ii) look-back rule to check Y1 if it had been
cash instead of the stock distributed. Limit doesn’t come into play here because cash
distribution in Y1 would have been $1K.
(c) In this case, the $1K-would-have-been-dividend is automatically ordinary income ala (b),
supra. Additionally, the look-back rule says that there is $750 excess over the would-
have-been distribution. (a)(1)(B) says to add the ratable share limit ($1K) plus the
associated basis ($500 from (a), supra) leaves $250 that gets capital gain treatment. That
leaves $500 of tax-free return of basis. If Vera had sold for just over the ratable share
limit, then the excess basis would have been attributed to her remaining shares.
(d) All transactions are OK. No taint if dividend wasn’t possible in the first place – (c)(2).
(e) Any disposition (disposal) of stock that isn’t a redemption is taxable. (a), (a)(1).
However, since there is no recognized gain or loss, (b)(3) says that as to Jason only (a)
doesn’t apply. But this is a transfer of 306 stock, so it remains 306 tainted when Claude
tries to sell it – (c)(1)(C). The sale becomes ordinary income to the extent of the look-
back. The basis carries over from Jason. But Claude is completely terminating his
interest in Argonaut, and there is no grandparent to grandchild attribution, so 306(b)(1)
allows Claude to avoid 306 and he will receive LTCG treatment.
If Jason had died, then 306 doesn’t apply and the stock isn’t tainted.
(f) Redemption of Jason’s preferred for $1.5K and half of common for $5K?
Common stock gets exchange treatment under 302(b)(2) because of the substantial
reduction in control. Preferred is tainted, redemption was in Y3, in Y3 Argonaut has $3K
E&P, and all of the preferred redemption is a dividend. (a)(2). The common becomes a
$4.25K gain after basis ($750) is recovered, so what about 306(b)(4)(B)? Not in
pursuance of plan principally for tax avoidance, but Jason only disposed of part of the
common stock, so (b)(4) doesn’t apply. So what about that extra portion? It immunizes
at least half of the common because there isn’t any bail-out feature of common stock.
Only to the extent that you dispose of the underlying common stock that caused the 306
taint ...
(g) None would qualify for the (b)(4) exception because the bylaws indicate that this is purely
a tax avoidance move, implicating 306 taint and making all $1.5K receive 301 treatment.

(h) Yes, 306 stock; yes, redemption subject to 306(a)(2); but tax free return to capital because
this is not a dividend but a return to capital.
2. Zapco Corp, 100 common (all owned by Sam Shifty), more than enough E&P.
(a)
(b)
331, 334(a), 346(a) 453(h)(1)(A)-(B); Reg 1.331-1(a), (b), (e).
Normally treated as if shareholders had sold their stock to the corporation in exchange for the
corp’s assets. 331(a). Typically, the liquidating corp recognizes gain or loss as if it had sold the
distributed assets to the shareholders at FMV. Each shareholder recognizes gain or loss on the
difference between their adjusted basis in the stock and the amount. Each shareholder takes a
FMV step-up basis in the assets received.
Corp sale of assets on an installment method over more than one year will allow shareholders to
recover basis before reporting gain or loss.
Shareholder level tax on corp earnings:

Policy
Timing – Shareholders are taxed on corp’s E&P only if and when the corp issues a dividend.
Wiedenbeck says that the timing is wrong because it is not fixed.
Taxpayer – Wrong
Rate – 301(c)(1) ordinary income – Wiedenbeck says wrong again. Same for liquidation, where
331 turns return into capital gain treatment
Compare:
A) Corp sale of assets and corp liquidation;
B) In-kind liquidation and shareholder sale of assets.
B2 - Asset sale
$$ exchange
Shareholders
Third
Party
B1 – in-kind Buyer
liquidation
A2 – cash
liquidation
A1 - Asset sale
$$ exchange
Corp
A) Step 1 corp sale of assets taxed under 1001 as corp level gain/loss recognition; Step 2 SH
recognition under 331. Double tax in effect, right result.

B) Step 1 in-kind liquidation creates SH-level tax on stock appreciation under 331(a), but there’s
no corp level tax on appreciated assets (pre-General Utilities) and shareholders will take 334(a)
FMV basis.
Segue to next section: Congress remedied this discrepancy in same end result/different tax
regimes problem by forgiving the corporate tax in the first example. In 1986, Congress revisited
the issue and enacted 336 requiring corporate-level recognition.
Problem 315
A, 100 shares Humdrum, $10K basis. Humdrum has $12K accumulated E&P. Humdrum
liquidates; tax consequences to A?
(a) Humdrum distributes $20K to A in exchange for stock?
(b) What if (a) above was a $10K distribution in Y1 and another $10K in Y2? Any problem with
no formal plan of complete liquidation?
(c)
(d)
(e)

336(a)-(d), 267(a)(1), (b), (c).
i. Background

336(a) and recognition to the corp

336(d)(1) “related person” recognition disqualification and (d)(1)(B) “disqualified property”:
Distributions to related persons, i.e. controlling shareholders (see 267 for definitions), will not
allow for recognition of loss if either (1) the distribution is not pro-rata among the
shareholders, or (2) the distributed property was acquired by the liquidating corp in a 352
transaction or as a contribution to capital within the five-year period ending on the date of the
distribution.
Policy on the pro-rata requirement? Congress presumably intended to single out
situations where a majority shareholder receives an interest in loss property that is
disproportionate to their stock interest in the corp.
Policy on disallowance for 351 nonrecognition exchange property loss?
336(d)(2) tax avoidance by “loss stuffing”:

Prevents the doubling of pre-contribution built-in losses. Only applies if distributing corp
acquired property in a 351 transaction or a contribution to capital as part of plan with
principle purpose to recognize the loss on liquidation. Losses are limited to amount of loss
accrued post-corp acquisition. Pre-contribution losses are deducted against the basis, but
cannot fall below zero. Additionally, losses may not be recognized on any property obtained
by the corp within two years of the adoption of a liquidation plan without Treasury approval.
Look at the above diagramed transaction. What if there is a third option, where shareholders
sell their stock directly to the third party buyer (Step 1), and then the buyer in-kind liquidates
(Step 2)? Triggers 1001 gain/loss at shareholder level; in-kind asset exchange invokes 336
asset level gain/loss. All of the first three are asset acquisitions.
What about a fourth option? Step 1, corp sale of assets; Step 2, no liquidation. 1001
asset g/l, invest sale proceeds in Step 2, but therein lies the rub. Any accumulated,

undistributed investment income will bring on an avalanche of penalty fees and earnings
taxes (531, 541).
Fifth option: 1. SH sale of stock to 3PB; 2. 3PB doesn’t liquidate. 1001 stock g/l; avoids
336 corp level asset gains.
Sixth option: 1. SH sale of at least 80% stock; 2. 3PB is corp and liquidates. 1001 g/l; but
in-kind liquidation defers corp tax to the shareholders upon sale of their shares. 336
337, 334(b), 381(a)(1).
Seventh option: 1. SH sale of stock; 2. 3PB elects 338. The Kimbell-Diamond case –
step transaction, in substance a direct asset acquisition. Electing 338 considers the stock
sale an asset acquisition. Would only make this election in three circumstances: if assets
have net declined in value; if assets have appreciated, but if target corp has net operating
loss carryovers; and
Eighth option: 1. SH sale of stock, SH is controlling parent corp; 2. 338(a) AND

338(h)(10) election. Parent liquidates sub in-kind, parent sells stock to 3PB. Opting into
338 turns transaction into simply corp level tax on asset gains.
Look for applicability of 338 on exam.
Problem 328
2. Liquidation of a subsidiary
332, 334(b)(1), 1223(1); Reg 1.332-1,-2,-5.
George L. Riggs, Inc. 331 (Tax Court 1975)
Parent corp 3PB

332 331
334(b) carryover basis 336, 336(d)(3) no loss recog. on prop that has declined in value
381(a)(1) E&P carryover
Subsidiary
337
B. Consequences to the liquidating subsidiary

336(d)(3), 337(a), (b)(1), (c), (d); 381(a)(1), (c)(2), (3); 453B(d), 1245(b)(3), 1250(d)(3); Reg
1.332-7.
No triggering of corp tax to the parent to the extent that the liquidated subsidiary’s assets are going
to the parent. The assets are given a 334(b) carryover basis, and the tax will be caught up to later
when shareholder sells stock (which will reflect parent’s value with additional liquidation
proceeds).
A. Taxable Acquisitions
B. Overview of Acquisitive Reorganizations

IV. Limits on the Retained Earnings Strategy
A. Penalty Taxes

Comparison Chart: Pre-tax Deferral, Roth Deferral & Roth IRA
Caution: P ea e e a e f e e c ded g da e e e fL c e ea fa cab e a e , eg la ion and o he go e nmen
g idance and o he ma ea onabl ha e a diffe en in e p e a ion of ha ma e ial. In addi ion, hi a ea of he la ha been and con in e o be bjec o ignifican
change. Whe e he i a ion a an , o ho ld al a en e ha he info ma ion on hi g id i ill c en .
Question Pre-tax Deferral Account Roth Deferral Account Roth IRA

Who is eligible to 401(k) An emplo ee ho i no pa of an Plan m pe mi Ro h fea e. Ro h fea e An indi id al ho a i fie ce ain ea ned income
establish account? e cl ded cla ifica ion and ho a i fie he age i no a ailable in 457(b), adi ional p ofi and adj ed g o income limi ( AGI ) a
& e ice e i emen and elec o defe ha ing o mone p cha e plan. de c ibed belo . In addi ion, a pa en o g a dian of
income. 401(k) An emplo ee ho i no pa of a mino child ma e abli h a Ro h IRA in a ea in
an e cl ded cla ifica ion and ho a i fie hich he mino ha ea ned income. A po e ma
he age & e ice e i emen and elec al o con ib e o a Ro h IRA on behalf of hi /he
o defe income. non- o king po e.
Who may benefit Emplo ee ho e pec o be in a lo e a Yo nge emplo ee in lo e a b acke Yo nge emplo ee in lo e a b acke
from contribution? b acke a e i emen i h long ime ho i on n il e i emen i h long ime ho i on n il e i emen
Emplo ee ho an o a oid c en a a ion Emplo ee ( ingle file /$95,000+ Emplo ee ho e pec a a e o
on defe al and ea ning income o ma ied/join file inc ea e b hei e i emen da e
/$150,000+ income) ho a e nable o Emplo ee in e e ed in e a e planning
con ib e o Ro h IRA d e o income oppo ni ie
con ain
Emplo ee ho e pec a a e o
inc ea e b hei e i emen da e
Emplo ee in e e ed in e a e planning
oppo ni ie
How much may be Con ib ion a e made on a p e- a ba i . Con ib ion a e made on an af e - a Con ib ion a e made on an af e - a ba i (no
contributed? ba i . ded c ible).
Le e of dolla limi a ed belo o 100% of
compen a ion ( bjec o ADP e ing 401(k) Le e of dolla limi a ed belo o 100% Le e of dolla limi a ed belo o 100% of ea ned
plan onl ). P e- a defe al and Ro h defe al of compen a ion ( bjec o ADP e ing income. Con ib ion made o Ro h IRA a e
combined ma no e ceed hi limi . 401(k) plan onl ). P e- a defe al and combined i h adi ional IRA fo p po e of
Ro h defe al combined ma no e ceed hi con ib ion limi . Abili o make Ro h IRA
limi . con ib ion i ied o AGI a de c ibed belo .
Ro h defe al become a ailable plan ea

beginning Jan a 1, 2006.
Tax Year Deferral Limit Tax Year Deferral Limit Tax Year Contribution Limit
2005 $14,000 2005 No pe mi ed 2005-2007 Up o $4,000
2006 $15,000 2006 $15,000 2008 Up o $5,000
Then, inde ed each ea fo infla ion in $500 Then, inde ed each ea fo infla ion in Then, inde ed each ea fo infla ion in $500
inc emen . $500 inc emen . inc emen .
(09/2005)
Are age 50 catch-up A ailable o pa icipan ho a ain age 50 b A ailable o pa icipan ho a ain age 50 A ailable o indi id al ho a ain age 50 b he end
contributions he end of he a able ea . b he end of he a able ea . of he a able ea .
permitted? Le e of dolla limi a ed belo o Le e of dolla limi a ed belo o
compen a ion ed ced b o he elec i e compen a ion ed ced b o he elec i e
defe al . P e- a ca ch- p defe al and Ro h defe al . P e- a ca ch- p defe al and
ca ch- p defe al combined ma no e ceed hi Ro h ca ch- p defe al combined ma no
limi . e ceed hi limi .
Ro h defe al become a ailable plan ea

beginning Jan a 1, 2006.
Tax Year Catch-up Amount Tax Year Catch-up Amount Tax Year Catch-up Amount
2005 $4,000 2005 No pe mi ed 2005 $500
2006 $5,000 2006 $5,000 2006 2008 and he eaf e $1,000
What income None. Pa icipan ma con ib e ega dle of None. Pa icipan ma con ib e ega dle A i di id a abi i ake R h IRA
restrictions apply? income le el. of income le el. con ib ion i de e mined b ingle o ma ied filing
a and Adj ed G o Income (AGI) a
de c ibed belo :
Filing Adjusted Gross Full/Partial
status Income (AGI) Contribution
Single o <$95,000 F ll
Ma ied
$95,000 - $109,999 Pa ial
Filing
Sepa a el $110,000 None
Ma ied <$150,000 F ll
Filing
$150,000 - $159,999 Pa ial
Join l
$160,000 None
Ma ied $0 F ll
Filing $1 - $9,999 Pa ial
Sepa a el $10,000 None
How is payroll & P e- a defe al a e no bjec o fede al Ro h defe al a e bjec o fede al income N/A.
withholding income a i hholding. Ho e e , a i hholding. FICA/Medica e
FICA/Medica e i hholding i ba ed on Social i hholding i ba ed on Social Sec i
handled? Sec i age hich incl de p e- a defe al . age hich incl de Ro h defe al . No e:
No e: P e- a defe al a e not bjec o a e Ro h defe al are picall bjec o a e
i hholding i h fe e cep ion . i hholding.
(09/2005)
How are deferrals Bo 1 401(k) defe al i e cl ded f om Bo 1 Ro h 401(k) defe al i incl ded in N/A.
reflected on Form Wage , ip , o he compen a ion ( ed o Wage , ip , o he compen a ion ( ed o
de e mine compen a ion bjec o fede al de e mine compen a ion bjec o fede al
W-2? income a i hholding). income a i hholding).
Bo 3 Incl de 401(k) defe al ( ed o Bo 3 Incl de Ro h 401(k) defe al ( ed
de e mine compen a ion bjec o Social o de e mine compen a ion bjec o Social
Sec i /Medica e). Sec i /Medica e).
Bo 12 Sho defe al amo n and Code D fo
401(k) plan . Guidance From IRS Required:
A ai ing g idance f om IRS in final
eg la ion and/o W-2 In c ion fo
2006. We an icipa e ha he IRS ill
in c emplo e o place Ro h defe al
amo n in Bo 12 and p o ide ne code fo
Ro h defe al (in ead of D).
What are Dea h Dea h Ro h IRA Acco n i a ailable fo di ib ion a an
distributable Di abili Di abili ime.
Se e ance f om Emplo men Se e ance f om Emplo men
events? Re i emen Re i emen
Plan e mina ion (401(k) onl ) Plan e mina ion (401(k) onl )
S bjec o he e m of plan doc men . O he in- S bjec o he e m of plan doc men .

e ice i hd a al de c ibed belo . O he in- e ice i hd a al de c ibed
belo .
Are hardship Wi hdra al ha mee hard hip need and Wi hdra al ha mee hard hip need T ea ed a an o he di ib ion.
withdrawals a i fac ion e ma be permi ed from pre- and a i fac ion e ma be permi ed
a defe al acco n . T picall defe al onl , f om Ro h Acco n . Ro h defe al onl ,
available? no ea ning . no ea ning .
Guidance From IRS Required --

Ordering Rules: If pa icipan ha p e- a
and Ro h acco n , he IRS ma e i e p o-
a ing di ib ion. G idance i e pec ed in
final eg la ion .
(09/2005)
Are in-service P e-Age 59 i hd a al of p e- a defe al in P e-Age 59 i hd a al of Ro h defe al – T ea ed a an o he di ib ion.
withdrawals 401(k) plan – No pe mi ed. No pe mi ed.
permitted? Po -Age 59 -- Plan ma pe mi in- e ice Po -Age 59 Wi hd a al in 401(k) plan --
i hd a al of p e- a defe al . Plan ma pe mi in- e ice i hd a al of
Ro h defe al .
Guidance From IRS Required --

Ordering Rules: If pa icipan ha p e- a
and Ro h acco n , he IRS ma e i e ha
in- e ice i hd a al be p o- a ed.
G idance i e pec ed in final eg la ion .
Are loans Plan ma offe loan f om p e- a a ell a Plan ma offe loan f om Ro h defe al No. Loan a e no a ailable.
permitted? o he o ce ( p o ce ain limi – gene all acco n a ell a o he o ce ( p o
50% of the participant s vested account ce ain limi – gene all 50% of he
balance). participant s vested account balance).
If loan defa l occ , en i e o anding loan Guidance From IRS Required: We a e

balance become a able. a ai ing addi ional g idance f om he IRS
o add e app op ia e a a ion of loan if
loan defa l occ and loan o igina ed f om
Ro h defe al acco n .
Are required RMD e i ed a he la e of a ainmen of age RMD e i ed a he la e of a ainmen of RMD le do no appl o Ro h IRA .
minimum 70 o e i emen . age 70 o e i emen .
distributions (RMD) Ma oll o Ro h IRA o a oid RMD.
@ age 70 ½
necessary?
What is a q alified N/A. The term “qualified distribution” is used T o e i emen m be me o T o e i emen m be me o di ib ion can be
distrib tion ? in con e of Ro h acco n onl . di ib ion can be alified: alified:
Ro h Acco n ha been in place fo Ro h Acco n ha been in place fo
fi e a able ea (f om da e of fi fi e a able ea (f om da e of fi
con ib ion) con ib ion)
One of he follo ing e en ha One of he follo ing e en ha
occ ed: occ ed:
A ainmen of age 59 A ainmen of age 59
Di abili Di abili
Dea h Dea h
P cha e of a fi home ( p o $10,000)
(09/2005)
What is a non- N/A. The e - alified di ib i i Pa icipan ma ake a di ib ion (a Ro h IRA Acco n holde ma ake a di ib ion
qualified ed in con e of Ro h acco n onl . pe mi ed in plan) e en if he c i e ia abo e e en if he c i e ia abo e ha e no been me (5- ea
ha e no been me (5- ea e i emen e i emen and/o alif ing e en ). Thi i
di ib ion ? and/o e en ). Thi i efe ed a a - efe ed a a - alified di ib i .
alified di ib i .
O de ing le : Fi a e di ib ed a e
Guidance From IRS Required -- con ib ion amo n .
Ordering rules: Ye o be cla ified in final
eg la ion . IRS ma e i e ha
i hd a al con ain p o- a ed ea ning i h
af e - a con ib ion .
What tax rules Follo ing a di ib able e en , he en i e p e- Ta a ion of ea ning i de e mined ba ed on Ta a ion of ea ning i de e mined ba ed on he he
apply at a acco n defe al and ea ning a e bjec he he di ib i i qualified non- di ib i i qualified non-qualified . No e:
o fede al and a e a a ion. qualified . N e: R h defe al a e e e Con ib ion a e al a con ide ed a -f ee.
distribution? bjec o a a ion pon di ib ion.
Qualified distribution Bo h Ro h defe al and
Qualified distribution Bo h Ro h ea ning a e a -f ee.
defe al and ea ning a e a -f ee.
Non-qualified distribution Ea ning a e bjec o
Non-qualified distribution Ea ning a e fede al and a e a a ion.
bjec o fede al and a e a a ion.
Does the premature The p ema e 10% di ib ion penal ma The p ema e 10% di ib ion penal (on The p ema e 10% di ib ion penal (on ea ning
10% distribution appl o en i e di ib ion aken p io o age 59 Ro h ea ning onl ) ma appl o non- onl ) ma appl o non- alified di ib ion aken
. alified di ib ion aken p io o age 59 p io o age 59 .
penalty apply? .
E cep ion appl ch a age 55 and e e ance E cep ion appl ch a dea h, di abili ,
f om emplo men , dea h, di abili , E cep ion appl ch a age 55 and b an iall e al pe iodic pa men , pa men of
b an iall e al pe iodic pa men , QDRO e e ance f om emplo men , dea h, ce ain heal h in ance p emi m af e job lo ,
pa men o al e na e pa ee, IRS le , and di abili , b an iall e al pe iodic n eimb ed medical e pen e , ed ca ion e pen e,
ded c ible medical e pen e . pa men , QDRO pa men o al e na e IRS le ie and fi ime home b e e pen e .
pa ee, IRS le and ded c ible medical
e pen e.
What are the Pa o i e i ed o i hhold 20% (on a able Pa o i e i ed o i hhold 20% (on N/A. Vol n a i hholding applie .
mandatory income amo n en i e i hd a al) fo income a on a able po ion of acco n onl ) fo income
di ib ion ha i eligible fo di ec ollo e b a on di ib ion ha i eligible fo di ec
tax withholding no di ec l olled o e . ollo e b no di ec l olled o e .
requirements?
Manda o ae a i hholding ma al o appl . Qualified distribution no manda o
i hholding
Non-qualified distribution manda o

i hholding on ea ning o ld appl .
Manda o a e a i hholding ma al o
appl .
(09/2005)
How are Fo m 1099-R Fo m 1099-R Fo m 1099-R
distributions
reported?
What direct rollover Pa icipan ma oll o e * o ano he eligible Pa icipan ma oll o e * o ano he Acco n holde ma not oll o e Ro h IRA dolla
opportunities exist? e i emen plan 401(k)/401(a), 403(b), 457(b) eligible e i emen plan 401(k)/401(a) o o ano he eligible plan b may oll Ro h IRA o
go e nmen al if ecei ing plan pe mi o o a 403(b) if ecei ing plan pe mi ollo e of ano he Ro h IRA. Amo n di ib ed and olled
adi ional IRA. Amo n di ib ed and olled Ro h Acco n o o a Ro h IRA. Rollo e o e i hin 60 da a e no bjec o p ema e 10%
o e i hin 60 da a e no bjec o p ema e of a Ro h Acco n o a 457(b) plan i not di ib ion penal .
10% di ib ion penal . pe mi ed. Amo n di ib ed and olled
o e i hin 60 da a e no bjec o
* Pa icipan m ha e di ib able e en in p ema e 10% di ib ion penal .
o de fo ollo e o occ . RMD , ha d hip
di ib ion and pa men p ead o e 10 ea * Pa icipan m ha e di ib able e en
o mo e a e no eligible fo ollo e . in o de fo ollo e o occ . RMD ,
ha d hip di ib ion and pa men p ead
o e 10 ea o mo e a e no eligible fo
ollo e .
The info ma ion incl ded in hi cha i p e en ed olel fo he p po e of ed ca ing he e abo p e- a and Ro h defe al fea e in emplo e - pon o ed plan and Ro h IRA . The Ro h defe al info ma ion i ba ed on
P opo ed R le p bli hed b he IRS on Ma ch 2, 2005. The Lincoln Life & Ann i Compan of Ne Yo k ( Lincoln ) make no e e en a ion ha an o all of he ma e ial i a o ia e o a licable o all em lo e o
pa icipan . Tho e ho choo e o e hi info ma ion do o on hei o n ini ia i e and a e e pon ible fo compliance i h all la , if and o he e en ch la a e applicable. Lincoln ongl enco age o o con l
o legal o a ad i o fo addi ional info ma ion.
Fo f he info ma ion ega ding Ro h IRA , plea e con l P blica ion 590 Indi id al Re i emen A angemen (IRA ). Thi p blica ion i a ailable a .i .go .
The Lincoln Di ec o SM i a g o p a iable ann i con ac i ed b he Lincoln Life & Ann i Compan of Ne Yo k, S ac e, NY on polic fo m #19476NY-A 7/04 (and a ia ion he eof) and i di ib ed b
b oke /deale i h effec i e elling ag eemen .
Lincoln Financial G o p i he ma ke ing name fo Lincoln Na ional Co po a ion and i affilia e .
IRS CIRCULAR 230 DISCLOSURE: Any discussion pertaining to taxes in this communication (including attachments) may be part of a promotion or marketing effort. As provided for
in government regulations, advice (if any) related to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used,
for the purpose of avoiding penalties under the Internal Revenue Code. Individuals should seek advice based on their own particular circumstances from an independent tax advisor.
LFD0509-1298NY
(09/2005)
I. Overview of Enterprise Taxation
How is corporate income federally taxed?
Three categories in the Code:
1. Sole proprietor (individual owner)
2. Partnership
3. Corporation
A. Conduit v. Entity Taxation
Business directly owned by proprietor
Taxed under §1, Schedule C – normal income tax
Business tax information reported with personal statements
Joint owners may be treated individually as sole proprietors for tax purposes
o Joint owners may individually elect to use different accounting methods, etc. on their tax
forms
o Cf. Partners, who are bound by joint firm decisions
2. Partnerships
Pass-through or Conduit taxation
Calculated as a business, but taxed to the individual partners
701 – not taxed as income of the firm directly, but as income to the partners.
702 – in determining income tax, each partner is taxed according to their interest in the business
on a pro rata basis of business income or loss. See also 703, 704.
Key: Allocation to partners of distributed share
Partners have to report distributive share of profit income, even if not actually distributed. If
partnership retains earnings, partners are still taxed.
3. Corporations
11(a) – corporation computes its profit or loss and is taxed as an entity
11(b) –“progressive” tax schedule, but most taxable corporations (except the largest ones) are subject
to a flat rate of 34%
The flip side of §11
61(a)(7) – dividends and the double tax. Corporation is taxed once, and earnings taxed again when
distributed as income to individual shareholders
A. C Corporations
“Regular corporations”
i. Corporate earnings are subject to “double tax,” once on corporate earnings, and once more
when earnings are distributed to shareholders through their income taxes.
Models of double tax. Assume TP owns all shares of Corp X, which made $100 in profit this
year. Assume applicable tax rates are corporate, 46%; individual, 70%; LTCG, 40%:
o Dividend Distribution – all after tax profits distributed to shareholder
Simplest form – a.k.a. “double tax”
CIT 46
Dividend 54
PIT 37.80 (.7 x 54)
Combined effective tax rate (sum of total taxes as percent of original income) – 83.8%
o Deductible Distribution – X distributes all $100 to TP as rent paid (deductible under
162(a)(3)) for premises leased from TP – still paid out to shareholder, but colored as a
business expense instead of a dividend. Most common in closely held corps, tends to be
self-policed by unrelated shareholders in large and widely held corps
Disguised dividend – modified pass-through when business pays expenses to shareholder
CIT 0
Distribution as rent 100

PIT 70
TP’s after tax proceeds 30
Combined effective tax rate – 70%
Are there any limits on the DD strategy? Only if closely held corp.
Reasonableness – “rent” in this situation would be subject to a substance test in
review. Tax consequences are not controlled by title, so if the corporation were to
distribute a gross over amount to an interested shareholder for any otherwise legit
purpose, they would be improper as to the amount of excess distribution. Substance
over form question.
o Retained Earnings – X retains and reinvests the $100; TP sells all stock in X at end of
year
Capital gain bailout
CIT 46
RE 54
Price paid for add’l assets 54
PIT 15.12 (.7 x .4 x 54, applying LTCP tax preference)
1001 – realized gain/loss – sales proceeds go up by the amount of reinvestment, but the
individual basis is the same as the amount she paid for the stock when originally bought.
Combined effective tax rate – 61.12%
Note: the one year mark is only required of the stock. In basic tax, the determinative
factor is whether the property sold is a capital asset. In this case, the asset is the stock
and not the $54 in RE.
Key to profitable following of RE strategy is based SOLELY on higher/lower
Are there any limits on how long may the RE strategy be taken advantage of?
o Penalty taxes (accumulated earnings tax 531/532/535(a),(c)(1)/537(a)(1), personal
holding company tax AET/541/)
AET: Congress encourages retention to foster “reasonable anticipated” (from 537(a))
internal growth (includes internal expansion and acquisitions according to Treasury
regulations), but excessive abuse of RE will result in massive tax consequences
through the AET formula above
Note – subjective test in 532 applicable only to corporations purposely formed
or availed to avoid tax liability!
PHCT: No subjective test as in AET. Two part test (% of income that is PHC
income, 5 or fewer controlling stockholders test)
o Corporate redemption of sock (another distribution, but not as a dividend)
o Liquidation of corporation – exchange stock for assets
Because of the retained earnings model, corporations have traditionally been used as tax reduction
vehicles. Shareholder nets value form sales of stock (1001 capital gain), and not in the more
highly taxable form of dividends. Less tax than if she had been sole proprietor, less tax than the
other two strategies.
Consequences of a corporate tax regime: tax rates. Unlike the S corporation, the C corp may
screw up vertical equity because it disproportionally taxes equity holders not according to their
respective stake, but unilaterally. This may disadvantage small stakeholders (like geriatrics
holding a few shares of stock).
B. S Corporations
If there is no corporate expectation of advantageous RE scheme, then may elect to incorporate as S
corp. Avoids tax liability on corporate earnings, but earnings must be reported. Shareholders are
then taxed on their pro rata share of the corporate earnings no matter the income’s disposition
(distributed to shareholders or not). The character of the monies reported (loss, gain, deduction,
credit) is retained in the taxpayer’s hands.
Limitations

o Eligibility – Cannot incorporate as S if more than 75 shareholders, one or more is foreign,
any shareholder is not an individual, more than one class of stock exists. All
shareholders must approve the S structure. 1361(a)
o Losses – shareholders cannot deduct losses in C corp because corporation is separate
entity, but S corps materialize losses as personal losses against unrelated income. 172.
Limited losses allowable as offset to percentage ownership. 1366(d)(1). Less generous
than partnership loss allowances, though.
o Special allocations – bars allocations because of only one class of stock. 1361(a).
o Owner-firm transactions – still controlled by C rules, while partnerships aren’t. 1371(a).
Conduit tax regime ensures that you pay a rate that is proportionate to your overall income,
unlike the note above showing the frustration of vertical equity.
4. Partnerships and Limited Liability Companies
A. Partnerships
B. Limited Liability Companies

Personal service corporations (PSCs) generally follow deductible distribution strategy to the
hilt
5. Policies
A. The double tax – treating corporations as separate entities form their shareholders. Central theme
in corporate taxation. Critics say it is inefficiently biased 1) against corporate as opposed to
noncorporate investment, 2) in favor of excessive debt financing for C corps, and 3) in favor of RE
at the corporate level rather than dividend distribution.
B. Higher personal rates create incentive for corporate investment
C. Favorable capital gains rates create incentive for long-term investment
D. Nonrecognition – gains or losses not taxable until realized in sale, exchange, or other event that
makes them easily measurable
6. Common law
A. Sham transaction – transaction that never occurred but is represented by the taxpayer as having
occurred. Usually reserved for more egregious cases, typically defined where court finds that
taxpayer was motivated by no business purpose other than obtaining tax benefits, and there is no
substance to the transaction because no reasonable possibility of profit exists
B. Substance over form – a business’ definition of a disputed transaction is not determinative. What
the transaction accomplishes, rather than what it portends to be, if the common law key to review
C. Business purpose – no valid business purpose but to create tax savings
D. Step transaction doctrine – combination of formally distinct transactions to determine tax
treatment of the integrated series of events. Interrelatedness of events to allow this test is a gray
area (some courts require binding legal commitments enforcing the whole of the transactions,
others simply look for “mutual interdependence”)
B. The Corporation as a Taxable Entity 1-27
1. Corporate income tax

A. Rates 11(b)(1)
Taxable income Rate
0 to $50K 15%
$50,001 to $75K 25%
$75,001 to $10M 34%
* $100K to 335K add 5%
* $15M+ add lesser of 3% or $100K
$18,333,333 35% flat rate

* - Rate “bubbles” to wipe out the advantages of the first $75K in income at the earlier rates. See
11(b).
B. Determination of taxable income 63(a)

Computed similarly to personal income taxes, with following exceptions:
No personal or dependency exemptions, medical expense, spousal support, etc., deductions
No standard deduction
70-100% deduction allowed to corporate shareholders for subsidiary dividend distribution to
parent corp
o Effect of 70% dividends received deduction is that corps are subject to 10.2%maximum
tax rate on dividends (34% rate x 30% includable portion of dividends). 243(a).
10% deduction limit to charitable contributions
$1M per year limit to publicly traded corps for executive compensation
Corp losses only deductible to extent of corp gains 1211
o Excess may be carried back three years or forward five

Lower brackets of §11. PSC taxed at 35% - not eligible for graduated rates. 11(b)(2), 1561.
Restricted accounting methods. 448. C corps generally not allowed to use cash method
accounting – must use accrual method accounting. C corps can generally afford to pay
someone the extra money for accrual, and it’s more accurate.
C corp can pick fiscal year, PSCs have to use calendar years. 441(i).
Distributions from subsidiaries – see above, 243(a). Only available to C corps.
D. Fairness and CIT

The breakdown of horizontal and vertical equity arguments for scaled taxes
Large corp with thousands of shareholders retains all earnings – violates verical equity
Two individuals, A & B, own all stock of corp A and corp B, respectively. Corps A & B have
equal revenue and operating expenses
o Additionally, need to know what each corp is doing with its earnings
o Assume that both corps distribute all after tax profits as dividends. Would still provide
horizontal equity.
o Assume A capitalize din stock exclusively; B partly in stock, but mostly in corporate
debt. B will see some deductible to the extent of corporate debt, while seemingly
economically identical A will not. Violates horizontal equity
E. Incidence of CIT
Short run – burdens shareholders if industry is perfectly competitive (commodity) or
unregulated monopolies
Long run – shifting of burden to owners of ALL capital
o X corp current dividend distribution
Y partnership
Differential will occur until after tax implications equalize and the cost of capital is
resultantly increased because of higher supply of capital (less tax, more in pocket, less
need for financing, more cash in bank stockpiles, lower interest rates)
F. Economic neutrality and inefficiencies in allocative resources

CIT favors unincorporated over incorporated businesses
CIT favors RE over current distribution
CIT favors debt rather than equity capitalization
Net result is estimated 25% deadweight loss in total CIT tax revenues
2. Alternative minimum tax 55, 56(a)(1)(A), (c), (g)(1-3; 4(A-Cii)), (5), (6); 57(a)(5-6)
Flat rate tax imposed on a broader income base than the taxable income yardstick used for the
regular corporate tax. Payable only to the extent that it exceeds corp’s regular tax liability.

AMT income (AMTI) taxed at 20% after initial $40K exemption. AMTI = CTI + tax preference
items – certain timing benefits from regular taxation
Adjusted current earnings (ACE)
Reread pp. 16-17. Confusing.
Ownership tests prevent splitting corporate profits among smaller corporations to minimize tax
liability. 11(b)(2).
Avoids ACE/AMT maze by passing corporate tax through to personal shareholder level. General
forms:
Problem 19
(a) Boots, Inc.’s taxable income $900,000
Regular tax liability $
(b)
(c)
(d)

Possible integration of corporate and individual tax systems into single, coherent, and equitable
system.
a. Dividends paid deduction to corporations (like interest payments). Would neutralize debt
capitalization favorableness. Eliminates CIT
b. Dividends received exclusion – Eliminates SH tax
c. Imputation-credit system – CIT remains, dividends taxed on SH, but dividend is increased to
comp for the CIT and CIT is treated as a credit against SH’s tax liability (i.e. $100 profit * .35
= $65 dividend, but “gross up”/impute dividend by CIT, so SH reports $100 dividend on
which they can claim the CIT as credit. SH at 40% taxable will have $35 credit, then simply
pays $5 difference)
d. Distribution relief alternatives:
Corp and SH taxes equal,
All shareholders taxable, AND
No corp tax preferences, then all three forms above yield same result.
Conduit tax treatment, but difficult to determine appropriate allocative tax treatment because of
disparate stock class treatment. General view is that unless different classes of stock are outlawed,
current complex capital structures prevent this type of integration. “Best in principle” winner,
Cannes 2002.
C. General capital tax

Treasury’s 1992 Comprehensive Business Income Tax (CBIT) proposal. Addressed bias between
distribution and RE strategies. As follows:
a. Deny deduction for any payments to capital owners (interest/dividends),
b. Interest and dividends received excluded from second round of taxation
c. Apply system to all business, regardless of business form
1. In general
Federal classification of business entities does not hinge on state law labels. However, state law
governance of legal relationships provides the criteria that the federal classifications are based on.

These federal adaptations of the “overall resemblance” test are contained in Reg. 301.7701-1 through -
3. It lists six characteristics normally found in a “pure” corporation:
Associates (two or more persons in shared control and ownership)
An objective to carry out the business and divide the gains therefrom
Continuity of life
Centralization of management
Limited liability
Free transferability of interest (shareholder ability to dispose of their shares)
A business will thus be treated as a corporation under federal tax laws if it more closely resembles this
organization than it does a partnership. This process of distinguishing between the two has caused
problems.
Absence of first two characteristics will prevent organization from classification as an association.
When distinguishing between associations and partnerships, the last four are considered and
weighted equally. Classification as an association will only occur if three of the remaining four
are present.
B. Limited liability companies

IRS classified as partnerships. Principal benefit of LLC over limited partnerships and S corps
(other pass-through entities) is that owners have limited liability, but may participate in business
management. Also, no strict eligibility requirements like S corps, and flexibility in taxation under
Subchapter K. Looks to be the dominant organizational form for the foreseeable future.
C. “Check the Box” regulations

Because of thinning lines between state law definitions of corps and partnerships, IRS chucked the
four-factor system in favor of default tax classification as partnerships unless electively “checking
the box” to be taxed as a C corp. This is only for businesses that have not incorporated under
some state incorporation law, because to change the regulations governing them would free them
from the statutory definition of “corporation” in 7701(a)(3) and frustrate the tax code. IRS regs
have no authority to revise statutes, but as a matter of policy are probably indicating that they’d
like Congress to change the statute itself.
Businesses may make this election after functioning as an S corp in the startup phase for loss pass-
through purposes. See 301.7701-3.c.iii – iv.
D. Publicly traded partnerships

Temporary loophole around double tax regime was amended quickly by congress when interest
began to be traded often like stock. 7704. PTPs are reclassified as corps when interests are either
1) traded on an established securities market, or 2) readily tradable on a secondary market.
Exceptions from reclassification on 90% or more of gross income is from passive income items
(dividends, rent, etc.).
301.7701-4. No double tax on trust income. Distributions are taxed to the recipient to the extent of the
trusts “distributable net income.” If trust income is accumulated, then it is taxed at §1(e) rates, and
normally not taxed again if the accumulated earnings are distributed later. If the trust becomes an
active trade or business, it is taxed as a normal corporation.
Two classes of trusts: 1) Conserve property (301.7701-4.a), and 2) “Active business” trusts
(301.7701-4.b). Regs suggest that ultimate test is whether state law trust is a state law “business
entity”.
Other considerations for trusts v. corporations: 1) active conduct of business, and 2) voluntary
association of business partners = corporate tax levied against trust. Spendthrift trusts are stuck in
this conundrum. See Estate of Bedell, 86 T.C. 1207 (1986).

Problem 36
(a) No double tax on the recipients. Trust was already taxed.
(b)
(c)
D. Recognition of the corporate entity

Ambiguity in relationships between agents and corporations examined.
Bollinger 37 (1988)
Shell corporation used as agent for partnership to avoid state usury laws and allow acquisition of bank
financing. When losses were incurred, Bollinger applied the accelerated depreciation deductions from the
real estate to his personal taxes (like a partnership) on income from other sources. IRS disallowed because
of state law formation as partnership, saying that losses must be attributed to corp. Tax court overturned,
US affirmed. If a corp is legitimately formed for reasons other than specifically avoiding tax
consequences, and the corp is acting as an agent for certain asset purposes as clearly indicated in corp
charter, no abusive avoidance scheme exists.
Why not an S corp? Severe limitations on pass-through for losses (not for gains, though).
II. Taxation of C Corporations
Quick taxable income overview

Income measurements –
Realization, look to intro language in 61, then 61(a)(3), 1001(a). Tax reckoning only when investment is
terminated.
Recognition, 1001(c)
Definition of 1001(c)*: Amount realized 1001(b) + case law
- Adjusted basis 1011 1012, plus or minus adjustments in 1016
Gain/loss Cost of property to extent you received
more than you put in.
Definition of gross income: Amount spent in consumption + change in taxpayer’s wealth.
* – Even though there is a realized gain, congress may choose to pass on taxing it. Most commonly because
gain is realized in technical sense, but investment continued in similar form. See e.g. 1031(a) (lifetime
exchanges), 351 (transfer to corporation nonrecognition). Every nonrecognition rule has an associated basis
rule. See e.g. 358 (associated basis rule for 351).
In corporations, 351 nonrecognition may occur if a transferor exchanges capital assets (as defined in 1221,
minus enumerated exceptions) for stock that is in essence merely a change in form of the initial investment in
the transferred property. The catch is when the transferor’s basis in the property is different than its FMV, and
is contingent on what the disposition of that property is after the transfer (i.e. transferor immediately sells the
received stock and must realize and recognize the FMV gain before he/she can recover their basis).
A. Corporate Organization
351(a), (c), (d)(1)-(2); 358(a), (b)(1); 362(a); 368(c); 1032(a); 1223(1), (2); 1245(b)(3).
Nonrecognition allows for avoidance of taxable consequences for raising business capital if the
exchange doesn’t substantially alter the nature of the transferor’s investment. Normal nonrecognition
policy consideration is that if swap is for such a similar form of investment, then the deferral in
accumulated value is warranted until this new investment is terminated for something substantially
different in form. 351 broadens this policy by nonrecognition of substance changes to encourage
business investment. The essence of 351 is to ascertain whether a transferor has a sufficiently
continuous relationship with the property transferred to a corporation to justify nonrecognition
treatment, or whether that transfer has severed the relationship with the transferred property, thereby

justifying recognition of a gain. Three requirements for nonrecognition benefits: 1) transfer of
property, 2) in exchange solely for stock, and 3) transferor control of corp immediately post exchange.

1032 is corporate nonrecognition statute – issuance of stock by corporation always a nonrecognition
transfer. 362 covers the basis for recognition by the corp – the transferor’s basis travels with the
transferred property, no matter the FMV. This is the crux of the problem in Intermountain Lumber,
infra, where the transferor wants recognition to avoid immediate taxes, but the corp wants to avoid so
they aren’t stuck with a lower basis than FMV (and cannot use depreciation of the more valuable FMV
figure as a tool to write off current taxes).
Property transferred retains its transferor’s basis while now in the control of the corp. Any gain or loss
on that property will be realized from the transferred basis. Same deal with transferees. If a transferee
exchanges property with a basis of $10 and FMV $100 for $100 in stock, then upon sale of the stock
(at $100) transferee must recognize $90 gain (as in $100 gain – $10 original basis).
1. Nonrecognition in 351, basis for recognition in 358.

2. Be aware of both sides of transaction (transferor and transferee tax consequences)
Problem 46
Realized gain/loss 1001(a)
Recognized gain/loss 1001(c), 351
Adjusted basis in property received 1012
Character of property received 1221
Holding period 1223
“Holding period” describes the tax status that differentiates capital gains from LTCG. If a
transferred item is a capital asset under 1221 (as opposed to normal income property), then the period
for which the transferor held that property prior to transfer may be “tacked on” to the stock received in
the exchange. Upon sale of the received stock, the total holding period will determine whether the
realized gain finally recognized is treated as short-term capital gains, or the lower bracketed LTCG.
(a) Distributor computations

A – Cash purchase = no material change. 1012 says basis in cash purchase is cost
B – Will realize $5K gain on sale of stock, none recognized. Character of property received changes
from inventory (which would have become regular income at sale) to stock with possible preferential
tax treatment under RE scheme
C – Must realize previously unrealized $5K loss immediately, won’t recognize until stock is sold
D – $25K realized, 0 recognized. Capital asset unless D is realtor. Won’t be able to clam a $5K loss
because D has already amortized $5K in depreciation on the transferred property. Looks like D meets
holding period. 1245(a)
E – $18K realized gain, no recognition, $2K basis transfers to stock. Promissory note becomes capital
asset under 453B(a), so 1223(1) tacking rule applies. 453B(a) mandates immediate recognition of gain
or loss on disposition of installment obligations because while E would have the 351 nonrecognition
allowance because the corp only gave him a promissory note in exchange for the property, he turned
around and sold it for hard cash.
(b) Distributee computations
Formalistic answer – corp didn’t contribute anything (the stock cost nothing, so they contributed zilch
to each transfer), so they realize full $100K of all transactions. But basis carries over with
corresponding transactions in 358(a), and tacking applies with 1223(2).
A – complete nonrecognition
B – Must recognize $5K gain when inventory is sold
C – May recognize $5K loss on sale of land
D – Must recognize $20K gain if equipment is sold.
E-
(c) Double tax. Justification? The transfer created new wealth of $10K, kind of like a successful double
down.

A. “Control” immediately after the exchange 351(a)

351 only applies if the transferors as a group “control” the corporation immediately after the
exchange. Must include direct ownership of at least 80% of all voting stock and 80% of all
nonvoting stock. 368(c). 318 constructive ownership rules don’t apply.
Intermountain Lumber 48 (Tax Ct. 1976)

Shook incorporated and transferred his mill to the new corporation. As part of the incorporation
plan, he agreed to sell 50% of his shares to Wilson. After the transfer, he tried to claim 351 so
he’d avoid taxes as nonrecognition of gain, and Wilson tried to argue that the stock agreement was
a sale so he could record a higher base and a larger deduction on higher depreciation. The court
said no, that the agreement to sell 50% was a condition of the incorporation, and thus Shook had
no intention of maintaining the 80% control necessary for 351 applicability. Intermountain had to
record the gains and depreciate them normally.
Even an implicit, albeit non-contractual agreement, will fall under the purview of the step-
transaction doctrine. Enforcement of this principle, though, is obviously problematic.
How could this have been constructed to still create a right to nonrecognition? Wilson was not a
contributor, and he should have been. Had he contributed at all, both Wilson and Shook would
have been transferors controlling 100% of the assets.
Options:
1. Cash contributions from both parties. Wilson contributes cash ($91K) directly to the
sawmill, Shook contributes the capital assets. Unfortunately, Shook would out-contribute
Wilson 2:1 ($182:$91), and the shares would more appropriately break down according to
that ratio.
2. Pre-incorporation partial sale. Shook sells half interest in his sole proprietorship to Wilson
(thus forming a partnership), and then incorporate it and buy the mill. Unfortunately, Shook
will be immediately taxed on all of the previously unrealized appreciation when he sells the
partnership interest to Wilson (only half of appreciation actually taxed because Shook only
sells half the partnership). On transfer to the lumber mill, Wilson will gain a FMV basis for
his contribution because of his initial cash purchase of the partnership interest being at FMV.
3. Cash boot. Shook contributes assets, Wilson contributes cash. Shook receives 182 shares of
stock, $91 cash “boot” back. Wilson contributes the same amount of cash and stock received.
However, this merely masks the transaction as contemporaneous corporate funneling to
Shook for control.
4. Lender financing. Bank makes $91K loan to Shook. He transfers the sole (encumbered)
proprietor assets to the lumber mill, Wilson contributes $91K. Both get 182 shares,
respectively. The lumber mill pays off the loan. The debt transfer does not prevent 351
nonrecognition, and the “constructive boot” is ignored for tax purposes (357(a)) ONLY IF the
loan is for some valid business purpose (357(b)).
5. Post-incorporation distribution. Shook transfers assets to lumber mill. Later, mill distributes
$91K to shareholders (Shook) as a 301(c)(2) return of capital (not a dividend because there
has been no profit in the corp yet). Wilson contributes $91K and receives 182 shares.
Nonrecognition on step 1, tax free return of capital on step 2, nonrecognition in step 3, but
still may run into a step-transaction doctrine problem.
6. Redemption. Initial transfer of assets from Shook ($182K FMV), $91K cash from Wilson,
and corp distributes 364 shares to Shook and 182 to Wilson. Corp then redeems 182 shares
outstanding from Shook for $91K.
B. Transfers of “property” and services

“Property” has been broadly construed to include cash, capital assets, inventory, AR, patents, and
in certain circumstances, intangible assets like patents and process knowledge. Services can’t be

considered property for 351 treatment, only income. 351(d). If a transferor receives stock for
both property and services, all of the stock can count against the 80% requirement. Stock as
compensation is computed under 83(b).
C. Solely for “stock”

Stock means normal equity investment with the company.
Problems 53-5
1. Qualify under 351?
(a) Yes to A’s transaction (realized but not recognized). Corp doesn’t pay tax because of 1032.
B gets hammered with both realization and recognition, even though B received all of the
nonvoting stock, because B ain’t got no control.
(b) Yes – step transaction doctrine. A and B are both transferors to the corp, and control is tested
on March 2 after B transfers.
(c) If control is tested post march 5, control is destroyed. D hasn’t contributed anything. But if
the test is as in (b), and that is successfully argued, then the nonrecognition still stands and the
“gift” is unrelated. Passes both narrow and broad interpretations of step-transaction doctrine,
either because the gift was not contractually binding (narrow), or because the gift was indeed a gift
and not a sale transaction in tax terms.
(d) No
2. Tax evaluations
Valuation in 61(a)(1), 83(a)
(a) No protection in 351, because Manager is offering service instead of property in exchange for
stock.
(b) Yes, 351 qualification if Manager is paying for her stock. As for the second part, “Is it
property?” A promissory note, if property, satisfies the control test. The total economic effect is
almost exactly the same as the situation in (a), but in this case instead of receiving stock as a
compensation package, Manager is essentially “discounting” her salary against a purchase
payment system for the stock she would have received in the (a) scenario.
(c) No, because of the de minimis value of the property in comparison to the stock received, in
what looks like a mask for service compensation. 1.351-1(a)(1)(ii). Recognize the de minimis
payment as purchase of equivalent stock, then tax Manager on the remaining $149K as income.
Ouch.
(d) Manager kicks in more than 10% of the value of stocks essentially allocated as “service
compensation,” so the transaction is not de minimis.
(e) Restricted in-kind compensation. Amount of compensation is based on time when in-kind
compensation becomes transferable or not subject to substantial risk of forfeiture. 83(a). Barring
Manager’s leaving, the valuation and taxation would mature when the restrictions on her shares
are lifted. Then there’s the 83(b) election to avoid the tax deferral and pay up front (possibly
insurance against massive taxation later if stock value skyrockets). Pays without regard to risk of
loss. Taxed as ordinary income up front. If sold, treated as market appreciation (LTCG).
What about (e) under 1.83-1(a)? “Until you pay tax, stock isn’t owned by service provider.”
Control issue? If Manager 83(a) pays up front, no issue. Otherwise, for tax purposes no one
would be the owner until someone paid taxes on them. but there should really be no issue at all,
since there is no control dispute at all. The stock, if Manager 83(b) elects out, is basically
unissued treasury stock, so effectively 100% of the corp is controlled by the remaining two parties
to the incorporation.
Alternatives to accomplish the business objective and Manager’s equity stake:

Issue two classes of stock, common and preferred, with respective low and high values
Have preferred represent most of the capital considerations of the corp
Distribute preferred to the capital investors

Distribute common (voting) at $1par, 51% to Java and the remaining 49% between Venturer
and Manager. Manager now becomes capital contributor.
Downside? Tax flexibility – can’t elect S corp because of two classes of stock.
Alternative 2 (Silicon Valley)
One class of stock
Warrants to service providers
Distribute common to Java and Venturer, none to Manager
Give manager warrant (pull option) for future common purchases
1.351-1(a)(1) says that warrants aren’t included in term “stock or securities”, so no control
issue
351 – Nonrecognition
358 – Shareholder basis rule
362 – Corporate basis rule
1032 – Corporate nonrecognition rule
A. In general
Policy: Tax all gain realized from transfer up to the amount of boot, because transferor is defeating
the “changed form investment” grounds for 351 nonrecognition.
Normal Boot Rule: Recognized gain = amount of boot; basis in transferor’s stock in 358. “Return
of Capital Last Rule”
Corporation basis: Transferor’s basis + transferor’s recognized gain from boot. 362.
Alternatives:
Partial sale approach: subdivide interest in property for transfer in exchange for 100% stock (step
one); sell remaining interest for non-stock consideration (step two).
Example:
$100 FMV
$ 10 Basis
Contribute 80%, so basis in exchanged property is 8. Transfer covers basis, so no recognized
gain on remaining realized gain (72 to corp under 351).
Sell 20% interest for $20 FMV bond. Realized gain $8 for transferor, but should be $20 (face
value of bond). Corp’s basis is $20, and corp’s basis in total property ends up being 28
(transferor’s 8 basis goes to corp under 362)
$10 of bond received is taxed to transferor (other $10 recovered as original basis – 301(c))
Results Realized gain Recognized SH’s Adjusted Corp’s AB

gain Basis stock property
Normal boot rule 90 20 10 30
351(b) Return of
capital last
Partial 351(a) sale 90 18 8 28
1001(c) treatment Pro rata
return of
capital
Contribution 90 10 (LTCG) 0 N/A
351(a)/ Return of
distribution 301(c) capital first
treatment
There is no boot rule for partnership organization (721(a)), so courts apply partial sale
treatment because of the literal substance of the transaction.

“Other property” not stock that is given by a corporation in exchange for transferred property.
351(b) requires transferor receiving boot to recognize any realized gain on the transaction to
the extent of the money or FMV of any nonqualifying property received. Requires
recognition of gain before basis can be recovered, so that boot cannot be abused.
When multiple items are transferred, each one is treated as a separate transaction.
Example:
$200K property with $20K basis transferred to corp for $170K stock and $30K cash.
There is still a $180 realization, but only required to recognize that gain to the extent of the boot
received. So transferor recognized $30K immediately, but doesn’t mess with the remaining $150
until the stock is sold or converted into another, corporately unrelated asset. The basis is then
fully recovered from the $30K of boot (with a tax on the remaining $10K after the basis
deduction), and the rest of the FMV is deferred to encourage corporate investment.

Debt instruments of the corporation exchanged to the transferor in return for the capital
contribution do not qualify for 351 nonrecognition, but they aren’t fully recognized immediately.
They are treated as installment payments under 453.
The transferor’s basis is first set off against the stock (non-boot exchange item) up to FMV. If the
basis doesn’t exceed the FMV, then there is no immediate charge. If it does, then the excess basis
is allocated to the installment portion of the transfer. 453 is then applied against the installment
portion of the contract. if there is any remaining basis, it offsets the face value of the obligation.
Note: gain from inventory property exchanged for a note is a SALE, and must be recognized
immediately.
Example:
Problem 63
A gives $22k FMV inventory ($15K basis); gets 15 common ($15K), $2K cash, 100 preferred ($5K)
B gives $20K FMV inventory ($7K basis), $10K FMV land ($25K basis); gets 15 common ($15K),
$15K cash
C gives $50K FMV land ($20K basis); gets 10 common ($10K), $5K cash, corp not for $35K/two
years
Tax consequences (gain or loss realized and recognized, basis and holding period)?
A
Total Equipment
FMV $22K $22K
FMV c. st. $15K $15K

FMV p. st. $ 5K $ 5K
Cash $ 2K $ 2K
Realized $22K $22K
Adj. basis $15K
Gain/loss $ 7K
Carryover basis $ 5K (AB in stock for future recognition)

Recognized $ 0 ($7K basis – $7K boot recognition)
Corp
AB equip. $15K (362(a) carryover basis from transferor)

+ 2K (Cash payment)
$17K (Corp basis in property - $5K in appreciation recapture for
future recognition)
B
Total Inventory Land
FMV $30K $20K $10K
% Total 66.7% 33.3%
FMV stock $15K $10K $ 5K

Cash $15K $10K $ 5K
Realized $30K $20K $10K
Adj. basis $ 7K $25K
Gain/loss $13K ($15K)
Carryover basis ($ 2K)

Recognized $ 0 ($13K basis – ($15K) boot recognition)
– OR –
Carryover basis $13K
Recognized $13 ($13K basis – 0 (no recognition of loss))
Associated basis for stock:

$ 7K Inventory
+ $25K Land
+ $10K Recognized gain
– $15K Cash boot
$27K Basis in stock
$15K Stock value

$27K Basis
–12K
Corp
AB inv. $ 7K (362(a) carryover basis from transferor)
+$10K (Cash payment)
$17K (Corp basis in inventory property)

+$ 0K (Only increase basis by boot on transferred property that
generated the recognized gain for transferor – already added to
inventory, supra)
$25K (Corp basis in land)
P.S. While only a portion of this stock qualifies for the tacking period, the tacking period may be
applied to all shares pro rata (the same 2/3:1/3 ratio).
C
Transferred:
Land $50K (FMV; $20 basis)
Recognized gain $30K (FMV – basis)
Received:
Common $10K
Cash $ 5K
Note $35K (Two year note)
Total boot $40K (Note + cash received)

Qualify for 453(a) installment payment option? Large portion of boot is installment note, and any
receipt of promise to pay later for transferred goods qualifies for 453(a).
How does basis get applied? Assign it first to stock (nonrecognition property) up to FMV, then
remainder (if any) to boot.
AB stock $10K (FMV fully covered by basis)
AB boot $10K ($40K total payments, so ¼ each payment treated as basis, ¾
each payment treated as gain)
Works out to taxable amount on $5k = 3,752, on $40K note = $26,250.
Corp
+$ 3.752K (Recognize gain only when transferor recognizes gain from
payments)
$K (Corp basis in land)
What if C had given $50K FMV non-capital assets?

C wouldn’t qualify for 453(a) installment treatment, and the $30K gain would all be taxable up
front. What about recapture when there is an installment note? 453(i), overriding 453(a) through
1245(a), says that any non-capital asset recapture income will be recognized according to the
payouts, i.e. exactly like the installment option..
357 – Corporate assumption of liability

358 – Basis to distributes (shareholder basis rule)
1031/1031(d) – Like-kind exchanges: “...such assumption [of taxpayer liability] shall be considered as
money received by the taxpayer [and subject to tax immediately].”
Carve out:
357(a) – Whoa, wait! Liabilities aren’t boot for purposes of immediate recognition, so you aren’t
taxed up front. So, to make up for this exception, 358(d) comps by reducing basis.
Most corp formations involve corp assumption of debt, which is normally considered boot for the
transferor. But applying that strictly to corp formations would frustrate 351. So 357 makes an
exception, and 358(d) comps for that immediate taxable loss by adjusting the transferor’s basis down
in the encumbered property. If the diminution of basis through 357 (a) would result in a negative
basis, then the transferor is required to recognize that negative amount as a gain at the time of transfer.
357(c).

Avoiding the “357(c)” trap. Lessinger contributed assets of his sole proprietorship to his corporation,
but the SP was insolvent and $200K in the red. He also contributed a note to the SP (basically a
scribble, an accounting entry that was scribbled into the ledger by Lessinger’s accountant (and possibly
while Lessinger was unawares)) with a face value of essentially that same negative amount to the SP,
which was also transferred. Lessinger avoided the negative basis 357(c) trap requiring negative basis
gains recognized on straight transfer of property. IRS balked. Court extrapolated their holding from a
broad reading of 357(c) and 362 together. Crux is “legally enforceable obligation to contribute money
in the future.”
Also, if Lessinger wasn’t allowed to contribute the note and the SP was in the red when it was
transferred, he runs into the Fraudulent Conveyances Act. Ouch.
Should that legally enforceable obligation to pay cash in the future represent a cash payment now?
Court doesn’t really answer it, but seems to indicate that they’d say “yes.”

Peracchi (9th 1998)

Alternatively to Lessinger, Peracchi was allowed to claim basis in his personal promissory note to his
corporation (a legitimate note, different than the Lessinger scribble [also the name of a new dance]).
Court reasoned that the note would be enforceable in bankruptcy, so there must be some basis because
of Peracchi’s increased exposure to risk in pledging the note. Therefore, he’s entitled to an upped
basis to the extent of his possible exposure to loss should the corp tank. The court limited this
allowance to notes worth approximately their face amount.
Note: You should always be able to beat this IRS argument by borrowing the money first, and then
pledging it in full to the corp. Some semblance of real liability goes a looong way to making this
“basis-up” strategy legitimate.
The real issue in both of these cases: TIMING. Not if you get a basis increase, but when the basis
increase should occur. Since this is a debt in both cases, should it be installment method
recognition???
Problems 80
1. A contributes: Inv, $10K FMV ($20K basis); land, $40K FMV ($20K basis, $30K mortgage).
A receives: 20 shares ($20K value), corp assumes mortgage.
a) $20K AB Inventory
+ $20K AB Land
– $30K Liability transferred (from 358(d))
$10K Basis in stock
Assuming that A isn’t a realtor, the holding period of the land transferred will be tacked pro rata
across all of the stock received. There is no holding period tacking for the inventory, as it isn’t a
capital asset.
Corp basis will be $20K.
b-d) Liabilities will be in excess of basis, so there will be a $5K recognized gain (357(c)). Will
end up with $0 basis:
$25K AB basis both inv and land
+ $ 5K Recognized gain
– $30K Liability
$ 0 Basis
Corp basis will be transferred basis, but 1.357-2(b) says prorate the basis across the gross value of
all contributed assets.
Wiedenbeck thinks that the allocation should be recognized according to the appreciation in
value of the respective items, not according to gross FMV as proscribed in 1.357-2(b).
2. B contributes: Building, $400K FMV ($100K basis), with first mortgage of $80K (valid business) and
second mortgage of $10K (personal, eve of transfer).
B receives: $310K stock, assumption of liabilities.
a) B gets hammered by 357(b), because a tax avoidance purpose combines total liability
assumed (avoidance AND valid business purpose), and treats the final number as cash boot.
b)
Policy: Don’t fuck around with 35’s graciousness. We’ll wallop you with recognition
immediately.
3.


Assignment of income. AR may be considered property for tax computation purposes ONLY WHEN it
serves the policy of 351. Accounts receivable are transferable, but the AR in this case were generated
form services. The service provider is always the entity taxed, no matter where the AR goes. Since
351 property can’t be services (351(d)), then there is a conflict that must be resolved in light of the
congressional purpose of 351 (look for hidden payment for services, etc., schemes to use
Exam tip: Always look for step transactions, alternative solutions, etc., when analyzing cases.
Liabilities under 357(c)(3)
482 Reallocation
If you have multiple related business, there may be a reallocation issue. Service has discretionary
ability to reallocate tax burden. The Service will look for evidence of improper reallocation of
amounts to mismatch income and split tax consequences.

Where liabilities give rise to a capital expenditure. Transfer of environmental liability. Corp
contributed land that was encumbered by environmental liabilities. Potential application of 357(c). to
the extent that the liabilities would be considered “ordinary repairs to land and equipment,” the costs
would qualify. But the extraordinary nature of these cleanup costs are too high, and must be
considered capital expenditures, which are specifically eliminated from 357 exception qualification.
Problem 90
a)
b) Design.
c) Yes.
d)
e)
f)

When a shareholder transfers property other than cash without receiving anything in return, they
have made a contribution to capital and can increase their basis in already held stock to reflect the
transfer. The transferred amount is excludable as gross income by the corp. Transferor’s basis
carries.
Fink 92 (1987)
Non pro-rata surrender of stock to capital. Not only did Fink want to take an AB deduction on the
surrendered and cancelled shares, but they also wanted to claim it as a 165(f) ordinary loss. They
claim that yes, the stock was a capital asset, but the loss was not incurred through a sale or
exchange. It was a surrender, so it eschews the capital gains/losses requirements of 1223.
Congress remedies this with 1224A. But the real issue in front of US was was there realized loss?
IRS says no, because they were still majority shareholders post-contribution. Service says they
should have upped their basis in the remaining stock by the basis of the amount of the stock
surrendered. US agreed.
Ways around: Have the corp buy shares from shareholders outright, then shareholders take
the proceeds form sale and contribute those to the corp as a direct contribution to capital. No
net change in assets, but the contribution then becomes a real contribution to capital.
302 would have helped this definition

C. Organizational expenses
Problem 100
B. Capitalization
1. Introduction
What difference does it make if investors hold stock, bonds, or notes? Tax treats debt and equity
differently, and the more favorable tax treatment is with debt. Issuing debt avoids the double tax;
repayment of debt is tax free on principal and capital gains for excess difference, where stock buybacks
(essentially debt repayment to the shareholder) may be taxed as dividends if the shareholder retains
some stock. See also the 351 stock/boot differences in tax recognition.
2. Debt v. equity
Problem – Deductions for interest, not for dividends
Incentives –
Policy – Substance v. Form
Case 1: GM Stock
GM Bonds Shareholder owns 0.000001% GM common, some bonds – so no real conflict.
Case 2: Closely help corp

A B C
60 sh 30 sh 10 sh Different levels of ownership will create equilibrium
30 bonds 10 bonds 60 bonds for fair distribution of corp wealth among both shares
and debt.
X corp
Case 3: Priority bonds over subordinate outside lender claims. What incentive is there for the
bondholders to act as proper creditors?
The IRS can analyze substance over form to determine whether corporate obligations are debt or
equity. There is a spectrum in case law that may help, with one end being equity (risk investment with
the potential of shared profits) and the other being debt (fixed promise from corp to repay principal
with interest at a fixed maturity date). Then there are all the spots in the middle, left to the courts to
decide where a particular investment falls. Some say that the disparate results in the courts have
created a “smell test” for either debt or equity. The principal factors of the smell test are:
Form of the obligation – While labels aren’t controlling, a proper label may ward off a
challenge that debt is actually equity.
The debt/equity ratio – Ratio of company’s liabilities/shareholder’s equity. The more thin the
capitalization, the better ammo for the Service to classify an item as equity under the rationale
that no lender in their right mind would loan out to a severely undercapitalized business.
However, the bar of what is and isn’t thin capitalization has been amorphous in the case law.
Intent – Gleaned by an objective look at criteria such as lender’s reasonable expectation of
repayment in light of the company’s financial condition, and the corp’s ability to pay the
principal and interest.
Proportionality – In closely held corps, debt held by the shareholder in the same proportion as
stock raises eyebrows with the Service. If close to equally leveraged, by what incentive
would the shareholder/debt holder enforce his/her own debt?
o “Stock overlap”: Assume that stock ownership and debt holdings are proportionally
equal among investers. Treasury says compare % stock owned and % of instrument in
question. If the lowest comparison from each investor added together tops 50%, then the

debt instrument will be considered equity (i.e., one shareholder’s relative stock is 20%,
another’s relative debt holdings are 31%, combined >50%, then debt = equity)
Subordination – Frequently, outside creditors require that shareholder debt be subordinated to
their claims.
Hybrid instruments
The big banks have tried to eschew a one-or-the-other classification by issuing products with massive
hybrid characteristics that they claim allow for interest deductions while allowing for equity treatment
on balance sheets. The Service has made announcements indicating that it will pursue disputes on
such hybrids that have unreasonably long maturity dates or the ability to repay principal with corporate
stock. Anyway, this is still a gray area. But 385(a) was amended to add a parenthetical that allows the
Service to treat hybrids as scrambled transactions – in part stock, and in part indebtedness.
In tax advising, do everything to avoid hybrids if there is concern about debt v. equity. Also
make sure capitalization of corp isn’t too thin, that client adheres to the terms of the debt
instrument, and that strict proportionality is avoided.

To prevent tax avoidance through the use of excessive debt, 385 allows the Treasury to create regs on
determining whether an interest in a corp is stock or debt in substance, regardless of how the corps
label it. 385(b) sets out factors to be taken into account when determining whether a debtor-creditor
relationship exists:
Form
Subordination (shareholder debt equal to or higher than outside lenders)
Debt/equity ratio
Convertibility
Proportionality
The 385(c) obligation of consistency locks the issuer’s characterization of the interest at the time of
issuance, but doesn’t restrict the Service from the reclassification endeavor listed above. The rule only
applies to the issuers; it doesn’t apply to the holders and how they apply the interests to their taxes.
Problems 123
1. A, B, and C form Chez. A contributes: $80K cash; B contributes: building, $80K FMV ($20K
basis); C contributes: $40K cash, $40K goodwill. Each receives 100 shares Chez common.
Chez requires $1.8M additional capital. Goodwill Bank loans $900K at two points over prime for
mortgage on renovated building.
Look to flowchart for aid in D:E question
a) Assume A, B, and C will contribute the remaining $900K equally in the form of $300K, 5-year
notes at variable rate of prime –1%. Passes 385(b)(1) because there is a fixed determination of debt,
fixed time. But proportionality is 100%, and the outside D:E is 1.8M:240K, or 7.5:1 (and 12.9:1 if you
use AB for equity). The inside D:E is 900K:240K, or 3.75:1 FMV (6.4:1 AB). So this doesn’t pass
safe harbor, but it’s not necessarily considered debt. You’d have to make a case that it wasn’t (i.e.,
numbers for safe harbor are close, another party would possible have made the same kind of loan, etc.).
But could this really pass when considering the commercially inadequate interest rate?
b) Assume (a), but that the note is a 10%, 20 year debenture payable only out of net profit.
Difference from above is that this is a hybrid, and then the instrument loses one of its only positive
aspects in the “it’s debt” argument.
c) Same as (a), but the investors will personally guarantee the Bank’s loan (which is now unsecured).
Should this be treated as the bank loaning $300K to each shareholder, and thus reduce Chez’s D:E?
Under this two step characterization, would this then be considered a shareholder’s contribution to
capital? What about when Chez would attempt to deduct an interest payment to Bank? Chez would
have to distribute the interest in the form of a dividend to the shareholders, who would then pay the
bank as interest on a personal loan and deduct it themselves. So shareholders wouldn’t care because
there’s no tax repercussion. Well, as mentioned above, the D:E is substantially lowered. But in this

characterization, the contribution to capital becomes true equity because the loan to Chez would not
have been made but for the shareholder’s guarantee.
d) Assume that A will loan the entire $900K with the same terms as (a). Becomes straight debt,
because there is no proportionality. Unless, of course, A is related to either B or C.
e) Debt in form as an unconditional obligation. Chez stops paying interest, so if A doesn’t sue for
payments, then there was probably no intention to treat the debt instrument in question as true debt.
May be reclassified as equity if there is failure to perform corporate obligations.
If you need to see policy considerations or a narrative guide to 1244 for recharacterizing loss for small
business shareholders, look in CB 131-33.
165 - losses
Debt – worthless securities 165(g) Also consider 165(j), 163(f) (registration required unless
v. bad debt business (ordinary income deduction) 166 1) term < one year, or
v. non-business (capital loss deduction) 166 Generes 2) privately placed loans)
301(c) – 1. mandatory d

243(a), (b)(1); 301(a), (c); 316(a); 317(a).
Regs: 1.301-1(c); 1.316-1(a)(1)-(2).

Function: Distinguish distribution properly subject to double tax from return of shareholder
invested capital.
Concept: Cumulative undistributed after-tax earnings.
Capital assets merely change of form – do not increase corp’s net assets until the changed asset gains
interest.
Earnings and Profits (E&P): Assets – liabilities – SH capital contributions = RE

Technical definition in 312.
ii. Start with corporate TI [corp’s ordinary method of accounting; tax law realization and
recognition laws govern]
iii. Adjustments for:
- Tax-free income
- Nondeductible current expenses (162, bribes, lobbying expenses, fines, etc.) and
losses (related party losses 267(a), etc.)
- Timing adjustments
Depreciation – ACRS (312(k)(3))
Installment sales (312(n)(5); 453)
316(a) – defines a dividend as any distribution of property made by a corporation to its shareholders
out of (1) earnings accumulated after Feb. 28, 1913 (“accumulated earnings and profits”), or (2)
earnings and profits of the current taxable year.
Makes two irrebuttable presumptions: (1) every distribution is made out of earnings and profits
to the extent that they exist, and (2) every distribution is deemed to be made out of the most
recently accumulated earnings and profits.
In testing for dividend status, look at the earnings and profits at the close of the taxable year in which
the distribution was made. Any dividend out of current earnings and profits is taxable, regardless of
historical deficits.

Problem 140
Gross profits from sales $20K
Dividends received from IBM 5K
LTCG 2.5K
Total gross income $27.5K
Deductions
Salaries – 10.25K
Dividends received (70%) – 3.5K
LTCL sale – 2.5K (limited by 1211)
Depreciation – 2.8K
Total $ 8.45K
Adjustments:
Tax exempt interest $ 3K
Dividends received deduction 3.5K (not allowed in computing earnings and profits; only in
Excessive depreciation 1.8K computing tax liability)
Total $ 8.3K
Decreases:
Excess of LTCL sale $ 2.5K
Estimated taxes .8K
Total $ 3.3K
Total A&D $ 8.45K

Total $13.45K
301(a), (b), (c); 312(a); 316(a). Regs 1.301-1(a), (b); 1.316-2(a)-(c).
Distribution is amount shareholder receives. Every distribution is a dividend to the extent of current
E&P. Distribution above P&E reduces shareholder’s basis. If basis is fully reduced, then remainder is
computed as gain from sale or exchange.
Note: cash distributions are capable even if accumulated E&P has been reduced to zero. Any
appreciated asset that has collateral value can be borrowed against to provide a cash distribution, while
not being reported on the annual E&P computation.
Problem 144
a. ... and E&P is reduced to zero according to 312(a) ($17.5 reduced to the extend of Pelican’s
available $5K in E&P – 312(a) cannot force a negative E&P)
b. All $10K is a dividend, regardless of the fact that there’s an accumulated dividend. Every
distribution comes first out of current E&P. 316.
c. Allocate all year-end E&P pro rata to all distributions made during current year (2 distributions,
$2K per). 316. Now apply pro rata to accumulated E&P (316 “or”), wiping out the remaining $8K of
the first distribution (accumulated E&P not prorated over all distributions like current E&P) and
leaving $2K to split between the last distribution (half goes to each). Leaves $1K accumulated E&P
per shareholder, and combined with the $2K current E&P results in $3K left over. This remainder is
applied to reduce the shareholder’s AB.
d. $7.5K dividend because the current loss is offset by historical E&P. Assuming that current E&P
declines steadily during the current year, $10K/4 (distribution on ¼ year) = $2.5K.
1.316-2(b) current E&P deficit (see p. 1274) – If there is a deficit in the E&P, you can assume steady
decline as year goes along, unless corp can show specific items that caused the E&P loss. If so, then
E&P can be allocated in real-time according to the events that caused the operating loss.

3. Distributions of property
General Utilities doctrine: 311(a). Distribution in kind allowed corp to distribute appreciated property
to shareholders to avoid corp-level tax on sale. SH would then sell and not realize gain because of
301(d) FMV basis rule. Congress figured it out and basically (with limitations) repealed doctrine in
311(b).
Problem 148
a. Current E&P goes up $9K on realization of FMV distribution. 311. Gain is taxed, which reduces
E&P. Net consequence is $6K (assuming 1/3 tax) increase in current E&P. SH receives FMV basis in
property received. 301(d). Distribution becomes dividend to extent of E&P (both accumulated and
current),
b.
c. First, corporate tax consequences. $9K gain. 311(b). Corp level E&P rises to remaining level
after corp gain tax. Step 2: SH consequences. Amount of distribution = FMV – property’s associated
liabilities. 301(b)(2). $20K - $16K = $4K distribution. Corp current earnings (in this case, at least the
newly realized $6K) covers, so all $4K is a dividend. 312 (a), (b). The result is corp E&P increase of
$2K ($6K remaining from initial gain – $4K dividend = $2K). SH basis = FMV, regardless of the
encumbrance (the inherited debt will equal a deduction on interest for the recipient). Scott Szcorczik is
Ralph Wiggum.
d. Assume AB land = $30K. If corp simply distributes land, the it will realized loss of $10K (301(b)
says FMV is used to calculate loss). E&P gets hit at full AB, so with $25K accumulated and $15K
current E&P – $30K, result is $10K rolled over into accumulated E&P next year. 312(a)(3). Corp
should have sold the land and then distributed the profits.
e. 1016(a)(2) – depreciation as a deduction.
4. Distributions of a corporation’s own obligations

311(a), (b)(1); 312(a)(2). Reg 1.301-1(d)(1)(ii)
Gain recognition rule doesn’t apply to distributions for corp’s own debt obligations. Normally, E&P is
reduced by the principal amount of the obligation attributable to that year. But in cases where there is
a lower current value on the debt obligation that face value, a corp could evade earnings tax by
eliminating book earnings with issuance of a facially overvalued debt obligation, skipping the earnings
tax in favor of the lesser dividend tax. In the case of an obligation with an original issue discount, then
corp can only reduce by that discounted amount.
Problem 151
312(a)(2). Somewhere in here there’s a $5K return of capital. Corp can lower E&P $5K (current
discounted value of the debt obligation), and then reduces corp assets $100K (wiping out all E&P and
paying out $5K of capital assets). Equals net of $5K dividend. Plus, recipient will owe taxes on
interest income (since the note will pay $100K and he bought it for $5K, there will be essentially $95K
in interest accumulated over the life of the obligation).
Reg 1.301-1(j)
High rent, family salaries, etc. are tools corps use to avoid dividends – which they aren’t able to
deduct. Rest assured, the IRS will hunt these things out, smoke them out of their caves, and get them
running. See Nicholls (Tax Court 1971) (constructive dividend for personal use of corporate yacht –
dividend to mom and dad, gift from them to son. What about calling it constructive compensation to
James the sailor?). See also 482, Revenue Ruling (considering two fully controlled corps, where one
sells the other an item at a gross undervalue, allowing the other to avoid E&P increases and higher
corp income tax).

243(a)(1), (3), (b)(1), (c); 246(a)(1), (b), (c); 246A; 1059(a), (b), (c), (d), (e)(1)
Corporate shareholders (corps, for godsakes) receive a deduction on dividends to corporations to avoid
triple taxation. 243 deductions:
General: 70%;

If recipient corp owns > 20% of distributing corp: 80%;
If both corps are controlled under an umbrella elected affiliation group: 100%.
246(c) holding provisions: What of a corp buys stock immediately pre-dividend at stock + dividend
price, receives the dividend, then sells the stock post for its face value? Corp could record dividend as
income (at 30%), and then claim the reduced sale price as a STCL to use the “loss” on the difference
between their purchase and sale price to offset other income elsewhere.

Note: A valid business purpose will prevent the dividend technique used in this case from becoming
the dreaded “sham transaction.”

302, 317(b)
302(a) sale treatment: if you fall into one of the four categories of (b), you get sale treatment (and
LTCG/LTCL tax treatment). If you don’t fall in (b), then you go to (d) and are treated as a dividend.
Example: Alpha Corp, 100 shares: X, 60; Y, 20; Z, 20.

If Y sells its shares to Alpha, then (b)(3) applies. Gets sale treatment, but in actuality the transaction is not
like a real sale because (decreases corp value through the distribution of capital assets, increases X & Z’s
ownership percentages).
What if X sells 15 to the corp? Reduces outstanding shares to 85, but X still maintains control of majority
shares. Still dividend treatment, even though there is different effect (no uniform dividend distribution,
ownership percentages and ROI entitlement altered, etc.). Normal dividend wouldn’t do that.
Assume complete redemption of Y. X percentage ownership increases to 75% (60/80); Z to 25% (20/80).
If there was a straight distribution of 20% of Alpha’s worth, then X would receive 12% of that amount; Y,
4%; and Z, 4%. But as this example goes, 20% is going to Y alone.
Wiedenbeck thinks that every redemption is in part a redemption and in part a sale because of the diluted
positive effects for remaining shareholders. Constructive dividend occurs to those shareholders who are
not actively participating in the transaction.
1. Constructive ownership of stock

302(c)(1), 318 (Constructive ownership)
Four categories of “attribution” rules (when close party’s stock ownership is attributable to the shareholder
and transaction in question)”
i. Family attribution
An individual is considered as owning stock held by spouse, children, grandchildren, and parents.
In-laws don’t count. No attribution from a grandparent to a grandchild.
ii. Entity to beneficiary attribution
Stock owned by or for a partnership or estate is considered as owned by the partners or
beneficiaries in proportion to their beneficial interests.
iii. Beneficiary to entity attribution
Stock owned by partners or beneficiaries of an estate is considered as owned by the partnership or
estate. All stock owned by a trust beneficiary is attributed to the trust except where the
beneficiary’s interest is “remote” and “contingent.”
A person holding an option to buy stock is considered as owning that stock. Takes precedence
over family attribution if both apply.

Problems 182
i. Wham, 100 shares: Grandfather, 25; Mother, 20; Daughter, 15; Adopted Son, 10 (Mother
option on five); Grandmother’s Estate, 30 (Mother 50% beneficiary). Apply 318 and determine
ownership amounts for:
Grandfather 85 (all – 15 from remaining 50% interest in Estate [(a)(2)(a),
(a)(5)(a) two-step attribution authority])
Daughter 55 (15 + Mother’s 20 + Mother’s option 5 + Mother’s Estate
interest 15)
Son/Daughter)
ii. Xerxes, 100 shares: Owned by Partnership in which A, B, C, D all equal partners. A’s wife W
owns all 100 Yancy Corp.
i. A, 25; W, 25; M, 0 (no family double attribution [(a)(5)(B)]).
b. How many, if any, of Xerxes owned by Yancy?
i. 25 [(a)(3)(C) B2E attribution + (a)(1) family attribution; double attribution not prohibited
because not a double-family construction]
ii. What if W only owned 10% of Yancy? Even for purposes of triggering the 50%
threshold of (a)(2)(C) E2B and (a)(3)(C) B2E, constructive ownership ties are still
applied.
c. How many, if any, of Yancy are owned by Partnership, B, C, D, and Xerxes?
i. 100 [((a)(1) spouse + (a)(3)(A) B2E Yancy) = A constructively owning 100 Yancy +
(a)(3)(C) B2E Partnership to Xerxes 50% threshold = Xerxes ownership of all Yancy]
A. Substantially disproportionate redemptions

302(b)(2); Reg 1.302-3.
If a shareholder’s reduction in voting stock as a result of a redemption satisfies three mechanical
requirements, the redemption will be treated as an exchange (and not the dreaded dividend). To
i. Immediately after the transaction, the shareholder must own (actually and constructively) less
than 50% of the total combined power of all voting stock,
ii. The percentage of total outstanding voting stock owned by the shareholder immediately after
the redemption must be less than 80% of the total voting stock owned by the shareholder
immediately before redemption, and
iii. The shareholder’s percentage ownership of common stock after the redemption also must be
less than 805 of the common stock owned before the redemption. If there is more than one
class of common, then the 80% test is applied by reference to FMV.
Attribution rules apply to these tests.

Step transactions masking dividends as exchanges. What if a majority shareholder X exchanged
shares qualified under 302(b) as making X a minority, on the knowledge that the corp would be
(b)(2)(D) for recognition of this ruling, making focus entirety of facts for determination of
302(b)(2) treatment or not.
Problems 186
1. Y Corp, 100 common, 200 NV preferred; Alice, 80 common, 100 preferred; Cathy, 20
common, 100 preferred. Determine if 302(b)(2) applies?
i. No. Nonvoting stock never qualifies for 302 treatment. Always a dividend.

i. Fails (b)(2)(B), must be < 50% voting power after redemption to qualify. Cathy still has
20 shares, so they’re split 50/50.
c. Same as (a), except Y also redeems 70 of Alice’s common.
i. Passes (b)(2)(B), but in this case the preferred stock may be qualified for 302 treatment
provided that the preferred stock is not 306 “tainted” stock. See §1.302-3(a).
d. What difference would it make in (c) if on Dec. 1 of same year Y redeems 10 of Cathy’s
common?
i. Only if Alice knew that Cathy’s shares would be redeemed. (b)(2)(D). But the statutory
step transaction may not apply in any case (knowledge or not), because 80% rule is the
test in the statutory definition of substantial disproportionality – not 50%. (b)(2)(C). IRS
would counter that step-transaction always applies, whether or not Congress reminds us
of it in one particular section or not.
2. Z Corp, 100 V common, 200 NV common, $100 FMV each; Don, 60 V common, 100 NV
common. Jerry, 40 V common, 100 NV common. If Z redeems 30 of Don’s V common, will
redemption qualify?
No.
B. Complete termination of a shareholder’s interest

302(b)(3), (c)(2)
Utility:
- Redemption of only nonvoting stock
- Waiver of family attribution – (c)(2)
- Redemption of 306 “tainted” stock
Why is there a waiver of family attribution only?
i. Waiver of family attribution

Attribution laws pose serious harm to closely held corps. If a parent cuts the corporate cord and
control goes to a child, etc., the parent would still be considered “in control” because of
attribution. 302(c)(2) provides a safe harbor from family attribution provided the following
criteria are met:
Immediately post, the distributee has no interest in the corp other than as a creditor,
The distributee does not reacquire interest within 10 years, and
If the distributee attempts to files I dunno...read the statute to figure this one out.
Further, 302(c)(2)(B) provides that family attribution can’t be waived if, in the 10 years prior,
either
The redeemed shareholder acquired any of the redeemed stock from a “Section 318”
relative, or
Any such close relative acquired stock from the redeemed shareholder.
Revenue Ruling 77-293 exception: Neither of these exceptions applies if tax avoidance was not
one of the principal purposes of the transfer.
Still: Always look for step transactions!
Policy? If you are really cutting ties, then a redemption and gift of operating assets is close
enough to a liquidation that real liquidation is not necessary to show that control has been
relinquished – provided that there is an affirmative showing that ties ARE cut by the distributee.
Lynch 188 (9th Cir. 1986)

If Lynch didn’t qualify for the 302(c)(2) waiver of attribution, he would have been fully taxed on
the redemption because of his residual constructive ownership of the entire corporation by and
through his son’s actual ownership of 100% interest in Lynch Corp.
Given the statutory silence on definition of “employee,” look to common law (in this case, torts).
IRS says it doesn’t care, the (c)(2)(A)(i) list is not exclusive to simply directors or executives – it
applies to all employees nonexclusively.
Alternative bases for similar holding:

- Debt:equity ratio – Father constructively owned son’s shares, and father was sole owner of
promissory note. Double coverage, and IRS would have called the note in essence preferred stock.
Pledge of son’s shares – See §1.302-4(d), (e). The pledge of stock was OK, but enforcing the
pledge (foreclosure on the stock) would be problematic for father.
- 302(c)(2)(B)(ii) 10-year look-back rule and Revenue Ruling 77-293 no-tax-avoidance rule.

First prospect –
Second prospect – Focus on waiver and interest requirement – “no interest including” language
again at forefront.
Third prospect – Unchecked discretionary veto power on extraordinary corporate policy. Bad!
Fourth – (c)(2)(B) look-back and how broadly should the tax avoidance exception be read?
ii. Waiver of attribution by entities

What if the redeemed shareholder is a trust, estate, or other entity that completely terminates its
actual interest in the corp, but continues to own shares attributed to a beneficiary to the entity?
Waiver of attribution is still possible, but only if the beneficiaries waive attribution and comply
with the 302(c)(2) restrictions as well.
C. Redemptions not essentially equivalent to a dividend

302(b)(1), Reg 1.302-2
Davis 204 (1970)

Davis bought stock from his company so that the company could secure a loan, with the intention
to redeem the stock once the loan was paid off. He bought in 1945 at $25/share and the corp
redeemed in the 1960s for the same price. He claimed the transaction for sale treatment as a return
of capital, but the IRS balked. CA9 held for Davis, US reversed. Davis had claimed that the stock
plan was for a valid business purpose, and therefore wasn’t a dividend (which is simply a RE
distribution or return of capital). US didn’t buy it, saying that the business purpose test is
irrelevant in determining dividend status. They reasoned that 302(b)(1)’s “not equivalent to
dividends” rule meant just that: since Davis never lost or changed in form any control of the
closely held corp, the redemption was like a dividend. In order to qualify as not essentially
equivalent to a dividend, a redemption must result in a meaningful reduction of the shareholder’s
proportionate interest in the corporation.
Note: constructive ownership rules apply under (b)(1).
Didn’t qualify for waiver of family attribution safe harbor because Davis only sold back the
preferred, and still had common stock outstanding. The (b)(3) safe harbor wouldn’t apply, either,
because the stock was nonvoting preferred, a transaction which can never avail itself to (b)(3)
protection.

What is the “meaningful reduction of shareholder’s interest” credo of Davis?
Himmel (2nd Cir. 1964) says “shareholder interest” includes:
The right to vote and thereby exercise control - Vote
The right to participate in current earnings and accumulated surplus, and -
Financial
The right to share in net assets on liquidation. -
Financial
In this example, buying out the shares of the estate alone would never satisfy for the (b)(3) safe
harbor. For (b)(2), the estate owns 1000 of 1750 outstanding shares. After redemption the estate
still constructively owns 50% – and (b)(2) requires < 50% immediately after redemption. (b)(1)
works, though, because a 50/50 standoff in control is good enough to call a “meaningful
reduction” because there is no more unilateral control over the corp.
However – look for who holds the “other” 50% of the stock. If it’s scattered, then there
may still be effective control of the distributee.


In this example, the trust will not have to worry about attribution to the parents, but it will to the
son-in-law’s kids. Thus, it fails the (b)(2)(C)(ii) 80% test, too. But just barely (attributable 24.x%
from son-in-law’s children). So the IRS says basically, “Close enough, you get 302(a) sale
treatment.”

C ahs the opportunity to call the shots in collaboration with A and B, so while C’s 18% is a
minority, it is still part of a control group. This is a dividend.
Problems 219
1. Z corp, 100 shares. A, 28; B, 25; C, 23; D, 24. Dividend or not under (b)(1)?
(a) Near miss on (b)(2)(C)(ii) 80% test (80% of A’s original 28% interest is 22.4%; after
redemption with only 93 shares outstanding, control was 22.6%). 0.2% off, so near miss
and “meaningful reduction” sale treatment OK.
(b) Same as (a), but only five shares redeemed and A&D are related. Ownership before was
52% (w/attribution). After (w/95 shares outstanding) 49.4%. Passes (b)(1).
(c) Same as (b), except A&B are related instead. Ownership before was 53% (w/attribution).
After (w/95 shares outstanding) 50.1%. Fails (b)(2)(B) < 50% test.
(d) Same as (c), but A&B hate each other. Always apply attribution, regardless of family
hostility.
Y corp, 100 C, 100 NVP.

Shareholder Common Shares Preferred Shares
A 40 0
B 20 55
C 25 10
D 15 15
E 0 20
2. Will the following qualify for 302(b) exchange treatment?

(a) Y redeems 5 preferred shares from E. No (b)(1) substantially disproportional treatment
because no voting stock redeemed, but legislative history says that it gets exchange
treatment.
(b) Y redeems all of its outstanding preferred stock. Redemption doesn’t affect A. E gets
(b)(3) safe harbor from complete termination of interest. No impact on vote, so probably
a dividend on that claim alone. Vote is “key factor,” but is it determinative factor? Still
earnings and liquidation rights factors outstanding. But looking beyond vote, what are
the economic rights of the shareholders and how are they affected?
1. B gets walloped going from majority of earnings stake to none. B should qualify for
sale treatment under (b)(1).
2. C has minor economic impact, so no meaningful interest. Dividend treatment.
3. D same as C.
3. Individual owns 10 common at $15K basis. What happens if to basis of five shares are
redeemed in a transaction classified as a dividend?
Should up the basis of individual’s remaining shares to carry forward the outstanding basis
that was not recognized as a return to capital yet.
What if all 10 shares were redeemed in a dividend transaction because the family attribution
waiver was unavailable?
See Reg 1.302-2 Example 2. Basis transfers to related party. Ouch.

In kind proceeds – 311(b) (General Utilities doctrine repeal)

E&P reduction
i. 301 treatment
Normal 312(a) and (b) rules for reduction of E&P distributed apply
ii. Sale treatment – 312(n)(7)
Reduces E&P by amount distributed, but not more than shares proportionate contribution to
E&P (reduction limitation)
302(b)(4), (e)
A redemption qualifying as a “partial liquidation” under 302(b)(4) are taxed to the distributee
shareholder as a 302(a) exchange. 302(e) mandates that the focus of examination for whether a
redemption is a partial liquidation is on the corporate level.
1. Exceptional features
Must be noncorporate shareholders. Yes, they receive 301 and 243 DRD treatment; but
1059(e)(1)(A) will make it an extraordinary dividend and reduce the basis – creating capital
gains and more tax. HOWEVER, 302(e)(4) pro rata redemptions will qualify for sale
treatment.
2. Definition
i. In general – major corp business contraction
ii. Safe harbor – 302(e)(2), (3)
3. Policy – 331(a), (b)

If there is a redemption that seems to be connected to a major corporate business contraction,
then shareholders can go ahead and treat as partial liquidation for sale treatment. Controverts
the Davis “meaningful reduction” credo, because the distribution in this instance would be pro
rata (with no “meaningful reduction” across the board) and yet still get sale treatment. This is
an exclusively corporate focus.
4. Disposition of controlled subsidiary

332 controlled subsidiary liquidation requirement. If you first liquidate, then IRS has to treat
the parent as if it had been operating independently. The subsidiary’s time can tack on to the
parent to help meet the five-year period if the parent liquidates and distributes the proceeds.
But what if parent just sells subsidiary’s stock instead of liquidating? No special treatment,
because no 332 liquidation has occurred. The grace doesn’t carry if there is no transfer of
taxable assets.
Note: If corporation simply distributes subsidiary’s stock, then corporate division rule in
355(a), (b) may apply – tax-free at both shareholder and corporate level if these provisions are
met (same requirements as partial liquidation safe harbor in 302(e)(2))
Problem 223
(a) Sale treatment for M & P from safe harbor exception; corp gets 301, 243 DRD, 1059
mess. Pro rata distribution, so no other tax schemes would work.
(b) Ruins the five-year requirement for the safe harbor.
(c) 302(e)(1) – when unforeseeable event causes destruction, and then proceeds of insurance
distribution are distributed to shareholders. Qualifies as sale treatment under general
rule.
(d) Sale treatment as a partial liquidation.
(e) Iris is a corp, so it is a dividend. Partial liquidation only for non-corporate distributees.
Only would qualify for sale treatment if Iris fell under one of the four 302 criteria. In this
case, 302(b)(3) termination of interest applies, so sale treatment OK.
(f) Won’t qualify under safe harbor because of five-year existence test. Also doesn’t
because it is a distribution of business assets and not a partial liquidation. See Reg 1.346-
1(a).

(g) See RR 79-184. Parent attribution for subsidiary’s operation and business history.
(h) See RR 79-184. Parent attribution for subsidiary’s operation and business history.

1. Bootstrap sales
Zenz 229 (6th Cir. 1954)
Integrated, prearranged transaction that IRS lost on, and today would fall under sale treatment
protection of 302(b)(3). Woman, intending to sell divest her interest in corp, sold part of her
stock to a third party and then had the corp redeem the remainder as treasury stock for
substantially all of the corp’s accumulated earnings and profits. IRS claimed that the payment
from the corp was a dividend, Zenz claimed it was a 302 redemption. Led to Revenue
Ruling 75-447 – the order of the steps doesn’t matter, but we recognize that we lost under
Zenz, so the two transactions (Zenz redemption and then sale of stock, or reversed order of
steps [sale of stock and then redemption]) will not be treated as a dividend. 302(b)(2) will be
applied “when all the dust has settled” – by simply comparing stock ownership pre- and post-
transactions.
2. Buy-sell agreements: Constructive dividend issues


McDonald’s franchise redemption prompted because of divorce. Wife characterized that the
stock redemption was actually sold to her husband pursuant to a divorce decree, and should
have 1041 property settlement nonrecognition. Step 1 – she gets 1041 settlement. Step 2 –
corporation redeems shares from husband (basically that he ripped off the corp for the
purchase price of her shares). Husband gets hammered on 302(d) and 301 because
constructive redemption to a 100% shareholder is essentially a dividend. She really screwed
her ex.
Note: IRS asserted deficiency against husband to compensate for the $450K lost from
ex-wife, but lost because there is no collateral estoppel between the two proceedings (he
was not a party to her proceedings, she was not a party to his proceedings).

Charitable bailouts. Grove, majority shareholder of corp, claimed charitable contribution
deduction under 170(e) for the FMV of his stock in corp donated to RPI. Corp redeems RPI’s
stock, and RPI doesn’t care about their classification because they’re tax exempt. What if
Grove had redeemed the stock first, and then donated the proceeds to RPI? Would have been
a redemption for Grove. IRS says Grove has no income, but is making a huge deduction. So
IRS says look at it as a step transaction, and no matter how the steps are arranged, it should be
termed a redemption that doesn’t pass 302 muster. Grove says RPI wasn’t under obligation to
redeem shares, so it would be unfair to treat the two transactions as part of an integrated plan.
Court bought it, regardless of Grove’s life interest in the donated stock and systematic
contributions in the same style to RPI.
170(f) has remedied Grove in further defining what can and can’t qualify for charitable
contribution treatment.

304 (except (b)(3)(C), (D), (b)(4)). Reg 1.304-2(a), (c) Examples (1), (3), and (4).
304 – Labeled as a redemption issue, but is it really about redemptions (read: other legislative
intentions)? Look more towards financial stake or control gain/lost with the transaction. What’s
different in 304 than a real redemption in a close corp? Assets leave the corp in terms of purchase
price, but corp gets substitute assets in exchange.
What about parent/subsidiary transactions? Subject to heightened scrutiny. When all the dust
settles in the transaction, look at the shareholder’s ownership interest in the parent corp.

Just know that when you have a sale of stock by a controlling shareholder to another corp that is
controlled, 304 may apply if there hasn’t been a change in control sufficient to award sale
treatment.
Niedermeyer 268 (Tax Court 1974)

304(a), (c)(3) – As messy as it gets. Sale of stock between corporations. 302(b) tests look to
ownership of issuing corp. change in ownership is as to AT&T, so mom and pop go from 91%
actual and attributable pre-transaction, 0% actual and 68% attribution post (for a net of 72%
ownership when change in amount of outstanding stock is recalculated). Mom and pop think they
pass 302(b) because they planned to completely terminate their interest with a family attribution
waiver (and the transaction would qualify for 302(c)(2) “immediately” because the transaction was
part of a single, integrated plan). No constructive ownership meant that their resulting interest
would be 0%. Problems: more than one kind of outstanding stock; mom and pop still held
preferred stock post-transaction (subject to a gift to charity). No family hostility exception, either.
Problems 275
1. In reading Niedermeyer, make sure you are able to answer the following:
(a) Why did 304 apply to the sale by the taxpayers of their AT&T common stock to Lents?
(b) Given that 304 applies, how do you test the “redemption” to determine if the taxpayers have a
dividend?
(c) Why were the taxpayers unable to waive family attribution?
(d) How could they have avoided this unfortunate result?
Answered generally in the case comment above.
2. Bail Corp, 100 shares, no accumulated earnings or E&P. Out Corp, 100 shares, $5K
accumulated, no E&P. Claude, 80 Bail (basis = $500 per/$40K total), 60 Out (basis = $150
per/$9K total). Remaining shares owned by unrelated individual. Tax consequences when:
(a) Claude sells 20 Out to Basis for $4K ($1K over basis)?
(b) Same as (a), except Claude receives $3K and one Bail share (FMV $1K)?
(c) Same as (a), except Claude receives one Bail share, and Bail takes the 20 Out shares subject to
a $3K liability that Claude incurred to buy the 20 shares of Out?
(d) Claude sells his Out shares to Bail for $12K?
D. Redemptions to pay death taxes

303(a), (b)(1)-(3), (c). Skim 6166.
One-time exemption from taxes for redemption of a decedent’s stock. Decedent’s redeemable
stock must comprise over 35% of the entire estate, or aggregation may be allowed for two or more
corps if at least 20% of the corps’ total outstanding stock is in the estate. For the latter test, stock
held jointly in any manner may be included in the calculation.

305, 306, 317(a)
1. Taxation of stock dividends under 305
305(a)-(d); 307; 312(d)(1)(B), (f)(2); 1223(5).
General rule: Stock received tax-free under 305(a) is treated as a continuation of the recipient’s old
stock. Accordingly, the basis in the old shares is divided among all shares total in relation to their
FMV.
Ex. If B owns 100 Corp shares at $20 basis, and Corp distributes 1 for 1 stock dividend, then B
ends up with 200 Corp shares and basis is spread down to $10 per.
Exceptions: 305(b)
(1) Optional stock or cash – The test is choice: forced to receive stock, or opt to receive stock?
Opting negates the tax-free transfer.
(2) ¡Disproportionate distribution! Nobody may have a choice, but if the effect is that some have
the opportunity to increase their stake in ownership, while others may just take cash or
property, then the whole dividend is taxable.

(3) Common or preferred mix – Indicates future change in proportional ownership depending on
corp’s future performance (different slices during liquidity/liquidation).
(4) Stock dividend ON preferred – Expands priority claim on future assets and earnings upon
liquidation to the detriment of common shareholders.
(5) Convertible preferred – Basically (3) parade of horribles all over again.
(6) Constructive stock dividends – 305(c) repetitive redemption plans are constructive dividends
and thus taxable.
Problems 289
1. Tax consequences on these “redemptions” in light of 305?
(a) No tax.
(b) Both Fay and Joyce are taxed, because B stock dividend was optioned. Frank is taxed because
preferred holders had option (see statutory language “any”).
(c) No tax on A dividend; B dividend taxed normally as income under 301. 1-305.3(b)(4).
(d) Expands the preferred “bucket,” and runs into (2). Change of proportional interest. Two part test:
in addition to proportional interest, someone has to walk away with money or property. That
hasn’t really happened here, though, but the statutory parenthetical is broad enough to encompass
that type of regular dividend stock. So fails part two of the test as well.
(e) Frank still gets everything, even though there’s a new priority. The new priority doesn’t materially
change anyone’s proportional interest, because Preferred A still retains its full preference to E&P
before the subordinated preferred stock.
(f) Debenture holders are stockholders because the debentures are convertible, and thus fall under the
305(d) definitions as shareholders. Becomes disproportionate distribution.
(g) The conversion ratio on the preferred stock is designed to maintain the proportions of interest that
existed under the unmodified plan. Should be no adverse tax consequences because the
shareholder rights don’t change, and Frank’s common-to-common transfer is not in the 305
criteria. However, what about the “distribution” to Fay and Joyce on preferred stock? Well, any
dividend on preferred should normally be taxable, but (b)(4) allows an exception that won’t
enforce taxation if the “distribution” of a conversion ratio change is simply to preserve the interest
of the preferred shareholders in light of a stock split.
(h) Standard optional distribution that is taxable under 301.
(i) Preferred convertible into common. Option again, since this is basically a two-step common stock
distribution that will likely lead to a change in proportional share class ownership. Taxable unless
the IRS passes it as not disproportionate – (b)(5). Test includes showing of incentives for
conversion. In this case, because of the 20 year lifespan of the conversion, they will probably all
convert if the business is in any measure successful (provided that other incentives make
conversion unattractive). If everyone converts, then ownership interests will still be proportional.
but it appears that Fay and Joyce are taxable under (b)(5) and Frank is taxable under (b)(3)(B).
2. 305(c) problems if Z corp agrees to annual redemption of 50 shares at the election of each
shareholder, and A (500 shares) makes such an election two consecutive years? B (300) and C (200)
do not elect.
That would depend on whether Z Corp has any current E&P. Anyway, not in form a stock dividend,
but certain shareholder’s interest increase as this plan progresses. Redemption is processed under
302(a)(1) (303 or 304 possible, but not in this case). Well, not 20% termination of voting power, no to
everything else... So look to “meaningful reduction in ownership” according to Davis. After the first
redemption, B and C can combine respective vote to overturn anything A does where they couldn’t
before. A gets sale treatment, B and C have constructive stock dividend ONLY if it is a redemption to
which 301 applies. In this case, B and C pass Y1.
But in Y2, the redemption for A doesn’t meet the safe harbors, and A gets hit with 301 tax on that
year’s redemption. Now 305(c) looms for B and C. They seem to have constructive, taxable dividend
unless the redemptions are isolated. These redemptions are part of a periodic redemption plan, so they
be sunk in Y2.


Distribution of preferred stock that was fully intended to be immediately redeemable by certain parties
to avoid taxes. Court OKed transaction, even with acknowledgment of the tax avoidance intent,
because the firm hadn’t violated the law. Three-step transaction that made the essentially-dividend
payment go to the insurance companies (Step 1: preferred stock dividend to Chamberlin; Step 2: sale
of those preferred stocks to insurance companies; Step 3: redemption of preferred from insurance
companies).

“Tainted” 306 stock is any stock other than common stock distributed by a corporation if
received by the taxpayer tax-free under 305(a). Also includes stock received in a tax-free
reorganization if the receipt of that stock had the effect of a dividend. Additionally, stock
exchanged for 306 stock will also be 306 stock if received in a carryover basis transaction.
The tax-bailout hook comes when a company distributes this stock, and then redeems it later
from the shareholder – avoiding the 301 taxable dividend status.
Of course, that leaves the question, “What is ‘common’ stock?” Typically, the IRS defines it
as any stock, whether voting or not, that participates without substantial restriction in
corporate growth.
RR 76-383 says that stock issued with a first right of refusal to the corp, but otherwise
completely like common stock (meaning without limitation on future equity rights) is
common stock because the right to sale will be a shareholder level decision to reduce
equity.
RR 79-163 says that any stock issued in a restructuring that has limited rights to
dividends or limited rights upon liquidation aren’t “common” stock.

Two dispositions lead to different rules:
Taxable: A taxable disposition of 306 stock will generally produce ordinary income to the
transferor. If 306 stock is redeemed, the amount realized on the redemption is treated as a
distribution, thus generating 301 income. The redemption of 306 stock may be treated as a
dividend only to the extent of E&P at the time of the redemption. Otherwise, distributions in
the red are treated as a normal return to capital – (c)(2).
Sold: More complex “look back” rule. Seller will generate ordinary income to the
extent that those shares would have been a dividend at the time of their original distribution.
So the seller has to look back to the corp’s E&P a the time of distribution to calculate how
much ordinary income they will realize on the current sale, and any excess realization is
treated as a reduction in basis of the 306 stock. Excess beyond that is normal gain from sale
of stock. The ordinary income cannot be claimed as a 243 DRD, and the issuing corp can’t
reduce E&P when 306 stock is sold.
iii. Dispositions exempt from 306

Tax avoidance and the legislative solution to Chamberlin. Only schemes designed to thwart
tax repercussions are subject to 306 taint. Therefore, 306 only applies when shareholders
exercise a withdrawal of corporate earnings while retaining their same measure of corporate
control. As before, exemptions are:
Complete termination of interest (meaning disposal of stock with no attribution
ramifications),
302(b)(3) termination of interest,
302(b)(4) partial liquidations,

Redemptions of 306 stock in complete liquidations,
Nonrecognition transfers (351 transfers, contributions to capital, etc.),
Any distribution and disposition or redemption found by the IRS to not be part of a tax
avoidance plan.

The answer to Chamberlin. Fireoved redeemed preferred shares in a corp that he claimed
under 306 exceptions as capital gain. Court disallowed, saying that redemption solely to
avoid taxes took the preferred stock out of the 306 exceptions. Business judgment test cannot
be used as a defense if there is no valid practical justification beyond tax avoidance.
Problems 309
1. In Y1, Argonaut Corp distributed nonconvertible, nonvoting preferred stock worth $1K to
Jason and Vera, unrelated 50/50 common shareholders. Common basis of $2K prior to
distribution and $3K immediately after. At time of distribution, Argonaut had $2K E&P. In
Y3, Argonaut had $3K E&P.
(a) Y1 tax consequences? Tax-free under 305(a) on distribution, but what about their basis?
307(a) for associated basis on dividends says that for tax-free dividends, take the basis of
the original stock and distribute it among the combined old and new stock proportionally.
In this case, preferred + common post is $1K + $3K = $4K FMV. Then take common
pre and distribute it proportionally according to the current FMV ($4K). Because $3K is
¾ of $4K, $1.5K basis of the $2K common pre is allocated to common post; the
remaining $.5K (¼ of $4K) is attributable to preferred.
(b) 306(a)(1)(A) says that Vera has $1K ordinary 301 income, limited only by the “ratable
share” exception and invoking the (a)(1)(A)(ii) look-back rule to check Y1 if it had been
cash instead of the stock distributed. Limit doesn’t come into play here because cash
distribution in Y1 would have been $1K.
(c) In this case, the $1K-would-have-been-dividend is automatically ordinary income ala (b),
supra. Additionally, the look-back rule says that there is $750 excess over the would-
have-been distribution. (a)(1)(B) says to add the ratable share limit ($1K) plus the
associated basis ($500 from (a), supra) leaves $250 that gets capital gain treatment. That
leaves $500 of tax-free return of basis. If Vera had sold for just over the ratable share
limit, then the excess basis would have been attributed to her remaining shares.
(d) All transactions are OK. No taint if dividend wasn’t possible in the first place – (c)(2).
(e) Any disposition (disposal) of stock that isn’t a redemption is taxable. (a), (a)(1).
However, since there is no recognized gain or loss, (b)(3) says that as to Jason only (a)
doesn’t apply. But this is a transfer of 306 stock, so it remains 306 tainted when Claude
tries to sell it – (c)(1)(C). The sale becomes ordinary income to the extent of the look-
back. The basis carries over from Jason. But Claude is completely terminating his
interest in Argonaut, and there is no grandparent to grandchild attribution, so 306(b)(1)
allows Claude to avoid 306 and he will receive LTCG treatment.
If Jason had died, then 306 doesn’t apply and the stock isn’t tainted.
(f) Redemption of Jason’s preferred for $1.5K and half of common for $5K?
Common stock gets exchange treatment under 302(b)(2) because of the substantial
reduction in control. Preferred is tainted, redemption was in Y3, in Y3 Argonaut has $3K
E&P, and all of the preferred redemption is a dividend. (a)(2). The common becomes a
$4.25K gain after basis ($750) is recovered, so what about 306(b)(4)(B)? Not in
pursuance of plan principally for tax avoidance, but Jason only disposed of part of the
common stock, so (b)(4) doesn’t apply. So what about that extra portion? It immunizes
at least half of the common because there isn’t any bail-out feature of common stock.
Only to the extent that you dispose of the underlying common stock that caused the 306
taint ...
(g) None would qualify for the (b)(4) exception because the bylaws indicate that this is purely
a tax avoidance move, implicating 306 taint and making all $1.5K receive 301 treatment.

(h) Yes, 306 stock; yes, redemption subject to 306(a)(2); but tax free return to capital because
this is not a dividend but a return to capital.
2. Zapco Corp, 100 common (all owned by Sam Shifty), more than enough E&P.
(a)
(b)
331, 334(a), 346(a) 453(h)(1)(A)-(B); Reg 1.331-1(a), (b), (e).
Normally treated as if shareholders had sold their stock to the corporation in exchange for the
corp’s assets. 331(a). Typically, the liquidating corp recognizes gain or loss as if it had sold the
distributed assets to the shareholders at FMV. Each shareholder recognizes gain or loss on the
difference between their adjusted basis in the stock and the amount. Each shareholder takes a
FMV step-up basis in the assets received.
Corp sale of assets on an installment method over more than one year will allow shareholders to
recover basis before reporting gain or loss.
Shareholder level tax on corp earnings:

Policy
Timing – Shareholders are taxed on corp’s E&P only if and when the corp issues a dividend.
Wiedenbeck says that the timing is wrong because it is not fixed.
Taxpayer – Wrong
Rate – 301(c)(1) ordinary income – Wiedenbeck says wrong again. Same for liquidation, where
331 turns return into capital gain treatment
Compare:
A) Corp sale of assets and corp liquidation;
B) In-kind liquidation and shareholder sale of assets.
B2 - Asset sale
$$ exchange
Shareholders
Third
Party
B1 – in-kind Buyer
liquidation
A2 – cash
liquidation
A1 - Asset sale
$$ exchange
Corp
A) Step 1 corp sale of assets taxed under 1001 as corp level gain/loss recognition; Step 2 SH
recognition under 331. Double tax in effect, right result.

B) Step 1 in-kind liquidation creates SH-level tax on stock appreciation under 331(a), but there’s
no corp level tax on appreciated assets (pre-General Utilities) and shareholders will take 334(a)
FMV basis.
Segue to next section: Congress remedied this discrepancy in same end result/different tax
regimes problem by forgiving the corporate tax in the first example. In 1986, Congress revisited
the issue and enacted 336 requiring corporate-level recognition.
Problem 315
A, 100 shares Humdrum, $10K basis. Humdrum has $12K accumulated E&P. Humdrum
liquidates; tax consequences to A?
(a) Humdrum distributes $20K to A in exchange for stock?
(b) What if (a) above was a $10K distribution in Y1 and another $10K in Y2? Any problem with
no formal plan of complete liquidation?
(c)
(d)
(e)

336(a)-(d), 267(a)(1), (b), (c).
i. Background

336(a) and recognition to the corp

336(d)(1) “related person” recognition disqualification and (d)(1)(B) “disqualified property”:
Distributions to related persons, i.e. controlling shareholders (see 267 for definitions), will not
allow for recognition of loss if either (1) the distribution is not pro-rata among the
shareholders, or (2) the distributed property was acquired by the liquidating corp in a 352
transaction or as a contribution to capital within the five-year period ending on the date of the
distribution.
Policy on the pro-rata requirement? Congress presumably intended to single out
situations where a majority shareholder receives an interest in loss property that is
disproportionate to their stock interest in the corp.
Policy on disallowance for 351 nonrecognition exchange property loss?
336(d)(2) tax avoidance by “loss stuffing”:

Prevents the doubling of pre-contribution built-in losses. Only applies if distributing corp
acquired property in a 351 transaction or a contribution to capital as part of plan with
principle purpose to recognize the loss on liquidation. Losses are limited to amount of loss
accrued post-corp acquisition. Pre-contribution losses are deducted against the basis, but
cannot fall below zero. Additionally, losses may not be recognized on any property obtained
by the corp within two years of the adoption of a liquidation plan without Treasury approval.
Look at the above diagramed transaction. What if there is a third option, where shareholders
sell their stock directly to the third party buyer (Step 1), and then the buyer in-kind liquidates
(Step 2)? Triggers 1001 gain/loss at shareholder level; in-kind asset exchange invokes 336
asset level gain/loss. All of the first three are asset acquisitions.
What about a fourth option? Step 1, corp sale of assets; Step 2, no liquidation. 1001
asset g/l, invest sale proceeds in Step 2, but therein lies the rub. Any accumulated,

undistributed investment income will bring on an avalanche of penalty fees and earnings
taxes (531, 541).
Fifth option: 1. SH sale of stock to 3PB; 2. 3PB doesn’t liquidate. 1001 stock g/l; avoids
336 corp level asset gains.
Sixth option: 1. SH sale of at least 80% stock; 2. 3PB is corp and liquidates. 1001 g/l; but
in-kind liquidation defers corp tax to the shareholders upon sale of their shares. 336
337, 334(b), 381(a)(1).
Seventh option: 1. SH sale of stock; 2. 3PB elects 338. The Kimbell-Diamond case –
step transaction, in substance a direct asset acquisition. Electing 338 considers the stock
sale an asset acquisition. Would only make this election in three circumstances: if assets
have net declined in value; if assets have appreciated, but if target corp has net operating
loss carryovers; and
Eighth option: 1. SH sale of stock, SH is controlling parent corp; 2. 338(a) AND

338(h)(10) election. Parent liquidates sub in-kind, parent sells stock to 3PB. Opting into
338 turns transaction into simply corp level tax on asset gains.
Look for applicability of 338 on exam.
Problem 328
2. Liquidation of a subsidiary
332, 334(b)(1), 1223(1); Reg 1.332-1,-2,-5.
George L. Riggs, Inc. 331 (Tax Court 1975)
Parent corp 3PB

332 331
334(b) carryover basis 336, 336(d)(3) no loss recog. on prop that has declined in value
381(a)(1) E&P carryover
Subsidiary
337
B. Consequences to the liquidating subsidiary

336(d)(3), 337(a), (b)(1), (c), (d); 381(a)(1), (c)(2), (3); 453B(d), 1245(b)(3), 1250(d)(3); Reg
1.332-7.
No triggering of corp tax to the parent to the extent that the liquidated subsidiary’s assets are going
to the parent. The assets are given a 334(b) carryover basis, and the tax will be caught up to later
when shareholder sells stock (which will reflect parent’s value with additional liquidation
proceeds).
A. Taxable Acquisitions
B. Overview of Acquisitive Reorganizations

IV. Limits on the Retained Earnings Strategy
A. Penalty Taxes

Safe Harbor
401(k)
Basic plan type Defined Defined Defined Defined Defined IRA based IRA based
Contribution Contribution Contribution Contribution Contribution
Who generally Corporations, Sole Sole Sole Sole Sole Sole

adopts partnerships, proprietorships, proprietorships, proprietorships, proprietorships, proprietorships, proprietorships,
limited liability partnerships, partnerships, partnerships, partnerships, partnerships, and partnerships,
companies limited liability limited liability limited liability limited liability small businesses limited liability
companies and companies and companies and companies and companies and
corporations with corporations corporations with corporations corporations with
no common-law 100 or fewer 100 or fewer
employees eligible employees employees
Can employer Yes Yes Yes No Yes Yes No

sponsor other
qualified
retirement plans
Who can Employee; Employee; Employee and Employee and Employer Employer Employee and
contribute employer employer employer employer employer
contributions are contributions are
optional optional
Cost index Low to High Low to Medium Low to Medium Low to Medium Low to High Low Low
depending upon depending upon
design complexity, design complexity,
service model service model
adopted and other adopted and other
factors factors
Maximum The lesser of The lesser of The lesser of The lesser of None None. The lesser of
employee deferral $19,000 for 2019 $19,000 for 2019 $19,000 for 2019 $13,000 for 2019 Contributions are $13,000 for 2019
contribution (indexed for (indexed for (indexed for (indexed for generally by (indexed for
inflation each inflation each year) inflation each inflation each Employer only inflation each
year) or 100% of or 100% of year) or 100% of year) or 100% of year) or 100% of
compensation compensation compensation compensation compensation
This chart is licensed under a Creative Commons Attribution-NoDerivatives 4.0 International License.
(Revised March 12, 2019 - www.401khelpcenter.com)
Page 1
Safe Harbor
401(k)
Employer Discretionary; Discretionary; Required match of Required match of Discretionary; Discretionary; Required match of
contributions maximum tax- maximum tax- 100% on the first 100% up to 3% of maximum tax- cannot exceed the 100% up to 3% of
deductible deductible 3% of employee employee's deductible lesser of 25% of employee's
employer employer deferral plus 50% compensation employer the emplo ee s compensation
contribution is contribution is 25% on the next 2% of contribution is compensation or (may be reduced
25% of eligible of eligible payroll; employee deferral OR 25% of eligible $56,000 to 1% in 2 of any
payroll; overall overall maximum payroll; overall 5 years)
maximum contribution per OR 2% of maximum
contribution per eligible employee is compensation to contribution per
OR
eligible employee 100% of 3% of all eligible eligible employee
is 100% of compensation not compensation to employees is 100% of
compensation not to exceed $56,000 all eligible compensation not 2% of
to exceed $56,000 employees to exceed $56,000 compensation to
all eligible
employees
Catch-up $6,000 for 2019 $6,000 for 2019 $6,000 for 2019 $3,000 for 2019 N/A N/A $3,000 for 2019
contributions for (indexed for (indexed for (indexed for (indexed for (indexed for
those ages 50 and inflation each inflation each inflation each inflation each inflation each
older year)1 year)1 year)1 year)1 year)
Employee eligibility Age requirement Age requirements Age requirement Age requirement Age requirement Age requirement All employees
cannot exceed 21; cannot exceed 21; cannot exceed 21; cannot exceed 21; cannot exceed 21; cannot exceed 21; earning $5,000 for
service service service service service have earned any past two years
requirement can t requirements can t requirement can t requirement can t requirement can t compensation in and is expected to
exceed one year; exceed one year exceed one year; exceed one year; exceed one year; three of the past do so in current
may exclude union may exclude union may exclude union two years if 100% five years; year; no age limit
employees employees employees vested; may received permitted; may
exclude union compensation of at exclude union
employees least $600; may employees
exclude union
employees
Page 2
Safe Harbor
401(k)
Who directs Employer/Trustee Individual Employer/Trustee Individual Employer/Trustee Individual Individual
investments? or plan may or plan may or plan may
allow individual allow individual allow individual
direction direction direction
IRS reporting by Form 5500 Form 5500-EZ Form 5500 Form 5500 Form 5500 None None
employer when plan assets
reach $250,000
Establishment By the last day of By the last day of Any date between Any date between By the last day of Established by the Any date between
deadline the plan year for the plan year for January 1 and January 1 and the plan year for time the corporate January 1 and
which the plan is which the plan is October 1; may October 1; which the plan is tax return (with October 1;
effective effective not have an as soon as effective extensions) is filed as soon as
effective date that administratively for the tax year in administratively
is before the date feasible for which the feasible for
plan actually businesses deduction is being businesses
adopted established taken established
after October 1st after October 1st
Complexity Index High Low Medium Medium Medium Low Low
Loans Yes1 Yes1 Yes1 Yes1 Yes1 No No
Roth Contributions Yes1 Yes1 Yes1 Yes1 No No No

Allowed
Page 3
Safe Harbor
401(k)
Funding deadline Employee Unincorporated Employee Employee Contributions must Funded by the Employee
contributions must businesses -- contributions must contributions must be deposited by time the corporate contributions must
be deposited as employer/employee be deposited as be deposited as the time the tax return (with be deposited as
soon as contributions: by soon as soon as corporate tax extensions) is filed soon as
administratively the time the administratively administratively return (with for the tax year in administratively
possible2; corporate tax possible2; possible2; extensions) is filed which the possible; employer
employer return (with employer employer for the tax year in deduction is being contributions must
contributions must extensions) is filed contributions must contributions must which the taken be deposited by
be deposited by for the tax year in be deposited by be deposited by deduction is being the time the
the time the which the the time the the time the taken corporate tax
corporate tax deduction is being corporate tax corporate tax return (with
return (with taken; incorporated return (with return (with extensions) is filed
extensions) is filed businesses -- extensions) is filed extensions) is filed for the tax year in
for the tax year in Employer for the tax year in for the tax year in which the
which the contributions: by which the which the deduction is being
deduction is being tax-filing date plus deduction is being deduction is being taken
taken extensions and taken taken
employee
contributions must
be deposited as
soon as
administratively
possible.
Minimum vesting Immediate on Immediate Immediate Immediate Employer Immediate Immediate

Employee contributions can
Contributions; be subject to
Employer vesting schedule
contributions can
be subject to
vesting schedule
Page 4
Safe Harbor
401(k)
When can Withdrawals can Withdrawals can Withdrawals can Withdrawals can Withdrawals can Withdrawals can Withdrawals can
withdrawals be generally be made generally be made generally be made generally be made generally be made be taken at any be taken at any
taken for the following for the following for the following for the following for the following time; withdrawals time; withdrawals
reasons: reasons: reasons: reasons: reasons: taken prior to an taken prior to an
employee reaching employee reaching
termination of termination of termination of termination of termination of age 59½ may be age 59½ and
employment employment employment employment employment subject to IRS within the first two
disability disability disability disability disability penalties; years of
withdrawals are participation, may
death death death death death generally be subject to a
retirement retirement retirement retirement retirement considered taxable 25% early
hardship hardship hardship hardship hardship income withdrawal
penalty; after two
If taken prior to an If taken prior to an If taken prior to an If taken prior to an If taken prior to an years, a 10% early
employee reaching employee reaching employee reaching employee reaching employee reaching withdrawal penalty
age 59½ may be age 59½ may be age 59½ may be age 59½ may be age 59½ may be would apply;
subject to a 10% subject to a 10% subject to a 10% subject to a 10% subject to a 10% withdrawals are
penalty;3 penalty;3 penalty;3 penalty;3 penalty;3 generally
withdrawals are withdrawals are withdrawals are withdrawals are withdrawals are considered taxable
generally generally generally generally generally income
considered taxable considered taxable considered taxable considered taxable considered taxable
income income income income income
1. This is a design option that the plan may or may not permit.
2. Plans with fewer than 100 participants must deposited employee deferrals no later than seven business days after the date the amount is withheld.
3. There is an exception to this rule which allows an employee who retires during the calendar year in which they turn 55, or later, to withdraw without penalty.
IMPORTANT NOTE: This chart provides a high-level comparison of the features and benefits of the plans included and is not intended as a comprehensive or detailed review of
each plan type. It is intended to be general in nature. As a result, exceptions to each plan feature can exist. Be sure to consult with a professional retirement planner or expert
before you act on any information contained in this chart.
Page 5
2017 Plan Comparison
Traditional lRA Roth lRA SEP SIMPLE lRA Profit Sharing/ 403(b)(7)*/Roth 403(b)(7) 401(k)/Roth 401(k) Safe Harbor 401(k)/ Individual K/
Money Purchase Roth Safe Harbor 401(k) Roth Individual K
Plan Features Contributions may be tax Tax-free growth and distributions Employer-funded; easy to establish Employee-funded; easy to Employer-funded; allows Primarily employee-funded; easy Employee-funded with possible Employee- and employer-funded; Employee- and employer-funded;
deductible (if individual falls (provided certain conditions are and maintain; minimal IRS filings establish and maintain; no ADP/ restricted coverage; allows to establish and maintain; pre- employer contribution; allows allows employers to maximize allows control over when the
within income guidelines); can met); nondeductible contributions and paperwork; low cost ACP nondiscrimination testing; control over when the money tax contributions may reduce restricted coverage; allows control contributions made by highly money will be withdrawn;
be used in conjunction with any may be made even after age 701 ⁄ 2 ; mandatory employer contributions; will be withdrawn; may allow employee's current taxable income over when the money will be compensated employees; may allow for loans; designed
retirement plan can be used in conjunction with any employer cannot maintain another for loans withdrawn; may allow for loans mandatory employer contributions; specifically for owner-only
retirement plan retirement plan no ADP/ACP discrimination testing businesses
Who May Establish Age limit: 701 ⁄ 2 Age limit: None Sole proprietors, partnerships, Employers with 100 or fewer Sole proprietors, partnerships, Public schools and 501(c)(3) Sole proprietors, partnerships, Sole proprietors, partnerships, Employer-only businesses
Income limit: None Income limit: $133,000 for single corporations, nonprofits, employees, including sole corporations, nonprofits, organizations corporations, nonprofits corporations, nonprofits including sole proprietors,
and $196,000 for joint government entities proprietors, partnerships, government entities partnerships, corporations,
corporations, nonprofits, and and nonprofits (may employ
government entities spouse)
Establishment Deadline Tax filing deadline Tax filing deadline Tax filing deadline plus extensions October 1 Plan year end, usually December Plan year end, usually December Plan year end, usually December October 1 Plan year end, usually December
(generally April 15) (generally April 15) 31 for calendar year plans 31 for calendar year plans 31 for calendar year plans 31 for calendar year plans
Contribution Tax filing deadline Tax filing deadline Tax filing deadline plus extensions Salary deferrals made on each pay Tax filing deadline plus Salary deferrals made on each pay Salary deferrals withheld each pay Salary deferrals withheld each pay Salary deferrals withheld
Deadline (generally April 15) (generally April 15) period; employer contributions by extensions period; employer contributions by period; for sole proprietors, when period; for sole proprietors, when each pay period; for sole
tax filing deadline plus extensions tax filing deadline plus extensions business income is determined; business income is determined; proprietors, when business
employer contributions by tax filing employer contributions by tax filing income is determined; employer
deadline plus extensions deadline plus extensions contributions by tax filing
deadline plus extensions
Contribution Annual contributions of up to Annual contributions of up to 25% of compensation up to Employees can defer up to $12,500; 25% of compensation up to Employees can defer up to Employees can defer up to Employees can defer up to $18,000; Employees can defer up to
Limit/Requirements $5,500 or 100% of compensation $5,500 or 100% of compensation $54,000; approximately 20% catch-up contributions of $3,000 $54,000; approximately 20% $18,000; catch-up contributions $18,000; catch-up contributions catch-up contributions of $6,000 if $18,000; catch-up contributions
(whichever is less); catch-up (whichever is less); catch-up for sole proprietors (due to self- if age 50 or older; employer must for sole proprietors (due to self- of $6,000 if age 50 or older; of $6,000 if age 50 or older; age 50 or older; employer typically of $6,000 if age 50 or older;
contributions of $1,000 if age is contributions of $1,000 if age is employment deduction) match dollar for dollar up to 3% employment deduction); PSP employer contribution of 25% of employer contribution of 25% contributes dollar for dollar on the employer contribution of 25%
50 or older; nonemployed spouses 50 or older; nonemployed spouses of compensation (can be lowered contributions are discretionary compensation; total combined of compensation (approximately first 3% and $.50 on the dollar of compensation (approximately
may also contribute up to $5,500 may also contribute up to $5,500 to 1% for two of every five years) and MPP contributions are employer and employee 20% for sole proprietors due for the next 2%; other employer 20% for sole proprietors due
per year if conditions are met per year if conditions are met OR 2% of compensation as a non- required by percentage specified contributions cannot exceed $54,000 to self-employment deduction); contribution options are available; to self-employment deduction);
($6,500 if over 50) ($6,500 if over 50) elective contribution in plan document (excludes catch-up contribution); total combined employer and additional non-safe harbor employer total combined employer and
long-tenured catch-up contribution employee contributions cannot contributions are allowed employee contributions cannot
for employees of 15 years or more exceed $54,000 (excludes catch-up exceed $54,000 (excludes catch-
with same employer contribution) up contribution)
Who Contributes Individual Individual Employer Employee and Employer Employer Employee and Employer Employee and Employer Employee and Employer Individual
Maximum Employee N/A N/A Age 21 or older, worked three of Earned at least $5,000 during Age 21 or older, worked one year Generally, all employees Age 21 or older, worked one year; Age 21 or older, worked one year; N/A
Eligibility Restrictions last five years and earned at least any two prior years and is (or two years if 100% immediate may exclude employees who work may exclude union employees and
$600 in each of those years; may expected to earn at least $5,000 vesting); may exclude employees less than 1,000 hours per year, union nonresident aliens; may not exclude
exclude union employees and in current year; may exclude who work less than 1,000 hours employees, and nonresident aliens employees due to minimum hours or
nonresident aliens union employees and nonresident per year, union employees, and last-day rules
aliens; no age limit restriction nonresident aliens
Vesting 100% 100% 100% 100% for both employee and Vesting schedule allowed 100% 100% for employee contributions; 100% for both employee and Vesting schedule allowed but
employer contributions vesting schedule allowed for employer contributions; vesting generally not used
employer contributions schedule allowed for any employer
contributions made in addition to
mandatory safe harbor contributions
Distributions Distributions taken prior to Tax-free distributions allowed Distributions taken prior to Distributions taken prior to age Distributions can only be taken Distributions can only be taken Distributions can only be taken with Distributions can only be taken with Distributions can only be taken
age 591 ⁄ 2 may be subject to a provided certain conditions are age 591 ⁄ 2 may be subject to a 591 ⁄ 2 may be subject to 10% with a triggering event such with a triggering event such a triggering event such as death, a triggering event such as death, with a triggering event such
10% penalty tax, in addition to met; no minimum distributions 10% penalty tax, in addition to penalty tax, in addition to ordinary as death, permanent disability, as death, permanent disability, permanent disability, attainment permanent disability, attainment as death, permanent disability,
ordinary income tax; minimum required at age 701 ⁄ 2 ordinary income tax; minimum income tax (25% penalty applies attainment of plan’s normal attainment of 591 ⁄ 2 , separation of plan’s normal retirement age, of plan’s normal retirement age, attainment of plan’s normal
distributions required at 701 ⁄ 2 ; distributions required at 701 ⁄ 2 ; if distribution is within two retirement age, separation from from service or plan termination, separation from service or plan separation from service or plan retirement age, separation from
exceptions to 10% penalty exceptions to 10% penalty years of participation); minimum service or plan termination; any or hardship; any distributions termination; any distributions termination; any distributions service or plan termination; any
may apply may apply distributions required at 701 ⁄ 2 ; distributions taken prior to age taken prior to age 591 ⁄ 2 (age 55 if taken prior to age 591 ⁄ 2 (age 55 taken prior to age 591 ⁄ 2 (age 55 distributions taken prior to age
exceptions to 10% penalty 591 ⁄ 2 (age 55 if separated from separated from service) may be if separated from service) may if separated from service) may 591 ⁄ 2 (age 55 if separated from
may apply service) may be subject to 10% subject to a 10% penalty tax, in be subject to 10% penalty tax, in be subject to 10% penalty tax, in service) may be subject to 10%
penalty tax, in addition to ordinary addition to ordinary income tax; addition to ordinary income tax; addition to ordinary income tax; penalty tax, in addition to ordinary
income tax; minimum distributions minimum distributions may be minimum distributions may be minimum distributions may be income tax; minimum distributions
may be required at 701 ⁄ 2 required at 701 ⁄ 2 required at 701 ⁄ 2 required at 701 ⁄ 2 may be required at 701 ⁄ 2
Loan Features Not available Not available Not available Not available Allowed Allowed Allowed Allowed Allowed
Plan Administration None None None None IRS Form 5500 and other ERISA IRS Form 5500 and other ERISA IRS Form 5500 and other ERISA IRS Form 5500 and other ERISA IRS 5500 EZ when plan assets
requirements** requirements if subject to ERISA** requirements** requirements** reach $250,000
*Employer may make matching or discretionary contributions within an ERISA 403(b); ERISA 403(b)s are subjected to ERISA requirements. **Owner-only plans are not required to file IRS 5500 until assets reach $250,000 or terminate. LPL Financial does not provide tax advice. Please consult your tax advisor.
Retirement Plan Portability
Receiving Plan Annual Contribution Limits 2016 2017 Tax Deductibility of IRA Contributions
(Tax Year 2017) for Participants in
To IRA Traditional IRA, Roth IRA, $5,500 $5,500 Employer-Sponsored Retirement Plans
Roth SIMPLE Coverdell Qualified SIMPLE Government
(Traditional SEP IRA Roth 401(k) 403(b) Roth 403(b) Spousal, Guardian
From IRA IRA ESA Plans3 401(k) 457(b)
Spousal) - IRA contributions are fully deductible if neither you nor your spouse
Traditional, Roth, Spousal IRA $1,000 $1,000 participates in an employer-sponsored retirement plan such as 401(k),
IRA Transfer or Transfer or
2
Catch-Up Contribution
Transfer or Conversion NO Rollover NO Rollover NO Rollover Rollover 403(b), or pension plan.
(Traditional Rollover Rollover2
Spousal) Rollover
- Deductibility is limited if you or your spouse participate in an
Coverdell ESA (per beneficiary) $2,000 $2,000 employer-sponsored retirement plan. Refer to the chart below to
Roth Recharacter- Transfer or Recharacter- NO NO NO NO NO NO NO NO figure your deduction.
IRA ization Rollover ization Employer Deduction Limit (SEP, MPP, 25% 25%
PSP, 401(k)5) aggregate aggregate
Transfer or Transfer or Transfer2 or comp comp Modified Adjusted Gross Income Maximum Maximum
SEP IRA Conversion NO Rollover NO Rollover NO Rollover Rollover
Rollover Rollover Rollover2 2017 2017
Elective Deferral (402(g) Limit): 401(k), $18,000 $18,000
SARSEP, 457 and 403(b)) Deduction Deduction
Married Filing Jointly Married
SIMPLE Transfer2 or Transfer2 or Transfer or Single for Those for Those
Conversion NO Rollover2 NO Rollover2 NO Rollover2 Rollover2
Delivering Plan
IRA Rollover2 Rollover2 Rollover Defined Contribution 415 Limit 100% comp 100% comp Filing Under Age 50 and
Filers You Only Spouse
(the lesser of) or $53,000 or $54,000 Separately Age 50 Older
Participate Participates
Coverdell Transfer or
NO NO NO NO NO NO NO NO NO NO Salary Deferral Catch-Up Limit $6,000 $6,000
ESA Rollover $62,000 $99,000 $186,000
(does not count against 415 limits $0 $5,500 $6,500
& under & under & under
Qualified Transfer or
4 in a 401(k) plan)
Rollover Conversion Rollover Rollover2 NO Rollover Rollover NO Rollover Rollover $63,000 $101,000 $187,000 $1,000 $4,950 $5,850
Plans3 Rollover
SIMPLE Plan Deferral $12,500 $12,500
$64,000 $103,000 $188,000 $2,000 $4,400 $5,200
Transfer4 or
Roth 401(k) NO Rollover NO NO NO NO NO Rollover NO NO SIMPLE IRA Catch-Up Limit $3,000 $3,000
Rollover $65,000 $105,000 $189,000 $3,000 $3,850 $4,550
Transfer or Defined Benefit 415 Limit $210,000 $215,000 $66,000 $107,000 $190,000 $4,000 $3,300 $3,900
403(b) Rollover Conversion Rollover Rollover2 NO Rollover NO Rollover Rollover Rollover
Rollover
$67,000 $109,000 $191,000 $5,000 $2,750 $3,250
Annual Compensation Cap $265,000 $270,000
Transfer4 or $68,000 $111,000 $192,000 $6,000 $2,200 $2,600
Roth 403(b) NO Rollover NO NO NO NO Rollover NO NO NO
Rollover SEP Participation Compensation $600 $600
$69,000 $113,000 $193,000 $7,000 $1,650 $1,950
SIMPLE Highly Compensated Employee (HCE) $120,000 $120,000 $70,000 $115,000 $194,000 $8,000 $1,100 $1,300
Rollover Conversion Rollover Rollover2 NO Rollover NO Rollover NO Rollover Rollover
401(k)
Key Employee Officer Definition $170,000 $175,000 $71,000 $117,000 $195,000 $9,000 $550 $650
Government Transfer or
Rollover Conversion Rollover Rollover 2
NO Rollover NO Rollover NO NO $72,000 $119,000 $196,000 $10,000
457(b) Rollover Social Security Taxable Wage Base $118,500 $127,200 $0 $0
& over & over & over & over
1
After-tax contributions require special consideration. Client should consult with a 3
Qualified plans include profit sharing, money purchase, defined benefit, ESOP, 5
Owner-only plans are not required to file IRS Form 5500EZ SF until assets reach This chart is designed to give you a basic overview of IRA deductions.
tax advisor for portability guidelines. target benefit. $250,000 or terminate. LPL Financial does not provide LPL Financial recommends you consult with a qualified tax advisor
2
Available only after the individual has been a SIMPLE plan participant for over 4
Only a plan merger could be done as a transfer. All other movement would need tax advice. Please consult your tax advisor. before making IRA decisions.
two years. to be done as a rollover.
PORTABILITY DEFINITIONS
Transfer Conversion Contribution Eligibility for Roth IRAs 2017

– Movement of assets from one account to another in which both accounts – Movement of assets from an eligible qualified plan or IRA to a Roth IRA. This type of
are considered to be like plans. This type of transaction does not generate transaction generates a 1099-R on the delivering side and a 5498 on the receiving Modified Adjusted Gross Income Phase Out Range
any tax reporting to the IRS and is therefore nontaxable. If the assets are side. This is generally a taxable event.
changing custodians, the receiving custodian will need to sign a letter of Married Filing Married Filing
Recharacterization Single Filers
acceptance accepting custodial responsibility of the account. Jointly Separately
– Movement of assets from one account into another account to undo a previous
Rollover transaction. This transaction is most common from a Roth IRA to an eligible IRA to $118,000–$133,000 $186,000–$196,000 $0–$10,000
– Movement of assets from one account to another. This type of undo a Roth conversion. Transaction will generate a 1099-R on the delivering side
transaction generates a 1099-R on the delivering side and a 5498 on and a 5498 on the receiving side. Member FINRA/SIPC
the receiving side for IRAs. The event may be nontaxable if it is done RP-0113-0217
properly and within 60 days. Tracking #1-575971 (Exp.02/19)
Contents
Business Entity Taxation Overview 1
Choice of Entity Question 1
Defining a Partnership §§ 761 and 7701(a)(2) 1
Defining a Corporation (§7701(a)(3))2
Reg. § 301.7701-2 Business Entities; definitions. 2
Check the Box Regs: Reg. § 301.7701-3 Classification of certain business entities 3
Changing Tax Treatment Reg. § 301.7701-3(g) 3
Publicly Traded Partnerships - § 7704 3
Social Security and Medicare Taxes 3
Ordinary Trusts v. Business Trusts Reg. § 301.7701-4 4
Formation of a Partnership 5
Contributing Property In Exchange for Interest of Partnership 5
Contributing Services for Partnership Interest 6
Single Person Entity to Partnership (Rev. Rul. 99-5) 7
Organization and Syndication Expenses § 709 7
Operations of a Partnership 8
Partnerships Generally § 701 8
Income to the Partners § 702 8
Income to the Partnership § 703 9
Partnership Taxable Year 10
Partnership Borrows Money or Reduces Debt § 752 11
Partnership Distributes Money to Partners 11
Partnership Sells Asset 11
Partnership Revalues Assets § 1.704-1(b)(2)(iv)(f) 12
Partnership Allocations 12
Allocating Sales or Exchanges of Contributed Assets § 704(c) 14
Allocation of Partnership Liabilities 14
Allocations where Partners' Interest Vary Throughout Year 15
Allocations in Family Partnerships § 704(e) 15
Transactions Between Partner and Partnership § 70716
Sales/Exchanges of Property Between Partnership and Partner § 707(b) [Issue Spot This] 17
Sale of a Partnership Interest 18
Operating Distributions 20
Liquidating Distributions 22
Liquidation of Entire Partnership 23
Death of a Partner 23
Business Entity Taxation Overview

• C Corp (“Double Tax”)
• The corporation pays tax if it earns a profit.
• IRC § 11 governs corporate taxation.
• The rates are high and the brackets are skinny.
• If the corporation distributes profits to the shareholder, then the shareholders are also taxed.
• § 61: dividends are income.
• Dividends are taxed at capital gains rates under § 1(h)(11).
• But see, § 1411: high-income individuals also pay 3.8% healthcare tax on dividends.
• This means, at its maximum, corp. profits can be taxed at 48% rate.
• Losses
• Shareholders may lose stock value, but it’s only deductible when the tock is sold and only
if it’s lower than shareholder basis.
• The corporation may take a deduction for losses on its tax return.
• S Corp
• Governed by subchapter S, § 1361 et seq.
• Taxed a lot more like partnerships than c corps.
• Not taxed on profits, § 1363
• Profits and losses pass through to the shareholders, § 1366
• Trusts
• Grantors are not taxed on the income to the trust, but only if they retain absolutely NO interest in
the trust.
• Either the beneficiaries pay tax or the trust pays tax.
• If the income is not distributed within the year, then it is taxed to the trust.
• If the income is distributed within the year then it is taxed to the beneficiaries.
Choice of Entity Question
Defining a Partnership §§ 761 and 7701(a)(2)
• From § 7701 (a)(2) Partnership and partner: “partnership” includes a syndicate, group, pool, joint
venture, or other unincorporated organization, which carries on a business, financial operation, or
venture and isn’t a corporation; and the term “partner” includes a member in such a syndicate, group,
pool, joint venture, or organization.
• From § 761 (a) Partnership: For purposes of this subtitle, the term “partnership” includes a syndicate,
group, pool, joint venture, or other unincorporated organization through or by means of which any
business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a
corporation or a trust or estate.
• Treated as mere co-ownership: Under regulations the Secretary may, at the election of all the members
of an unincorporated organization, exclude such organization from the application of all or part of this
subchapter, if it is availed of—
• (1) for investment purposes only and not for the active conduct of a business,
• (2) for the joint production, extraction, or use of property, but not for the purpose of selling
services or property produced or extracted, or
• (3) by dealers in securities for a short period for the purpose of underwriting, selling, or
distributing a particular issue of securities,
• if the income of the members of the organization may be adequately determined without the
computation of partnership taxable income.
• Reg. § 301.7701-1(a)(2): Certain joint undertakings give rise to entities for federal tax purposes. A joint
venture or other contractual arrangement may create a separate entity for federal tax purposes if the
participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.
• Joint Undertaking Merely to Share Expenses: doesn’t create a separate entity – i.e. two
persons jointly construct a ditch to drain surface water.
• Mere Co-Ownership of Property For Rent: This doesn’t create a separate entity for tax
purposes even if they maintain and keep it in repair.
• Co-Ownership with Services: a separate entity exists if co-owners of an apartment building
lease space AND provide services to the occupants either directly or through an agent.
• Podell v. Commissioner: Court identifies elements of a joint venture:
• (a) contract showing intent of business venture establishment;
• (b) agreement for joint control and proprietorship;
• (c) a contribution of money, property, and/or services; and
• (d) a sharing of profits. (This is most important factor)
• Problem Examples:
• (a) A B and C buy a parcel of land as tenants in common and hold the land as an investment.
This is not a partnership - mere co-ownership of property does not give rise to a partnership. This
is explicitly an example here.
• (b) Same as (a), but they subdivide the property and A B and C sell the sub lots. Looking at the
Podell Case below, this is probably enough to be considered a joint venture and thus this is likely
to constitute a separate entity. The act of subdividing would often be enough.
• (c) Two lawyers share an office and a secretary. Each services and bills his own individual
clients. Unlikely. This is more akin to the 'constructing a ditch' example. One key to this is profit
sharing - here, they are not dividing their profits. This doesn't meet the first definition of
"partnership".
• (d) Doctor will locate and purchase a building, architect will remodel it. When the work is done,
the building will be sold by the doctor-architect real estate company and architect will receive
25% of the net profits. This is definitely a partnership because you have a division of profit.
Division of profit is crucial - division of gross revenue is not. Division of PROFIT is key.
• (e) Same as above if the doctor retains 3 of the units as rental and the architect gets the last one.
This is akin to the Allison case below. Taking out part of the property in kind is not dividing
profits. This is more like taking a percentage of gross rather than profit. One crucial fact is that
they're not dividing up the profit, rather the overall assets of the project. Likely no entity here.
• (f) Fisher will purchase and operate a fishing boat. Lender provides 10 year nonrecourse loan to
Fisher. The arrangement will be evidenced by a note secured by the boat which will require
repayment of the principal sum ratably over the 10 year period. In addition, lender will receive
15% of Fisher's net profits from the fishing operation each year of the arrangement. This
probably isn't a partnership. However this is close. If they had called this a partnership, it very
well might have been called a partnership.
Defining a Corporation (§7701(a)(3))
• (3) Corporation: The term “corporation” includes associations, joint-stock companies, and insurance
companies.
• So, this doesn't give you much other than when dealing with these specific business types. Further, the
state law that says whether you're a corporation is persuasive, but not binding for tax purposes.
Reg. § 301.7701-2 Business Entities; definitions.
• (a) Business entities. For purposes of this section and § 301.7701-3, a business entity is any entity
recognized for federal tax purposes (including an entity with a single owner that may be disregarded as
an entity separate from its owner under § 301.7701-3) that is not properly classified as a trust under §
301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code. A business entity
with two or more members is classified for federal tax purposes as either a corporation or a partnership.
A business entity with only one owner is classified as a corporation or is disregarded; if the entity is
disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of
the owner.
• (b) Corporations. For federal tax purposes, the term corporation means—
• (1) A business entity organized under a Federal or State statute, or under a statute of a federally
recognized Indian tribe, if the statute describes or refers to the entity as incorporated or as a
corporation, body corporate, or body politic; [So, if state law refers to the company as a
corporation, then it's automatically a corporation for tax purposes.]
• (2) An association (as determined under § 301.7701-3);
• (3) A business entity organized under a State statute, if the statute describes or refers to the entity
as a joint-stock company or joint-stock association;
• (4) An insurance company;
• (5) A State-chartered business entity conducting banking activities, if any of its deposits are
insured under the Federal Deposit Insurance Act, as amended, 12 U.S.C. 1811 et seq., or a
similar federal statute;
• (6) A business entity wholly owned by a State or any political subdivision thereof, or a business
entity wholly owned by a foreign government or any other entity described in § 1.892-2T;
• (7) A business entity that is taxable as a corporation under a provision of the Internal Revenue
Code other than section 7701(a)(3); and
• (8) Certain foreign entities—[corporations in other countries]
• [This is a complete list - if you're not under this list, you are not a corporation.]
Check the Box Regs: Reg. § 301.7701-3 Classification of certain business entities
• (a) In general. A business entity that is not classified as a corporation under § 301.7701-2(b) (1), (3),
(4), (5), (6), (7), or (8) (an eligible entity) can elect its classification for federal tax purposes as
provided in this section. An eligible entity with at least two members can elect to be classified as
either an association (and thus a corporation under § 301.7701-2(b)(2)) or a partnership, and an
eligible entity with a single owner can elect to be classified as an association or to be disregarded as
an entity separate from its owner. [So, this allows the business to elect to be taxed as a corporation
or partnership (or sole proprietorship).]
• (b) Defaults (no election): Domestic eligible entities will be considered a partnership if it has two or
more members; or disregarded as an entity separate from its owner if it has a single owner.
Changing Tax Treatment Reg. § 301.7701-3(g)
• An elective change in classification will result in:
• Partnership to Association: Partnership contributes all assets and liabilities to the association in
exchange for stock in the association. The partnership then liquidates by distributing the stock of
the association to its partners.
• Association to Partnership: The association distributes all of its assets and liabilities to
shareholders in a liquidation. The shareholders then contribute all distributed assets and
liabilities to a newly formed partnership. [Note: This is a heavily taxed transaction.]
• (a) General Rule: Publicly traded partnership is treated as a corporation.
• (b) Defines PTP: Any partnership if such interest are traded on an established securities market or
interest in such partnership are readily tradable on a secondary market.
• (c) Exception: 90% or more of the company’s gross income must come from qualified income as defined
by (d).
• 6.2% Social Security tax for employer and employee
• 1.45% Medicare tax for employer and employee
• No Personal Exemption
• Social Security Wage Base for 2015: $118,500 – this is the capped social security wage tax
amount
• Self Employment
• 12.5% social security tax
• 2.9% medicare tax
• Tax base: 92.35% of net earnings from self-employment
• Filing threshold: $400 of net earnings from self-employment
• Social security base for 2015: $118,500 minus wages
• Medicare Surtax: After $200k ($250k for married, joint return) of wages, compensation, or self-
employment income, taxpayer pays an additional 0.9% in Medicare surtax.
• 3.8% of net investment income
• Applicable only to extent adjusted gross income is greater than $200,000 ($250,000 married)
• Applicable to investment income (dividends, interest, recognized gains on stocks, bonds) income
from financial trading business, and passive activity income
• Not applicable to income from non-rental, non-financial-trading business activities in which
taxpayer materially participates
• Not imposed on wages or self employment income
• This is § 1411.
• Partnerships and Wages: Wage tax is not applicable to partners in a partnership
• Partnerships and Self-Employment Tax: Self-employment tax is imposed on pass through income
from partnership business to general partners (NOT imposed to limited parters)
• S-Corporations Pass-Through Income: Self-employment tax is NOT imposed on pass-through
income from S corporations to shareholders
• S-Corporations Wages: Wage tax is imposed on S corporation shareholders only to the extent of
wages paid.
If you don’t take out wages, you never have to pay SS/Medicare taxes – however, the IRS will look at blatantly
evasive actions – you’re supposed to take out a ‘reasonable’ wage.
Ordinary Trusts v. Business Trusts Reg. § 301.7701-4
• Trusts are not pass-through entities - they are single tax, but not exactly pass-through. When a trust earns
income, that is taxed to the trust if the trust accumulates it. If it distributes to the beneficiaries, just the
beneficiaries pay the tax.
• (a) Ordinary trusts. In general, the term “trust” as used in the Internal Revenue Code refers to an
arrangement created either by a will or by an inter vivos declaration whereby trustees take title to
property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules
applied in chancery or probate courts. Usually the beneficiaries of such a trust do no more than accept
the benefits thereof and are not the voluntary planners or creators of the trust arrangement....
• (b) Business trusts. There are other arrangements which are known as trusts because the legal title to
property is conveyed to trustees for the benefit of beneficiaries, but which are not classified as trusts for
purposes of the Internal Revenue Code because they are not simply arrangements to protect or conserve
the property for the beneficiaries. These trusts generally are created by the beneficiaries simply as a
device to carry on a profit-making business which normally would have been carried on through
business organizations that are classified as corporations or partnerships under the Internal Revenue
Code. [So, if they are carrying on a business, it's not a trust anymore and is instead a business
entity under -2 or -3.]
Formation of a Partnership
Contributing Property In Exchange for Interest of Partnership
• General Rule § 721(a): No gain or loss recognized to a partnership or partners in the case of
contribution of property to the partnership in exchange for an interest in the partnership.
• "Goodwill" is property for § 721 purposes.
• Receivables are property for §721 purposes.
• Investment Company Exception §721(b): Gain WILL be recognized on a transfer of property
to a partnership which would be treated as an investment company (defined in §351). A transfer
will be considered a transfer to an investment company if (Reg. § 1.351-1(c)):
• (i) The transfer results in diversification of the transferors' interests; and
• (ii) The transferee is:
• (a) a regulated investment company;
• (b) a real estate investment trust;
• (c) a corporation more than 80% of the value of whose assets are held for
investment and are readily marketable stocks or securities, or interest in regulated
investment companies or real estate investment trusts.
• Treatment of Money as Securities § 351(e): The biggest problem is that § 351(e)
considers money as securities for this evaluation. Thus, at least 20% of the assets cannot
be money or stocks and other equity interests in a corporation or §351 will consider
this a transfer to an investment company and gain will therefore be recognized.
• Partner's Basis of Interest § 722: The basis of an interest in a partnership acquired by a contribution of
property, including money, shall be the amount of such money and the carry-over basis of such property
contributed plus any gain recognized under § 721(b).
• Holding Period § 1223: This only applies to capital gain (§1231) type assets that would recognize long
term capital gain (more than 1 year). The holding period will tack onto the partner's interest as well as
the partnership's assets.
• Partnership's Basis of Contributed Property § 723: Basis of property contributed is the carry-over
basis plus any amount of gain recognized by the contributing partner under § 721(b).
• Assumption of Liability Greater than Contributing Partner's Basis: The partnership will not
receive inside basis increase when the partnership assumes a liability and the partner recognizes
a gain on that assumption of liability. This will create an inside-outside basis discrepancy unless
they make an election under §754. If there is a §754 election, the basis of the contributed
property is increased by the gain recognized to the partner.
• Special Rules:
• ("1245 Property") Property (Not Real) That Was Depreciated § 1245: The depreciation you
took here was ordinary, so 1245 would normally recapture the gain and prevent you from
ignoring such gain. However, § 721(b)(3) negates this effect and §1245(b)(3) creates such
exception provided there is a transferred basis in the contributed property. This doesn't get rid of
the potential recapture as § 1245(a)(2) keeps this in the property through the definition of
"recomputed basis".
• Holding Period: The holding period will only transfer as to the adjusted basis of the
capital asset transferred if the gain is due to depreciation.
• Installment Notes § 453B(a): 453B(a) requires the recognition of any gain realized on the
disposition of an installment obligation. However, § 721 steps in again and allows the
nonrecognition of the installment note gain.
• Encumbered Assets § 752(b): If the partner contributes assets that have a liability attached to
the property, § 752(b) applies. The partner is treated as receiving a distribution of cash equal to
the liability. Steps:
• 1) First, apply the basic partnership formation rules: §§ 721, 722, 723
• No taxation here and partner would get the carry-over basis of the contributed
property.
• 2) Then, deal with the liability: §752
• First, § 752(a) applies: he gets an increase in his partner liability because he is
liable for his portion of the assumed debt. This is treated a contribution of money
by such partner in the partnership and therefore increases his outside basis by his
share of the liability once it's in the partnership. The same goes for every other
partners' bases as their liabilities go up by their share of the liability.
• Then, § 752(b) applies: he gets a decrease in his partner liability because the
partnership is assuming his individual liability. This is treated as a distribution of
money to the partner by the partnership. Therefore, the partner's basis in the
partnership interest decreases by the assumption of personal liability.
• Liability Assumption Greater than Carryover Basis + Liability
Increase: Here, if the liability is greater than the carryover basis plus his
recent increase in partner share of liability, the remaining amount is
considered a recognized gain. This partner's outside basis would therefore
be 0.
• Nonrecourse Liability Here:
• Reg. § 1.752-3(a)(2): We make believe that the asset is sold
just for the amount of debt and then ask how much would
be allocated to the contributing partner. The contributing
partner thus is allocated the mortgage amount minus the
basis in the property.
• Reg. § 1.752-3(a)(3): Then, the remaining amount moves
to tier 3. This would allocate the remaining amount to each
partner.
• If the partner wants to avoid a gain here, the partner can also
contribute cash equal to the amount of gain he would recognize or
property with a basis equal to or greater than such amount. Or, the
partners could agree that C continues to bear the economic risk of
loss for the debt through an indemnity agreement.
• Contributing Assets and Obligations (e.g. Accounts Payable): Reg. § 1.752-1(a)(4) says that
an obligation is a liability for §752 only if the obligation:
• (A) Creates or increases the basis of any of the obligor's assets (including cash);
• (B) Gives rise to an immediate deduction to the obligor; or
• (C) Gives rise to an expense that is not deductible in computing the obligor's taxable
income and is not properly chargeable to capital.
• [So, based on these definitions, accounts payable to a cash-method contributor are
not considered a liability because they are deductible when paid; so, the
contributing partner wouldn't have to worry about gain here with this kind of
liability. Rather, he will simply be attributed the partnership gain as it is collected
under § 704(c)(1). HOWEVER, if the contributing partner was on the accrual
method he would have deducted this amount already and this could be considered a
liability.]
• Problem Examples Page 45,48, 52
Contributing Services for Partnership Interest
• Contributing Services for Initial Capital Account: Under §83, the person performing the services has
to report the FMV of the property as ordinary income. There are three steps here:
• 1) Partnership Consequences: Partnership is treated as if it conveyed a percent interest in its
assets to the partner or performed the services. This is treated as if the partnership satisfied a debt
with this interest and will therefore be treated as selling your property to your creditor. So, the
partnership will realize a gain equal to the (Total Unrealized Gain on Assets) x (percent interest
conveyed). HOWEVER, the partnership also gets a deduction under IRC §83 equal to the
amount that the contributing partner reports as income.
• 2) Other Partner Consequences: Now, because the partnership has a gain on these assets, the
other partners realize this gain as a pass-through gain respective of their distributive share.
HOWEVER, because the partnership gets this deduction, the deduction passes-through to the
partners. So, the outside basis of the partner remains the same.
• 3) Recontribution of Property: Now, we make believe that the partner that received the interest
contributes that interest in the property of the partnership back to the partnership. This will be
tax-free for both parties under §§ 721, 722, and 723 and will step up the basis by the realized
gain.
• Contributing Services for Share of Profits Going Forward (no Initial Capital Account): Under § 83,
the partner performing services should be taxed now, but it's too difficult to value this at this point in
time. Thus, it is not taxed now.
• Rev. Proc. 93-27: If you perform services and get a profits only interest, then there is no taxation
unless one of the three exceptions apply:
• If the profit interest relates to a substantially certain and predictable stream of income
from partnership assets, such as income from high-quality debt securities or a high-
quality net lease;
• Bogdanski doesn't think that an average is enough to meet the substantially
certain test.
• If within 2 years of receipt, the partner disposes of the profits interest; or
• Diamonds Case: If you turn around and sell your interest right after you get it,
you CAN realize this. Though, it will be a capital gain.
• If the profits interest is a limited partnership interest in a "publicly traded partnership"
within the meaning of section 7704(b) of the IRC.
• Problems Page 61, 75
Single Person Entity to Partnership (Rev. Rul. 99-5)
• Situation: you have a single-member LLC and is currently a disregarded tax entity (tax nothing). What
happens when someone else buys an interest in the LLC to become taxed as a partnership? Will she be
taxed? Will it be treated as a partnership formation?
• In this ruling, there are two different ways to do this:
• 1) Sell the new person part of your LLC interest.
• Here, she gets the new person's money - shouldn't this be taxable?
• RULING: This is a taxable event - she will be treated as selling new person one half of
each of the LLC's assets and recognize gain/loss for each of those assets. For new person,
we'll treat him as contributing the assets he just purchased to the LLC.
• 2) Have him contribute money to LLC for new interest.
• Here, she doesn't get new person's money, so should this be taxable?
• RULING: We'll treat this as a formation of a new partnership - new person gets a cash
basis in his interest at what he contributes.
Organization and Syndication Expenses § 709
• Placement Fee paid to Broker in selling partnership interests: this is a "syndication expense" that is
not deductible or amortizable as an organizational expense under §709.
• Organizational fee paid to Developer to organize and negotiate the terms of the partnership: This
is an "organizational expense" under §709(b)(3) as defined under Reg. §1.709-2(a) to include fees for
services "incident to the organization of the partnership, such as negotiation and preparation of the
partnership agreement."
• Fees paid to Attorney to draft agreement and file necessary papers and prepare offering
documents: Fees related to the drafting of the partnership agreement and filing papers to form the
partnership are "organizational expenses" and can be deducted. However, fees attributable to local
securities "registration fees" and legal fees of an underwriter, placement agent or "issuer" for securities
advice are "syndication expenses" and must be capitalized.
• Accountant fees for preparing the financial projections in the offering documents: "syndication
expenses" and must be capitalized.
• Printer fees to print the partnership offering prospectus: Rev. Rul. 85-32 says this is a "syndication
expense" that is not deductible or amortizable.
• See Chapter 2 Answers for last 2. Problems Page 82.
Operations of a Partnership
Partnerships Generally § 701
Partners, not Partnership, Subject to Tax § 701: A partnership is not subject to income tax; rather, the
partners are liable for income tax in their separate capacities.
Income to the Partners § 702
• (a) Generally: Each partner shall take into account their separate distributive share of the partnership’s
gains and losses.
• (1) gains and losses from sales or exchanges of capital assets held for not more than 1 year,
• (2) gains and losses from sales or exchanges of capital assets held for more than 1 year,
• (3) gains and losses from sales or exchanges of property described in section 1231 (relating to
certain property used in a trade or business and involuntary conversions),
• Stated separately because under §1231, you get a capital gain if sold at a gain, but an
ordinary loss if sold at a loss.
• Depreciation Recapture §1245: Depreciation overrides this making depreciation
recapture ordinary income.
• (4) charitable contributions (as defined in section 170 (c)),
• Stated separately because there are different caps.
• (5) dividends with respect to which section 1 (h)(11) or part VIII of subchapter B applies,
• When one corporation receives a dividend from another, they are largely deductible by
the recipient.
• (6) taxes, described in section 901, paid or accrued to foreign countries and to possessions of the
United States,
• (7) other items of income, gain, loss, deduction, or credit, to the extent provided by regulations
prescribed by the Secretary, and
• (8) taxable income or loss, exclusive of items requiring separate computation under other
paragraphs of this subsection.
• Reg. § 1.702-1(a)(8)(ii): If it might be taxed differently, then state is separately.
• E.g. this applies to the interest on a margin account. This is a broker lending the company
money to buy securities. This is due to § 163(d) as investment interest - it is only
deductible against investment income if you have any. We want this interest to pass
through to the shareholders separately here so they can apply this to their net investment
income for the year.
• See Problem Page 107 Answers for example of calculated income to partnership and
separately stated income/deductions.
• (b) Character of Income: Determined at the partnership level.
• Inventory in the hands of Contributing Partner § 724: However, §724 would make this gain as if
it was sold by a contributing partner.
Income to the Partnership § 703
• (a)(1) The items in § 702(a) will be separately stated.
• (a)(2) Partnerships may not deduct:
• Personal exemptions
• Foreign taxes
• Charitable contributions (though partners are allowed to deduct these)
• Net operating losses
• Individual itemized deductions
• Deduction for depletion (for oil and gas wells)
• (b) Any elections must be made by all of the partners at the partnership level, except:
• Discharge of indebtedness income
• Mining deductions
• Foreign taxes
• Change in Partner's Basis §705(a): A partner's basis in his interest shall be:
• Increased by the sum of his distributive share for the taxable year of:
• taxable income of the partnership
• tax-exempt income of the partnership
• decreased by:
• distributions by the partnership to the partner as provided by §733
• the partner's distributive share for the taxable year of losses of the partnership
• Limitation on Allowance of Losses §704(d): A partner’s share of distributive losses is only allowed to
the extent of the adjusted basis of such partner’s interest in the partnership at the end of the partnership
year in which such loss occurred. Any excess of such loss over such basis shall be allowed as a
deduction at the end of the partnership year in which such excess is repaid to the partnership. [So, excess
losses are not wasted - they go to a carryover account for when you get basis.]
• Avoid this limitation: Simply have the partnership take out a loan - the loan will generate basis
for the partners to use. Or, have the partner contribute property enough to offset the loss.
• Capital and Ordinary Loss In Excess of Basis: The carry over basis for losses is proportional.
• If an interest with a loss carryover account is transferred in a gift setting, it's unlikely that the
donee will get the loss carryover account. No regulations on this, though.
• Problems Page 111
• At-Risk Amounts - Limitation on Pass-Through Losses §465: Individuals and certain C-corps can
take losses only to the extent that the taxpayer is 'at-risk.' This is to prevent people from taking losses
when the basis in their interest is generated out of non-recourse debt. Any losses past the 'at-risk' amount
will carry forward, however.
• "At-Risk" Amount § 465(b): Moves up and down with income/loss and distributions just like
outside basis. When you sell your interest, you do get to carry over the suspended loss.
Calculated as the sum of:
• Cash contributed
• Basis of property contributed
• Amount of debt for which the taxpayer is personally liable
• Assume here that the partnership is worthless but all the partners are solvent
• FMV of interest in property pledged as security for such borrowed amount (other than
property used in such activity)
• Any loans by partners to the partnership are not considered at risk amounts.
• Limitation on Passive Activity Losses §469: You cannot take losses from a passive activity against
anything other than passive activity gains.
• This includes rental activity.
• Just like § 465, this does NOT apply to publicly traded corporations.
• So this prevents people from taking these losses against anything other than passive gains.
• There are ways to cope with this - if you are going to have passive losses, go buy something that
has passive gains.
• Active business losses, on the other hand, are deductible against everything.
• "Passive Activity":
• Trade or business in which the taxpayer does not materially participate, or rental (469(c))
• Determined separately for each partner
• Limited partners passive per se (IRC § 469(h)(2))
• Includes non-managing LLC members
• Regulations provide exceptions for active LPs and LLC members
• Exception for real estate professionals - IRC §469(c)(7)
• Exception for "Mom and Pop" rental house - IRC § 469(i)
• So, there are Passive Income Generators (often rental properties) to absorb your losses.
• Example:
• We have an investor who makes 200k in his lawfirm and 40k from investments.
He also has 8k passive income and 10k passive losses. Here, he can only use 8k
deductions against his income, but the 2k extra just gets carried forward.
• HOWEVER, these are available to offset your interest when you finally sell your
passive income assets.
• Schneer v. Commissioner: We don’t tax partners on what they bring into the firm; rather, we tax them
on what they’re entitled to take out under § 704.
Partnership Taxable Year
• Importance: Under §706(a), the income passes through from the partnership to the partners at the end
of the partnership's year. This means that the partners may be able to defer income a substantial amount
of time if the partnership's taxable year is different than the partners'.
• For maximum deferral, a calendar year of Jan 31 would be the best to get the full 11 month tax
deferral. If there's going to be a bunch of losses, you want to minimize the deferral - you would
use calendar year.
• Reference to Partners § 706(b)(1)(B): Except as provided by (C), a partnership shall not have a taxable
year other than:
• First) Majority Interest Taxable Year § 706(b)(1)(B)(i): Taxable year which constituted the
taxable year of 1 or more partners having an aggregate interest in partnership profits and capital
of more than 50 percent. This is tested on the 1st day of the partnership taxable year (without
regard to this clause). If the partnership's taxable year changes by reason of this paragraph, it
doesn't have to change again for either of the 2 taxable years following the year of change.
• Else) Principal Partners §706(b)(1)(B)(ii): if no majority interest taxable year, the taxable year
of all the principal partners of the partnership. A principal partner is a partner having 5% or more
share of profits.
• Else) Calendar Year § 706(b)(1)(B)(iii): otherwise it's the calendar year.
• Business Purpose § 706(b)(1)(C): A partnership can have a taxable year regardless of (B) if it
establishes a business purpose.
• Deferral of income to partners is not a business purpose.
• Time to gather tax info for its calendar year partners isn't likely a good business purpose either.
• Safe Harbor 25% test: There is a business purpose if 25% or more of the partnership's gross
receipts for the selected year are earned in the last two months. This test looks back to the three
preceding years that correspond to the requested fiscal year. So there must be a 3 year pattern to
use this 25% test.
• § 444 Election: Regardless of everything thus far, the partnership can elect for a calendar year up to 3
months prior to calendar year (sept-nov) if they make a deposit for the tax due to remove the deferral of
taxes under §7519.
• Problems Page 104
Partnership Borrows Money or Reduces Debt § 752
• (a) Increase in Partner's Liabilities: Any increase in partner's share of liabilities or any increase in the
partner's individual liabilities by reason of the assumption by the partner of partnership liabilities is
considered as a contribution of money by such partner to the partnership.
• (b) Decrease in Partner's Liabilities: Any decrease in a partner's share of the liabilities of a partnership
or decrease in a partner's individual liabilities by reason of the assumption by the partnership shall be
treated as a distribution of money to the partner by the partnership.
• Debt Allocation Reg. § 1.752-3(a): Nonrecourse liabilities generally are allocated according to the ratio
in which the partners share profits.
• Recourse vs. Nonrecourse Reg. §1-752-1(a):
• (1) Recourse Liability: Partnership liability is recourse to the extent that any partner or related
person bears the economic risk of loss for that liability.
• Recourse and Limited Liability (Reg. § 1.752-2(a)): In the case that only some partners
(general partners) are liable for the loan, they will be allocated the liability because they
bear the economic risk of loss for this liability.
• (2) Nonrecourse Liability: Partnership liability is a nonrecourse liability to the extent that no
partner or related person bears the economic risk of loss for that liability.
• Nonrecourse and Limited Liability (Reg. § 1.752-3(a)): Even if only some partners
(general partners) are liable for the loan itself, this is a nonrecourse loan, so the partners
are equally allocated the liability.
Partnership Distributes Money to Partners
• Non-Taxable Event §731: Gain is not recognized to the partner unless the money exceeds their basis.
• Partner's Basis in Interest §733 and § 705(a)(2): When a partnership distributes money to a partner
(other than in liquidation of the partner's interest), the basis in the interest is reduced by the amount of
any money distributed and the amount of the basis to such partner of distributed property other
than money (as determined under §732).
Partnership Sells Asset
• Generally §704(a): Look to the partnership agreement. The gain or loss is split between the partners in
their distributive amounts. Any gain or loss increases or decreases the partners' capital accounts and
outside bases.
• Contributed by Partner with Built-in Gain §704(c): When a partnership sells an asset contributed by
a partner that had built in gain on it, the built in gain is taxed to the contributing partner for the amount
of that built in gain. The remaining amount is split between the partners in their distributive amounts.
• Contributing Partner's Capital Account: The contributing partner's capital account doesn't go
up from the 704(c) gain either because it was already accounted for in the contribution. It does,
however, increase the contributing partner's outside basis by the 704(c) amount.
• Contributed Receivables §724(a): Any gain or loss shall be treated as ordinary income or ordinary loss.
• Contributed by Partner Which was Inventory In Hands of Partner § 724(b): any gain or loss
recognized by the partnership during the 5 years period starting after contribution shall be treated as
ordinary income or loss. (i.e. real estate in the hands of a real estate trader)
• New Partner After Asset has Gain: If a new partner is introduced to the partnership and an asset
already has gain built from being in the partnership, the new partner will not be taxed under §704(c)
principles.
Partnership Revalues Assets § 1.704-1(b)(2)(iv)(f)
• Under this reg, the partnership may revalue its assets on the occurrence of several events (including a
new contributing partner) if it meets various requirements under Reg. § 1.704-1(b)(2)(2)(iv)(f)(5). The
partners will increase their capital accounts by any appreciation from the book value, but the assets basis
does not go up and the partners' outside bases don't go up.
• New Partner and Partnership with Liabilities: If a new member is added, the liabilities are re-
allocated according to the partner interests and this will adjust the outside bases of the partners
because of the increase and decrease of a partner's share of liabilities under § 752.
• New Partner in regards to Asset that already had gain: If a new partner is introduced to the
partnership and an asset already has gain built from being in the partnership, the new partner will
not be taxed under §704(c) principles. The partners that were with the partnership while that gain
was had will be taxed according to their distributive shares - also, if the partnership revalued
their assets when the new partner came in and they sold the new asset, their capital accounts
won't go up because it was already increased when they did the revaluing.
Partnership Allocations
• Generally Partnership Agreement §704(a): Generally, a partner's share shall be determined by the
partnership agreement. However, §704(b) applies to prevent abuse or if the agreement doesn't provide
for the allocation.
• Limitation on Allocation § 704(b): A partner's distributive share shall be determined with the partner's
interest in the partnership (determined by taking into account all facts and circumstances) if:
• 1) the partnership doesn't provide for the allocation; or
• 2) the allocation to the partner under the agreement does not have substantial economic effect.
• Orrisch v. Commissioner: The Orrisches allocated all depreciation deductions to the Orrisches
however, when the partnership would break up, each partner would get everything equally. The building
depreciation would come out of each partner's account equally. The Orrischs were not suffering the
economic loss of depreciation. Therefore, this did not satisfy §704(b).
• Substantial Economic Effect Reg. § 1.704-1(b)(2): Two Part Analysis:
• Economic Effect (b)(2)(ii): Follow the requirements of (b) otherwise there will be a fact-based
analysis.
• (a) Consistent with the underlying economic arrangement of the partners. When there is
an economic benefit or burden that corresponds to an allocation, the partner to whom the
allocation is made must receive such economic benefit or burden.
• "The Big Three Requirements" (b) An arrangement will have economic effect if it
meets three requirements:
• 1) The partners maintain capital accounts according to rules of (b)(2)(iv) of this
section;
• 2) Upon liquidation the partners only get what's in their capital account; AND
• 3) If you have a negative balance in your capital account, you are obligated to
restore the balance to the partnership by the end of the year.
• Reg. § 1.704-1(b)(2)(ii)(d) Alternate Test: Instead of this last
requirement, you can have a "qualified income offset" clause in
agreement. See below.
• Substantial (b)(2)(iii): Even if you live up to the big 3 requirements, if the allocations don't
really effect anyone's economics, then we'll ignore them for tax purposes. Essentially, if the tax
allocation is helping one person and not harming another, it won't be substantial. They are trying
to avoid two kinds of abuse:
• Shifting Allocations § 1.704-1(b)(2)(iii)(b): Simply adjusting the tax so that less tax is
paid.
• E.g. all the foreign source income is assigned to D (up to D's distributive share)
who is a non-resident alien and doesn't pay taxes on foreign source income. This
would be a shifting allocation and would not have substantial economic effect.
This would be okay if instead ALL foreign income was assigned to D for his
distributive share - rather than an amount UP TO his distributive share.
• Transitory Allocations §1.704-1(b)(2)(iii)(c): Simply allocating something that will be
largely offset by one or more other allocations and there is a "strong likelihood" that such
allocations and offsetting allocations will be made. (no strong likelihood after 5
years)You just need a reasonable possibility that this allocation could have an impact on
bottom line economics for it to pass here.
• Maintenance of Capital Accounts Reg. §1.704-1(b)(2)(iv)(b): The partners' capital accounts must be:
• Increased by the amount of money contributed by him to the partnership,
• Increased by the FMV of property contributed by him (net of liabilities that the partnership is
considered to assume)
• Increased by allocations to him of partnership income and gain including gain exempt from tax
• Decreased by the amount of money distributed to him by the partnership
• Decreased by the FMV of property distributed to him by the partnership
• Decreased by allocations to him of expenditures of the partnership
• Decreased by the allocations of partnership loss and deduction
• See Problem Set Page 160.
• Qualified Income Offset Reg. § 1.704(b)(2)(ii)(d): Alternate Test - the partnership agreement contains
a "qualified income offset" if it provides that a partner who unexpectedly receives an adjustment,
allocation or distribution will be allocated items of income and gain in an amount and manner sufficient
to eliminate such deficit balance as quickly as possible. Essentially, if something causes an account to
go below zero, they will report enough partnership income to bring their account back to zero.
Most commonly, this is due to a distribution - if it causes your capital account to drop below 0,
then you pay taxes on the negative amount.
• Economic Effect Equivalence Reg. § 1.704-1(b)(2)(ii)(i): Even if your partnership agreement
doesn't spell this out, if state law gets you to the same place, then it's the same as if your
agreement actually said that.
• Contributed Obligations to Pay Reg. §1.704-1(b)(2)(ii)(c): Also, when a partner contributes a
promissory note for an amount, he gets a "constructive" bonus to his capital account equal to the
promissory amount. It will be constructively treated as part of the capital account provided it
becomes due if he leaves the partnership (within 90 days after partner liquidation at the latest).
• Allocations Attributable to Nonrecourse Debt Generally Reg. § 1.704-2(b): When we've got
allocations for nonrecourse loan deductions, the regulations pretty much allow the partners to do what
they want.
• Amount of Nonrecourse Deductions Reg. §1.704-2(c): The amount of nonrecourse deductions
allowed in a taxable year is the net increase in partnership minimum gain during the year.
• Partnership Minimum Gain Reg. §1.704-2(d): Amount of partnership minimum gain is
determined by computing for each partnership nonrecourse liability any gain the partnership
would realize if it disposed of the property subject to that liability for no consideration other than
full satisfaction of the liability, and then aggregating the separately computed gains.
• Requirements To Be Satisfied Reg. § 1.704-2(e): There are four requirements to be deemed in
accordance with the partners' interests:
• 1) Meet the big 3 requirements or the first 2 and have a qualified income offset in
agreement.
• 2) These allocations must line up with other allocations that have substantial economic
effect of some other significant partnership item attributable to the property securing the
nonrecourse liabilities.
• 3) You must have a minimum gain chargeback provision in your agreement.
• Minimum Gain Chargeback Requirement Reg. §1.704-2(f): When the
partnership is paying off the debt, the partnership will be paying that back out of
income. That income must be allocated to the partners in the same way they are
taking deductions. So, if the deductions are allocated 80/20 for a time and then
switch over to a 50/50 allocation, it will be fine as long as the income that is used
to pay for the debt on the property is allocated the same way.
• 4) all other allocations must be valid.
• Problems page 172.
Allocating Sales or Exchanges of Contributed Assets § 704(c)
• Allocations and Contributed Assets §704(c): The partner that contributed the asset takes the built-in
gain or loss when it is sold.
• Selling an Asset with Built-in Gain: The entirety of the built-in gain is allocated to the contributing
partner. Any excess is allocated to the partners according to their distributive share.
• Type of Gain § 724 (a): If the asset was an ordinary gain asset in the hands of the contributing
partner (i.e. 751(d) inventory property), it will be ordinary gain for the contributing partner.
• Sold for Less than FMV at time of Contribution: There are three methods for allocating this
economic loss that, ideally, the partnership agreement chooses:
• Traditional Method ("Ceiling Rule" Reg. §1.704-3(b)(1)): Under the traditional
method, the gain on the sale will be allocated to the contributing partner. Although, this
doesn't recognize that the partnership actually took an economic loss and it will create a
disparity in the book/taxes.
• Remedial Allocation Method Reg. § 1.704-3(d): This would allow the partnership to
elect to essentially recognize a loss on the disposition of the asset and then tax the
contributing partner as if the asset was disposed of at the FMV at the time of contribution
(full gain to contributing partner). This method is done by creating an offsetting remedial
item in an identical amount and allocates it to the contributing partner.
• Traditional Method with Curative Allocations §1.704-3(c): The partnership under the
traditional method may make curative allocations to fix this. So, initially, the gain will be
entirely allocated to the contributing partner and then when further income comes into the
partnership, it will be allocated entirely to the contributing partner until the 'economic
loss' suffered by the partnership is cured.
• Reg. §1.704-3(b)(1): For section 704(c) property subject to amortization, depletion, depreciation,
or other cost recovery, the allocation of deductions attributable to these items takes into account
built-in gain or loss on the property. For example, tax allocations to the noncontributing partners
of cost recovery deductions with respect to section 704(c) property generally must, to the extent
possible, equal book allocations to those partners. (See Problem 2 pg 192)
Allocation of Partnership Liabilities
• Under §752, we pretend that the partners are borrowing the liability rather than the partnership and when
the partnership pays off the debt, we make believe that the partners pay the debt off.
• Recourse Liabilities Reg. § 1.752-2 "Doomsday" Scenario: Run through the "Doomsday" scenario
here where all of their property has no value and if the partners all had money and they all sued each
other, how much does everyone have left to pay?
• Example 1: A, B, and C form a partnership by contributing 20k each. They satisfy the big 3
requirements and allocate profits and losses 40% to A, 40% to B, and 20% to C. They then take
out a 40k recourse loan to fund the purchase of 100k property. To figure out how § 752 allocates
this loan's basis, we run the doomsday scenario:
• Doomsday: The property is sold for nothing here which creates a 100k loss. According to
the agreement, 40k of the loss goes to A, 40k to B, and 20k to C. Add these to the capital
accounts and A has -20k CA, B has -20k CA, and C has 0 CA. Therefore, the basis would
get allocated 20k to A and 20k to B.
• Example 2: Same as example 1, but A contributes 10k, B contributes 20k, and C contributes 30k.
In the doomsday scenario, A has a -30k CA, B has a -20k CA, and C has a 10k CA. However,
there's only 40k liability to go around. Thus, it is proportionally allocated using a ratio of (40k /
50k). 30k x 4/5 = 24k and 20k x 4/5 = 16k. Therefore, A will receive 24k of the basis for this
liability and B will receive 16k of the basis.
• Example 3: Same as example 1, but A and B are limited partners who are not obligated to restore
a capital account deficit, but the partnership agreement includes a qualified income offset? Here,
when we run the doomsday scenario, and the property is sold for a 100k loss, the loss can only
be allocated to A and B up to their capital accounts. Thus only 20k allocated to A, 20k allocated
to B, and the remaining 60k is allocated to C. This drop's A's account to -40k. Therefore, the
entire 40k basis jump from the liability will go to C.
• Example 4: Same as example 3, but A contributes 15k stock to the partnership as security for the
liability and all income on the stock is allocated to A. This stock contribution increases A's
capital account to 35k. When the 100k loss is allocated, 35k is allocated to A, 20k will be
allocated to B and the remaining 45k will be allocated to C. This brings A's CA to -15k, B's CA
to 0, and C's capital account is reduced to -25k. Therefore 15k will be allocated to A and 25k will
be allocated to C. This would be the same if A contributed a 15k note as security under the
alternate test for economic effect because A is treated as bearing the economic risk of loss to that
extent.
• Example 5: Same as Example 3, except A personally guarantees the 40k liability. Because we
assume that everyone has money, the guarantee has no effect. A would have a right of
subrogation against the partnership which would in turn oblige C to pay. So, the basis is entirely
given to C.
• Nonrecourse Liabilities Reg. §1.752-3: A partner's share of the nonrecourse liabilities of a partnership
equals the sum of:
• 1) Partner's share of partnership minimum gain.
• 2) Partner's share of gain under §704(c).
• 3) Partner's share of the excess nonrecourse liabilities determined in accordance with the
partner's share of the profits.
Allocations where Partners' Interest Vary Throughout Year
• Disposition of less than entire interest § 706(c)(2)(B): The taxable year of a partnership shall not close
with respect to a partner who sells or exchanges less than his entire interest in the partnership or whose
interest is reduced.
• Change in Interest § 706(d)(1): If during any taxable year there is a change in any partner's interest,
each partner's distributive share of any item of income, gain, loss, deduction, or credit shall be
determined by the use of any method prescribed by the secretary which takes into account the variation
of interests during the year. Two Available Methods:
• Proration: You can wait until the end of the year and prorate based on the interest during each
day.
• Interim: "Close the books" at each partnership ownership change and calculate the actual losses/
gains.
• Example: A, B, and C each own 1/3 of ABC Partnership. On October 31, C contributes
additional property and thus gets an increase in his partnership share so that A and B now each
own 25%, and C owns 50%. During this year, they have an operating loss of 24k.
• Proration Method: Using the proration method, 10/12 of the loss is allocated with the
first 1/3 each interest split and 2/12 of the loss is allocated with the 25/25/50 split. So,
20k is allocated 1/3 each and 4k is allocated 1k to A and B and 2k to C.
• Interim Method: Let's say the loss was entirely accrued during the middle of the year.
Using the interim method, the loss would be allocated 1/3 to each of the partners because
they would look at the losses at the time of the interest change to see how to allocate it.
6.66k loss to each partner.
• Proration Required for Certain Deductions...
Allocations in Family Partnerships § 704(e)
• Personal Service Income Allocation Prevention § 704(e)(2): In the case of any partnership interest
created by gift, the distributive share of the donee under the partnership agreement shall be includible in
his gross income, except to the extent that such share is determined without allowance of reasonable
compensation for services rendered to the partnership by the donor. This prevents a personal service
allocation.
• Income Splitting from Property §704(e)(1): A person is recognized as a partner for purposes of this
subtitle if he owns a capital interest in a partnership in which capital is a material income-producing
factor, whether or not such interest was derived by purchase or gift from any other person. So, the donee
must get a capital account - if you try to give the donee a greater share of income than their capital
account, this won't work.
Transactions Between Partner and Partnership § 707
702/731 707(a) 707(c)
Rent, salary, fee, interest always
Could be capital gain Always ordinary income
ordinary income
Income "passes through" when Cash-method partner not taxed Income "passes through" when
reported by partnership until receipt deducted by partnership
Partnership deducts unless capital Partnership deducts unless capital
Basis shifts per IRC §705
expenditure expenditure
One tax maximum Possibility of double taxation/basis Possibility of double tax/basis
• Transaction can be one of 3 things:
• § 702/731: partner's share of income.
• § 707(a): partner not acting in capacity as partner; or
• § 707(c): partner getting guaranteed payments.
• Importance: It matters when determining the type of income to the partner and whether it can be
deducted by the partnership.
• Partner not Acting in Capacity as Partner §707(a): If the partner engages in a transaction with a
partnership other than in his capacity as a partner, the transaction shall be considered as occurring
between the partnership and a stranger. Repercussions:
• Rent and salary paid - this is always ordinary income
• Income not taxed to cash-method service partner until paid
• Partnership will get to take a deduction under §162 (unless it's a capital expenditure)
• If it's a capital expenditure, the it will be double taxed - the partnership couldn't deduct
this and each partner would pay taxes on the full pass through income and the partner
who isn't acting in capacity as partner would receive further taxation on his income from
the transaction.
• What would make personal service income 707(a)?
• Not "basic duties" of partnership
• Little or no risk
• Short-lived allocation
• Payment close in time to services
• Tax-avoidance motive
• Special allocation large compared to regular allocation
• Reg. § 1.707-1(a) Examples:
• Loans of money or property by the partnership to the partner or by the partner to the
partnership
• The sale of property by the partner to the partnership
• The purchase of property by the partner from the partnership
• Rendering of services by the partnership to the partner or by the partner to the partnership
• Where a partner retains ownership of property but allows the partnership to use such
property for partnership purposes, i.e: to obtain credit or secure firm creditors by guaranty
pledge or other agreement
• The substance of the transaction governs rather than its form. However, the taxpayer will
be stuck with whatever form they pick.
• Pratt v. Commissioner: Two partners were paid management fees which were a percentage of
rentals. The issue was that the taxpayers were cash-method while the partnership was accrual.
This allowed the partners to defer tax payment. Held: they were performing the basic duties of a
partner and were therefore acting as a partner.
• Important Factor: whether they are performing the basic duties of a partner.
• Further, if you're doing something unusual, it's more likely to be considered a capital
expenditure which will be double taxed.
• Architect Partner - Problem 2 Example (Page 235):
• A commercial office building constructed by a partnership is projected to generate gross
income of at least 100k per year indefinitely.
• Architect, whose normal fee for architectural services is 40k contributes cash for a 25%
interest in the partnership and receives both:
• a 25% distributive share of net income for the life of the partnership and
• an allocation of 20k of partnership gross income for each of the first 2 years of the
partnership operations after the property is leased.
• The partnership expects to have sufficient cash available to distribute 20k to Architect in
the first 2 years and the agreement requires such a distribution.
• This is a § 707(a) transaction because:
• The 20k/year of gross income looks like a fee
• The allocation is only for 2 years.
• There is a tax motive/advantage to treat it as pass through income
• This is NOT a §707(c) guaranteed payment because this is based on gross income
rather than without regard to income.
• Legislative History Factors that Make a Transaction a §707(a):
• Not "basic duties" of partnership
• Little or no risk of not getting paid
• Short-lived allocation
• Payment close in time to service
• Tax-avoidance motive
• Special allocation large compare to regular allocation
• Guaranteed Payments §707(c): To the extent determined without regard to the income of the
partnership, payments to a partner for services or use of capital shall be considered as made to a stranger.
• Timing Purpose: If you have a guaranteed payment, it's treated just like a § 707(a) payment for
income vs. capital gain, but it doesn't change the timing. If you have a guaranteed payment,the
partner has to report it as income as soon as the partnership deducts it or adds it to the basis even
if the partner hasn't yet been paid.
• Example Problem 1 Page 246: AB equal partnership earns 12k ordinary income and 8k LTCG.
• (a) What if A is required to be paid 15k for services regardless of income. This will be
considered a §707(c) guaranteed payment. A will report 15k ordinary income and the
partnership will get this as a deduction. Thus, they will have an operating loss of 3k. This
1.5k loss passes through to each partner and a 4k LTCG passes through.
• (b) Same as (a), but A's services relate to improvements on land owned by the
partnership. This normally just goes into the basis of the property, so no deduction for the
partnership. So, partnership will still have 20k income and A will have 15k ordinary
income on top of this. The 15k of capital expenditure will go into the basis of the
property.
Sales/Exchanges of Property Between Partnership and Partner § 707(b) [Issue Spot This]
• A sale/exchange of property between a partnership and a partner can be treated as either a sale between
the parties, or a combination of a contribution and distribution.
• Determination of Exchange of Property § 707(a)(2)(B): this doesn't say much - it just indicates that
there is an issue. There are some regulations on this: Reg. §§ 1.707-3 through -8. It basically lays out a
smell test for whether it's a sale or a combination of a distribution and contribution. The regulations do
set up a 2 year presumption. If a contribution and distribution are within 2 years of each other, they are
rebuttably presumed to be related. But, outside of 2 years, you're fine. So, wait 2 years to be sure that it's
not a sale.
• Sale between Partners § 707(a)(2)(B): Also, if one partner contributes property and another
contributes money then the first takes out the money and the second takes out the property, this
will constructively be treated as a sale between the two partners.
• If it is considered a sale, §707(b) applies:
• Losses Disallowed §707(b)(1): No deduction is allowed from sale or exchange of property
between:
• (A) a partnership and a partner owning directly or indirectly more than 50 percent of the
capital interest or profits interest
• (B) two partnerships in which the same persons own directly or indirectly, more than 50
percent of the capital interests or profits interest.
• Gains Treated as Ordinary Income §707(b)(2): A sale or exchange of property, which in the
hands of the transferee is property other than a capital asset will have ordinary income gain if it
is between:
• (A) A partnership and person owning more than 50 percent of the interest in such
partnership.
• (B) two partnerships in which the same person owns more than 50 percent of the
interest.
Sale of a Partnership Interest
• Generally §741: Gain or loss shall be recognized to the transferor partner and will be considered a
capital gain or loss except as provided in § 751.
• Transfer of Liabilities §752: Don't forget that the basis in a partnership interest from partnership
liabilities transfers with this interest to the buyer's.
• "Hot Asset" Rules § 751: The amount of money or FMV of property received by a transferor partner in
exchange for his interest in the partnership will be ordinary income if attributable to:
• 1) unrealized receivables of the partnership, or
• Unrealized Receivables § 751(c): includes rights to payment for goods delivered ( or to
be delivered) to the extent therefrom would be treated as ordinary income, OR services
rendered or to be rendered.
• 2) inventory items of the partnership,
• Inventory Items § 751(d): includes:
• 1) property of the partnership described in § 1221
• 2) any other property which if sold would be considered an ordinary income
• 3) any other property held by the partnership which, if held by the selling partner
would be considered property which if sold would produce ordinary income.
• Problem 1 Page 271: A owns a 1/3 interest in ABC partnership which manufactures and sells
inventory. A, B, and C each made initial cash contributions of 75k. All income has been
distributed as earned. On Jan 1, A sells his interest in the partnership to D. The partnership has
the following Balance Sheet:
Assets Partner's Capital
Basis FMV Basis FMV
Cash 45k 45k A 75k 135k
Inventory 75k 90k B 75k 135k
Acc. Receivable 0 45k C 75k 135k
Capital Asset 105k 225k
TOTAL 225k 405k 225k 405k
• (a) What if A sells his interest to D for 135k? Normally, under § 741, A would simply
have a 60k gain. § 751 jumps in because we have hot assets here. The inventory and the
accounts receivable are both hot assets. Therefore, we make believe the partnership sold
all of the hot assets and determine how much ordinary gain A would receive. Here, the
partnership would have 60k ordinary income from such a sale and A would have 20k
ordinary income. Therefore, 20k of A's gain on his sale of the interest will be ordinary
income and the rest will be capital gain.
• (b) What if each partner originally contributed 150k and the capital asset has a basis of
330k and A sells his interest to D for 135k? Here, there would normally be a 15k capital
loss under §741. However, 751 steps in to make him realize his share of the hot asset
income (still 20k). Therefore, he will realize 20k ordinary income from the hot assets and
35k capital loss.
Basis FMV Basis FMV
Cash 45k 45k A 150k 135k
Inventory 75k 90k B 150k 135k
Acc. Receivable 0 45k C 150k 135k
Capital Asset 330k 225k
TOTAL 450k 405k 225k 405k
• (c) What if each partner originally contributed only 45k cash instead of 75k and the
capital asset was purchased subject to a 90k liability? A sells his interest to D for 105k.
This is the same as (a). A's amount realized is 135k (105k cash and 30k reduction of
liability). His basis is 75k, so his total gain is again 60k and the 751 computation will
result in the same 20k ordinary income from the hot assets and 40k capital gain.
• (d) What if A sells her interest one quarter of the way through the year when A's share of
the partnership income is 30k? D will pay A 165k and will acquire A's right to income.
Under §706, she does have to report income for the first 3 months of the year because the
partnership's taxable year closes as to them. So, here, A's basis would jump to 105k and
the FMV of the interest would be at 165k. Therefore, the gain will still be 60k and the
outcome will be the same as (a). 20k ordinary income and 40k capital gain.
• Inside/Outside Basis Mismatch for Buyer: When a partnership interest is sold, it results in the
partnership's outside basis being higher than the inside basis of the assets inside the partnership.
• Treatment without Election §743(a): The general rule is that the basis of the partnership
property shall not be adjusted as a result of an exchange of a partnership interest or on the death
of a partner UNLESS they make a § 754 election (or unless the partnership has a substantial
built-in loss immediately after such transfer).
• § 754 Election: If the partnership files an election, the basis of partnership property shall be
adjusted accordingly:
• Distribution of Property: Under § 734.
• Transfer of Partnership Interest: under §743.
• Time and Manner of Election Reg. § 1.754-1(b)
• Commitment of Election: You can't revoke a 754 election without permission from the
IRS.
• Treatment With Election § 743(b): In a transfer of an interest in a partnership by sale or
exchange or upon death of a partner, a partnership with the 754 election shall increase/decrease
the basis of the partnership property by the difference between the basis to the transferee partner
of his interest in the partnership and his proportionate share of the adjusted basis of the
partnership property. This boost in basis will increase with respect to the transferee partner
only.
• Forced because of Substantial Built-in Loss § 743(d): You can be forced to make the basis
adjustment if there is a substantial built-in loss in the partnership. A partnership has a substantial
built-in loss if the partnership's adjusted basis in the partnership property exceeds the FMV of
such property by 250k.
• Allocation of Basis When Basis is Shifted § 755: You apply it proportionately depending on the
appreciation of each asset. The main goal of §755(a) is to minimize disparities between basis and
FMV. You divide the assets into classes:
• 1) capital assets and § 1231 property (LTCG)
• 2) all other property (ordinary income)
• Then, allocate basis adjustments based on relative appreciation in each class.
• Problem 2 on 288 example.
Operating Distributions
• Partners Generally § 731(a):
• (1) No gain shall be recognized except to the extent that any money distributed exceeds the basis
of such partner's interest in the partnership.
• (2) No loss shall be recognized to such partner unless there is a liquidation of a partner's interest
and they receive no property other than money, unrealized receivables, and inventory. If there is
a liquidation of the partner's interest loss is recognized to the extent of the excess of their basis in
such interest over the sum of any money distributed, and the basis to the distributee of any
unrealized receivables, and inventory.
• Partnerships Generally §731(b): No gain or loss recognized on a distribution to a partner of property,
including money.
• Partner's Basis in Property Received in Non-liquidating Distributions §732(a):
• (1) Generally: The basis of property (other than money) distributed by a partnership to a partner
other than in liquidation of the partner's interest shall be its adjusted basis to the partnership.
• (2) Limitation: The basis to the distributee of property to which (1) applies cannot exceed the
adjusted basis of the partner's interest reduced by any money distributed in the same transaction.
• Example Problems Page 300: ABC Partnership distributes 10k cash and land worth 10k with basis of
5k. A has a basis of 20k, B has a basis of 10k, C has a basis of 5k.
• A will have no income here because his basis in his share is greater than the money and property
he received. From §732, we know the basis in the property he receives is going to be a carryover
basis. Also, from § 733, we know the basis in his partnership interest will be reduced by cash
received and the 5k basis in the land. So, he will have 5k remaining basis in the partnership. The
partnership will not be taxed under §731(b).
• B will not have any income here because the money distributed doesn't exceed the basis of her
interest in the partnership. However, because she doesn't have any remaining basis, B will not get
any carryover basis in the land. § 732(a)(2) applies; the basis of the property cannot exceed the
adjusted basis of the partner's interest in the partnership reduced by any money received in the
same transaction. So, § 732(a)(2) prevents any basis from carrying over in this case. B will
receive the property with 0 basis. Her basis in the partnership interest will also be 0.
• Note that this creates an inside/outside basis mismatch here.
• C will have 5k gain here under §731(a) because the money received exceeded the basis of his
partnership interest. He will also have a 0 basis in the property transferred and a 0 basis in his
partnership interest.
• If C took out the land first - this would suck up all of his basis. Then, if he took the
money out later, he would be hit with a 10k gain because he will have no basis. Though,
he would have 5k basis in the property distributed.
• Note: Every time that §732(a)(2) applies and every time a partner is taxed on a gain with a
distribution, the inside/outside basis will not match.
• Partner Draws Not Considered Distributions Reg. § 1.731-1(a)(1)(ii): Monthly draw are not
distributions covered by 731 - this is basically a loan from the partnership. The understanding is that at
the end of the year, the partnership will then make a distribution to the partner in that amount minus the
draw amounts.
• Mini 754 Election § 732(d) - (Good for Taxpayer) if you have a partner getting a distribution of
property (some kind of asset) and they had purchased their interest in the last 2 years, they can make
their own mini 754 election just for them. (a) would normally apply, but (d) allows them to make the
adjustment to said property regardless of whether the partnership makes the 754 election.
• Securities Treated Like Money §731(c) - (Bad for Taxpayer) If the partnership distributes marketable
securities, this should be treated like money. Under § 731(a), the only way you can get income is if you
have distribution greater than your basis. Congress is trying to recognize the fact that marketable
securities are essentially money. There are exceptions in §731(c)(3).
• §731(c)(3)(B) limits the amount recognized. Don't go here. No one knows what this exception is
for. This is an issue spotter.
• Taint of "inventory" property §735 - (Bad for Taxpayer) if you take an ordinary income type asset
out of the partnership, then it will produce ordinary income even if you sell it (and it wouldn't be
ordinary income to you). For example, let's say the partnership sells real estate, but you do not
personally (i.e. you're a dentist). It will still be ordinary income to you if the partnership distributes the
property to you. If the distributee holds on to the property for 5 years, the 'taint' goes away.
• Inside/Outside Basis Mismatch: When analyzing the balance sheet, you look at the FMV of these
assets rather than the book values. This requires an appraisal of all the assets of the partnership.
• Example Problems Page 309: The ABC partnership has three equal partners and the following
balance sheet. A receives CA #1 in an operating distribution. A has a one-ninth interest worth 20k
in the partnership capital and the profits after the distribution.
Basis FMV Basis FMV
Cash 60k 60k A 70k 80k
Capital Asset #1 90k 60k B 70k 80k
Capital Asset #2 40k 60k C 70k 80k
Capital Asset #3 20k 60k
TOTAL 210k 240k 210k 240k
• (a) Result to A and the Partnership if there is no §754 election? A would recognize no gain or
loss here because A is not receiving any money. What about A's basis in the property? Normally
the basis is carry over from the partnership, but A only has 70k outside basis. Therefore, A will
take a basis haircut here dropping the basis of the asset to 70k. Also, A's basis in his interest will
drop to 0. B and C would be unhappy here because that 20k basis that got burned belonged in
part to them. However, now the inside and outside basis no longer match. After the distribution,
this is what the balance sheet would look like:
Basis FMV Basis FMV
Cash 60k 60k A 0 20k
Capital Asset #2 40k 60k B 70k 80k
Capital Asset #3 20k 60k C 70k 80k
TOTAL 120k 180k 140k 180k
• (b) What result if §754 election had been made before this distribution? The results to A are the
same. Again, the partnership does not recognize its loss. However, the §754 election triggers an
upward adjustment of 20k, equal to the distributed property's downward change in basis. This is
allocated among the partnership assets by the §755 rules in proportion to the appreciation in the
remaining properties. CA 2 has an appreciation of 20k. CA 3 has an appreciation of 40k. So, CA
2 takes 2/6 of the appreciation and CA 3 takes 4/6 of the appreciation. This means 6,666
appreciation goes to CA 2 and 13,333 goes to CA 3 ending in the following balance sheet:
Basis FMV Basis FMV
Capital Asset #2 46,666 60k B 70k 80k
Capital Asset #3 33,333 60k C 70k 80k
TOTAL 120k 180k 140k 180k
Basis FMV Basis FMV
Capital Asset #2 46,666 60k B 70k 80k
Capital Asset #3 33,333 60k C 70k 80k
TOTAL 120k 180k 140k 180k
• Contributed Property § 704(c) Assets ("Mixing Bowl" Rules): Property contributed with a built in
gain is taxed to the contributing partner - you can't shift that built in gain to the other partners by
distributing that asset out to other partners.
• Distribution of Contributed Property § 704(c)(1)(B): If any property so contributed is
distributed by the partnership within 7 years of being contributed, the contributing partner shall
be treated as recognizing gain or loss from the sale of such property with FMV at time of
contribution.
• Problems Page 314.
• Partner Contributes Appreciated Assets and Receives Other Assets §737 [Issue Spotter]:
Here, 737 applies and the partner shall be treated as recognizing gain equal to the lesser of:
• The excess of FMV of property received over the basis of partner's interest in the
partnership immediately before the distribution reduced by the amount of money received
in the distribution; OR
• The net precontribution gain of the partner.
• Also, don't forget if you contributed property to a partnership and you take a distribution within 2
years, §707 can make this a sale.
• "Hot Assets" § 751(b): If the distribution has the effect of changing the partner's share of those assets,
the distributions will be treated as a taxable sale between the distributee and the partnership. You can't
have one partner take out hot assets and other partners take out only cool assets.
• Example Problems Page 324
Liquidating Distributions
There are two ways to leave - either sale of partnership interest or bought out by partnership:
• Sale of Partnership Interest: Sell their interest to a new person or remaining partners - this is covered
in Sale of a Partnership Interest above - 741 says this is a capital gain or loss unless there are hot assets.
• Bought Out by Partnership: Similar to an operating distribution, but:
• Basis Rules §732:
• (b) Distributions in Liquidation: The basis of property distributed by a partnership to a
partner in liquidation of partner's interest shall be equal to the outside basis of such
partner's interest reduced by any money distributed.
• (c) Allocation of Basis: Two tier approach:
• Hot Assets First: First, the basis first goes into any unrealized receivables and
inventory items up to the adjusted basis of each such property in the partnership.
• Then To Other Assets: Basis is added to the rest of the assets.
• Loss Recognition § 731(a): If you have leftover basis and all you get is cash, receivables, and
inventory, then you can take an immediate capital loss on your partnership interest. Otherwise,
the remaining basis is added to the other assets.
• Example Problems Page 334
• Potential Guaranteed Payment § 736:
• § 736(a): Distributive share or guaranteed payment (income)
• Applies if the partner gets more than their partnership share - this should not get
run through §731/2 - this is really the other partners paying this person as if he
was a stranger. This is good for the other partners because it's deductible.
• § 736(b): Distribution rules
• Says the distribution rules apply if the partner just gets their share.
• Payments for partnership property.
• What could trigger 736(a)?
• Severance pay
• Noncompetition payments
• Insurance-type payments to disabled partner
• Example Problem Page 347
Liquidation of Entire Partnership
• If the entire partnership is being liquidated, there's no need for §736 analysis. A partnership can be
liquidated in two ways:
• Partnership actually liquidates
• Constructive Liquidation § 708(b)(1)(B): If there is a sale or exchange of 50 percent or more of
the total interest in partnership capital and profits within a 1-year period.
• The regulations essentially say that a new partnership is formed.
• Bogdanski doesn't think this is necessary and is fairly meaningless because there's no
taxable events. The only thing he can think of is that it gets rid of a §754 election.
Death of a Partner
• When a partner dies, their tax year ends. Further, the partnership taxable year closes for that partner and
some income flows to that partner.
• There are three potential options:
• The Estate succeeds decedent as partner
• Partnership interest is sold as above in Sale of a Partnership Interest
• Partnership interest is liquidated as above in Liquidation of a Partnership Interest
• Issues:
• Proration of Income: The partnership year closes upon death of partner as to that partner, so
they can either close the books or pro-rate the years results.
• Outside Basis: The outside basis is stepped up (or down) under § 1014 except:
• No inside basis step-up unless a §754 election is in place.
• There is no step-up for income in respect of a decedent (§691)
• We don't step up basis to income earned by decedent before they died but hasn't
been reported yet. You can't use 1014 to cut off income earned by the decedent
before they died. When the estate collects it, the estate must pay tax on it.
• When grandma sold some property and it was in escrow when she died. The gain
on this sale will be IRD, so this will be capital gain to the estate.
• This rule applies to a partnership interest - when you die as a partner, any income
that the partnership has earned but not yet received: your portion of that income
will be subtracted out when the partnership interest transfers upon death.
• Example Problem 403: D is 1/3 general partner in the DEF partnership. D dies at a time when the
partnership has earned 15k for the current year and his share of the partnership income for the year is 5k.
Under all the sale agreements below, D is to be paid 30k for his interest which includes his share of
income. Immediately prior to his death, DEF’s balance sheet looks like the following:
Basis FMV Basis FMV
Cash 9k 9k D 3k 30k
Cash Not Yet
15k 15k E 3k 30k
Accounted For
Receivables for
0k 45k F 3k 30k
Services
Depreciable
0k 3k
1245 Property
Goodwill 0k 18k
TOTAL 24k 90k 9k 90k
• When D dies, his taxable year ends and the partnership’s taxable year ends as to D’s interest. 5k
of the 15k received this year will pass through to D. This increases D’s outside basis, but this
outside basis dies with D.
• The FMV of D’s interest is 30k, however we have IRD from the receivables. Therefore, the basis
of the partnership interest is reduced by 15k.
• Partner’s Buyout D’s Interest: Here, that 15k income attributable to the hot asset would be
recognized by the estate as ordinary income. No matter how you do it, the partner here (D’s
estate) will have 15k of income.
• Partnership (in which capital is a material income-producing factor) Liquidates D’s
Interest: If they take the receivable, then the hot asset rules will apply.
• See Problem Answer for more in-depth analysis.
- Comparison of Retirement Plans
Tax Year
2007 401(k) Roth 401(k) Traditional IRA Roth IRA
Contributed money is at first post tax money.
However, contributions are may be tax
Tax Implications deductible which reduce your tax basis for that
Money is deposited as "tax deferred" and then Income is post tax money and no taxes have to tax year. Then, distributions are taxed at the Income is post tax money and no taxes have to
taxed at normal income bracket for distributions be paid under qualified distributions normal income for distributions paid under qualified distributions
Based upon MAGI; Single: full contrib up to

Income Limits No income limits for contributions to Traditional $99k, partial contrib to $114k; Married: full
Generally none, but somewhat complicated due Generally none, but somewhat complicated due IRAs. However, if you make "too" much money, contrib up to $156k, partial contrib to $166k;
to HCE (highly compensated employees) rules to HCE (highly compensated employees) rules you can not deduct the contributions. can't contribute more than you make in that year
$15.5k/yr for under 50, $20.5k/yr for 50 and over $15.5k/yr for under 50, $20.5k/yr for 50 and over
Contribution in 2007; limits are a total of trad 401k and Roth in 2007; limits are a total of trad 401k and Roth
Limits 401k contributions. Employee and employer 401k contributions. Employee and employer $4k/yr for age 49 or below; $5k/yr for age 50 or $4k/yr for age 49 or below; $5k/yr for age 50 or
combined contributions must be lesser of 100% combined contributions must be lesser of 100% above in 2007; limits are total for trad IRA and above in 2007; limits are total for trad IRA and
of employee's salary or $45k. of employee's salary or $45k. Roth IRA contributions combined Roth IRA contributions combined
Employer or
Individual Employer sets up this plan Employer sets up this plan Individual sets up this plan Individual sets up this plan
Matching
Contributions Matching contributions available through
Matching contributions available from employers. employers, but they must sit in a pretax account No matching contributions available No matching contributions available
Distributions can begin at age 59 1/2 as long as

Distributions Distributions can begin at age 59 1/2 and the contributions are "seasoned" (been in the
Distributions can begin at age 59 1/2 or owner account has been open for at least 5 years; there Distributions can begin at age 59 1/2 or owner account for at least 5 years or owner becomes
becomes disabled are exceptions though becomes disabled disabled
Must start withdrawing funds at age 70 1/2 Must start withdrawing funds at age 70 1/2
Forced
unless employee is still employed and owns less unless employee is still employed and owns less Must start withdrawing funds at age 70 1/2
Distributions than 5% of the company. Penalty is 50% of than 5% of the company. Penalty is 50% of unless employee is still employed. Penalty is
minimum distribution. minimum distribution. 50% of minimum distribution. None.
Yes, while distributions of contributions come out

tax and penatly free, distributions will be subject
Contribution to taxes based upon the proportion of the
Withdrawal distribution considered as earnings on the
No, but loans from this plan are available contract, with penalties due on that amount as At any point, the owner may withdraw the total
depending upon employer's plan well. No contributed into the IRA
Early Early withdrawal that is more than contributions

Withdrawal plus seasoned conversions are subject to normal
10% penalty plus taxes including withdrawal for 10% penalty plus taxes for distributions before income taxes and 10% penalty if not qualified
hardships See Above age 59 1/2 with exceptions distributions
Conversions Can be converted to A Roth IRA. Taxes need to Cannot be converted to a trad 401k, but upon Can be converted to a Roth IRA. Taxes need to
be paid during the year of the conversion. Other termination of employment, can be rolled into be paid during the year of the conversion. Other
limiations though Roth IRA limitations though.
Funds can be either transferred to another Funds can be either transferred to another
Changing institution or they can be sent to the owner of the institution or they can be sent to the owner of the
Institutions Can roll over to another employer's 401k plan or trad IRA who has 60 days to put the money in Roth IRA who has 60 days to put the money in
to an (traditional?) IRA at an indepenent Can roll over to another employer's Roth 401k or another institution in a rollover contribution to another institution in a rollover contribution to
institution. to an Roth IRA at and independent institution. another traditional IRA another Roth IRA
Page 1 of 2
The 2019 chart: Retirement plan options

At-a-glance
Feature SEP SIMPLE IRA Money purchase Safe harbor 401(k) 401(k)
Any employer Employers who, on any day Any employer Any employer Any employer Any employer
employer during the preceding year,
have 100 or fewer employees
earning $5,000 or more in
compensation. No other plan
may be maintained at the
same time.
October 1 of current year Last day of employer’s Last day of employer’s New plans must be established Last day of employer’s
deadline, including taxable year taxable year three months prior to plan year- taxable year
extensions end. Existing plans must be
May be less restrictive, May be less restrictive but May be less restrictive, May be less restrictive, May be less restrictive, but cannot May be less restrictive,
employees but cannot exclude cannot exclude employees but cannot exclude but cannot exclude exclude employees who exceed: but cannot exclude
employees who exceed: who receive $5,000 in employees who exceed: employees who exceed: • Age 21 employees who exceed:
• Age 21 compensation in each • Age 21 • Age 21 • Completion of one year of service • Age 21
• Employed three of the year of any two preceding • Completion of one year • Completion of one year • Completion of one year
years (doesn’t have to of service (1,000 hours of service (1,000 hours sharing and match may be two of service (1,000 hours
be consecutive) and are in 12 months). May in 12 months). May years if 100% immediate vesting.
• $600 annual income
expected to receive $5,000 be two years if 100% be two years if 100% sharing and match may
Requires 100% in the current year.
participation of eligible immediate vesting. immediate vesting. be two years if 100%
employees. immediate vesting.
Employer’s discretion up Employer must make either: Mandatory employer Employer’s discretion up Employer must make dollar-for- Employer’s discretion up to
to 25% of employee’s dollar-for-dollar matching to 25% of eligible payroll. dollar matching contributions up to 25% of eligible payroll. Can
employer compensation with a contributions up to 3% of in plan document. Up to Maximum allocation per 3% of employee compensation and be made as a matching
maximum of $56,000 employee compensation, 25% of eligible payroll employee is $56,000 50 cents on the dollar for the next
for 2019. If contribution not to exceed $13,000 with a maximum of for 2019. 2% of employee compensation contribution, or both.
is made, requires 100% per employee for 2019, or $56,000 per employee or contribute 3% of total eligible
participation of eligible contribute 2% of total eligible for 2019. employee compensation.
employees. employee compensation, not
to exceed $5,600 for 2019. sharing contributions allowed. Total
employer contributions may not
exceed 25% of eligible payroll.
Page 2 of 2 , continued
Feature SEP SIMPLE IRA Money purchase Safe harbor 401(k) 401(k)
employer deadline, including deadline, including deadline, including deadline, including including extensions including extensions
extensions extensions extensions extensions
Employees can contribute Employees can defer up to N/A N/A Employees can defer up to $19,000 Employees can defer up to
a traditional IRA $13,000 per year (2019), per year (2019), or 100% of $19,000 per year (2019), or 100%
employee contribution of up to or 100% of compensation, compensation, whichever is less. of compensation, whichever is
$6,000 per year (2019), or whichever is less. Employees who are age 50 and older less. Employees who are age 50
$7,000 if age 50 or older, Employees who are age can defer an additional $6,000. and older can defer an additional
to their SEP account in 50 or older can defer an Employee and employer contributions $6,000. Employee and employer
addition to the employer’s additional $3,000. per employee cannot exceed $56,000, contributions per employee cannot
SEP contribution. or $62,000 if age 50 or older. exceed $56,000, or $62,000 if age
50 or older.
Deduction for employer. Employer contributions Deduction for Deduction for Employer contributions deductible Employer contributions deductible
and deferrals Tax-deferred for deductible to employer, employer. Tax- employer. Tax- to employer, tax-deferred for to employer, tax-deferred for
employee. tax-deferred for employee. deferred for deferred for employee. Employee contributions employee. Employee contributions
Employee contributions are employee. employee. are pre-tax and tax-deferred. are pre-tax and tax-deferred.
pre-tax and tax-deferred.
100% vested immediately 100% vested immediately Several permissible Several permissible 100% vested immediately on Several permissible vesting
vesting schedules vesting schedules Safe Harbor contributions, vesting schedules
schedule allowed on non-safe
Loan No No Yes Yes Yes Yes

1
Generally not subject to No testing Subject to top- Subject to top-heavy Plan will pass 401(k) ADP and Subject to ADP, ACP and top-heavy
top-heavy testing heavy testing testing ACP tests if Safe Harbor rules are testing
followed and will also meet top-
heavy test requirements
Same as IRA. 10% 10% premature 10% premature 10% premature 10% premature distribution 10% premature distribution
premature distribution distribution penalty distribution distribution penalties penalties may apply. Must begin penalties may apply. Must begin
penalty may apply. Must may apply; penalty is penalties may may apply. Must distributions at age 70½ unless still distributions at age 70½ unless still
begin distributions at increased to 25% during apply. Must begin begin distributions employed.2 In-service distributions employed.2 In-service distributions
age 70½. In-service distributions at at age 70½ unless available if plan document allows. available if plan document allows.
distributions allowed. distributions at age 70½. age 70½ unless still employed.2 In-
In-service distributions still employed.2 In- service distributions
allowed. service distributions available if plan
not allowed. document allows.
1. Loan Limits: Maximum of 50% of vested balance up to $50,000. Payments must be made at least quarterly with level amortization.
2. Owners of 5% or more of a company must start distributions at age 70½.
RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC. © 2018 All rights reserved. 20147 (12/18)
Partnership Tax Notes
Code pages 126-160
Regulations pages 480-735
• Chapter 1. Choice of Entity: What is a Partnership for Tax Purposes?

• Subchapter K of IRC: §§701-761
• Partnership acts as a conduit, through which its various items of income and loss flow to
the individual partners, who must annually report their shares of those items on their own
income tax returns
• Subchapter K provides rules governing:
• The character
• Timing
• Amount of income or loss allocated to each partner
• Tax consequences of moving property into and out of partnerships
• Characterization of transactions between partners and their partnerships
• Definition of Partnerships. What business ventures are governed by Subchapter K?
• §761: a syndicate, group, pool, joint venture, or other unincorporated organization
through, or by means of which any business, financial operation, or venture is carried on
and which is not within the meaning of this Title, a corporation or trust or estate
• + Check the box regulations
• All business entities with 2 or more members are taxed either as
partnerships or corporations
• Has a business entity been formed? If no, Subchapter K does not apply
• 1. Separate Entity
• Any entity recognized for federal tax purposes, i.e. entity separate from its
owners
• Much broader than partnership definition under UPA
• A joint venture or other contractual arrangement may create a separate
entity for federal tax purposes if the participants carry on a trade,
business, financial operation or venture and divide the profits therefrom
• E.g. lessor/lessee, employer/employee, lender/borrower
• But not necessarily
• When does a joint venture or other contractual arrangement create an
independent entity for tax purposes?
• Undertakings solely to share expenses do not create a separate
entity
• Two features which distinguish an entity from mere co-ownership are
• Business activity
• Sharing of profits
• Whether the activities of the members with respect to (e.g. cab) rose to the
level of the conduct of a business
• 2. Not a corporation
• Once characterized as an entity, the enterprise will be taxed as a
partnership unless it elects to be taxed as a corporation
• If co-owners are unaware that they have created a partnership, they
may inadvertently trigger adverse tax consequences
• §761 “election-out” procedure
• If an unincorporated organization is used for investment purposes, and not
for the active conduct of a business, and the income of the individual
members can be determined without the need to compute the
organization’s taxable income, then at the election of all members, the
organization will not be taxed under Subchapter K
• Choice of Form of Doing Business
• Traditionally the choice was simply between corporate form and the partnership form
(general/limited)
• Since 20 years ago, however, the limited liability company (LLC) has been gaining
popularity
• Share all the non-tax advantages of the corporate form, as well as taxed like
partnerships
• Non-tax considerations
• Owners’ desire to limit their personal liability for the business’ debts
• The ability to easily transfer ownership interests in the business
• The ability of the managers of the business to contract on behalf of the company
without consulting each and every owner
• *limited partnerships have some of these advantages, though not all
• There must be at least one general partner who is liable for the business’s
debt
• Although limited partners are not liable for the partnership’s debt, they
will lose this protection if they participate in management
• Tax considerations
• The existence of the double tax on corporate income is the primary tax
consideration that influences the choice of business entity
• Historically, dividends received by individual shareholders were treated as
ordinary income
• Since 2001, however, dividends received from domestic corporations are
treated as net capital gain and subject to a maximum tax rate of 15%
• Some corporations can avoid the corporate level tax and pass through SOME of
their losses to their shareholders by electing to be taxed under Subchapter S (S
Corporations)
• However, Subchapter S imposes substantial restrictions, making
Subchapter K more favorable
• Main advantage of an S Corporation over a partnership is the fact that a
shareholder of an S Corporation can be an employee, while a partner of a
partnership cannot
• Why historically the popularity of C Corporations over Partnerships
• Blatant non-tax advantages
• The rate of tax on corporate income was substantially lower than that of
individuals
• Second level of tax does not apply until earnings are distributed, earnings
could be accumulated at the corporate level at a lower tax cost than if they
were taxed directly to the owners
• But this is no longer true, i.e. corporate bracket is 35%
• Under the current brackets, very little reason to opt for C Corporation, unless the
start-up has intentions to go public
• Especially since most of the non-tax advantages are available in most
states in the form of LLCs
• LLC offers all of its members limited liability without restrictions on their participation
in the enterprise
• Ownership in the LLC can be freely transferable
• Electing Partnership Treatment: The ‘Check the Box” Regulations
• If publicly traded, the entity will be taxed as a C Corporation, even if it is a partnership or
LLC for local law purposes
• If the entity is organized as a corporation under local law, the entity will be taxed as a C
Corporation unless it is eligible (and elects) to be an S Corporation
• All other business entities with 2 or more members, including partnerships and LLCs,
will be taxed as partnership UNLESS the entity makes an affirmative election to be taxed
as a C Corporation
• Previously, the determination was made by comparing the number of corporate
characteristics of the entity to the number of non-corporate characteristics
• Aggregate versus Entity approaches
• Pure Aggregate conception
• Partners would be viewed as co-owners, each with an undivided interest in the
partnership’s assets and each partner would account separately for her share of all
partnership transactions
• Pure Entity conception
• The partnership would be treated as a separate and distinct taxpayer, adopting a
method of accounting and a taxable year and annually reporting its taxable
income
• The partners would each own an undivided interest in the partnership entity, and
would be viewed very much like shareholders in a corporation
• When Subchapter K was enacted in 1954 Congress adopted a hybrid approach
• For most purposes, a partnership is treated as an aggregate of its partners
• Not a taxpayer, and its partners report their shares of partnership
operations each year on their own tax returns
• Entity considerations
• A partnership must adopt a method of accounting, a taxable year and
report its taxable income each year on an information return
• Partnership has a basis in each of its assets, and the character of its income
is determined at the partnership level
• In computing income, partnership must make various elections, such as
how to depreciate its assets, or whether to use the installment method
• *These are necessary to avoid the administrative nightmare which would
ensue if each partner was required to track, monitor and report each of the
above
• Chapter 2. Partnership Formation: The Basics
• Congress’s purpose: provide flexible & simple rules for those choosing to do business in the
partnership form
• Ensure nonrecognition of gain or loss wherever feasible
• Formation of a partnership rarely results in recognition of gain or loss
• Matters concerning calculating each partner’s share of an item of income and deduction
are largely left to the agreement of the partners
• The role of the partnership entity for tax purposes: to serve as an accounting entity to
assist the partners (and the IRS) in calculating their shares of the venture’s income and
deductions
• Basic statutory scheme for the formation
• §721. Nonrecognition. Except in cases of certain investment partnerships, §721 protects
both the partnership and its partners from recognizing any gain or loss on the transfer of
property to a partnership in exchange for an interest in the partnership
• §722. Partners’ ‘Outside Basis’. Each contributing partner takes as her basis in the
partnership interest received, an amount equal to the sum of the adjusted basis she had in
any contributed property, plus any cash contributed
• In contrast to “inside basis” which is the partnership’s basis in the contributed
property
• Since the partner has merely changed the form of her investment in the
contributed property, they are permitted to “tack” the holding period she had in
that property to the holding period of her partnership interest
• §1223(1) Some items contributed to a partnership, such as money,
inventory and services, do not have holding periods, i.e. when a partner
receives her interest in the partnership in exchange for such items, their
holding period in the partnership interest received begins upon formation
of the partnership
• §723. Partnerships’ ‘Inside Basis’. Partnership takes a transferred basis in contributed
property equal to that of the contributing partner
• Partnership is entitled to tack the partners’ holding periods to its own
• Common issues on formation
• Property v. Services for §721 purposes
• Unclear what property is, but includes money, installment obligations, goodwill,
and accounts receivable of a cash method taxpayer
• If a person contributes services in exchange for a capital interest in a partnership,
such exchange is not protected by §721 and is a taxable event
• Litigation over the precise scope of ‘property’ and ‘services’
• Stafford v. United States (Fifth Circuit 1980)
• Taxpayer, a real estate developer, successfully negotiated a letter of intent
with an insurance company for the financing of a hotel
• Government argued that the exchange of that letter for a partnership
interest merely compensated the taxpayer for his services
• Taxpayer argued that the letter was property in its own right
• The Court stated that the letter was of value and constituted property for
purposes of §721(a)
• Contributions of Appreciated (or Depreciated) Property
• §704, generally, gives partnerships enormous flexibility in allocating their income,
loss and deductions such flexibility does not extend to pre-contribution gain or
loss
• The ‘built-in’ gain or loss must be taken into account by the contributing partner
• Take into account using any ‘reasonable method’
• E.g. ‘traditional method’: for allocating built-in gain or loss from
non-depreciable property defers recognition of the gain or loss
until the partnership ultimately recognizes it, and then allocates the
gain or loss to the contributing partner
• Example
• A contributes stock with $100 value and $60 basis to ABC
partnership
• ABC sells the stock for $130, resulting in $70 gain
• ABC must first allocate $40 of the gain to A
• ABC may then have the partners allocate the remaining $30 as
they like
• Contribution of Depreciable Property
• For the contributing partner
• Whether the contribution will trigger recapture of depreciation under
§1245 or §1250 in spite of the general nonrecognition rule of §721
• §§1245 and 1250 appear to trigger recognition of gain in what might
otherwise be expected to be a nonrecognition transaction, but contain
exceptions including transactions described in §721
• Contributing party is protected from the recognition of recapture
• Remains subject to recapture upon a later disposition by the
partnership
• For the partnership
• How should it calculate its cost recovery deductions with respect to the
contributed property
• Partnership steps into the shoes of the contributing partner
• Inherits adjusted basis in the property
• Inherits partner’s method of cost recovery
• Characterization of Gains and Losses from the Disposition of Contributed Property
• §702 treats a partnership as a distinct entity, separate and apart from its partners
• Out of concern with the possibility of converting ordinary income into capital
gains, §724 establishes 3 special characterization rules for gain or loss
• Unrealized receivables (§751c)
• Any gain or loss that is recognized by the partnership on the
disposition of that property is characterized as ordinary, no matter
how long it is held by the partnership
• Inventory items (§751d)
• Any gain or loss that is recognized by the partnership within 5
years of the contribution shall be characterized as ordinary
• Capital loss property
• If built-in loss, then, to the extent of the amount of that build-in
loss, any loss recognized on that property by the partnership within
5 years of the contribution shall be characterized as capital
• Liabilities (Chapter 8)
• Generally, when an individual borrows money to invest, even without personal liability,
she is given basis for the borrowed funds but does not recognize income
• Currently given basis credit for future outlays
• §752 provides rules for dividing partnership liabilities among the partners, and
each partner is treated as making a cash contribution to the partnership in an
amount equal to her share
• I.e. each partner is given credit in her outside basis for her share of
partnership liabilities
• §752(a) Each partner is treated as contributing cash to the partnership in an
amount equal to any partnership liabilities that she assumes, and any increase in
her share of partnership liabilities
• +§722 = increases the partner’s outside basis by the amount of such
increase
• §752(b) A partner is treat as having received a distribution of cash from the
partnership in an amount equal to the amount of any of her individual liabilities
that are assumed by the partnership, and any decrease in her share of partnership
liabilities
• +§733 = reducing the partner’s outside basis (but not below zero) by the
amount of the distribution
• Recourse liabilities are allocated to those partners who bear the economic risk of
loss associated with those liabilities
• Determining who bears the risk of loss: who would have the ultimate
responsibility for the liability if all assets of the partnership became
worthless and the liability became due
• Nonrecourse liabilities allocated among the partners in the same way the partners
share profits
• Makes sense because payments on the liability will come from profits
from the venture
• Contribution of encumbered property
• When a partner contributes encumbered property to a partnership, the partnership
replaces the partner as obligor on the loan
• Contributor is simultaneously relieved of her personal liability on the loan,
and as a partner becomes responsible for a share of the partnership’s
responsibilities
• Only the net change is taken into account
• When there is a net increase in a partner’s share of partnership liabilities,
she is treated as having made a cash contribution in that amount
• When there is a net decrease in her share of partnership liabilities, she is
treated as having received a cash distribution
• If the contributing partner’s net decrease in liabilities is greater
than her total basis in all the assets she contributes, the contribution
will result in gain!
• 2 important implications
• A partner’s outside basis reflects her share of partnership liabilities
• Under some circumstances, the “deemed” cash distribution which occurs
on the distribution of encumbered property may result in recognition of
gain
• I.e. outside basis will not go below $0
• Contributions of accounts receivable and payable (by a cash method taxpayer)
• Concern of the assignment of income: income inherent in the accounts receivable
must be taxed to the contributing partner
• Treating the accounts receivable as property for purposes of §721
• Assigning partnership a transferred (typically zero) basis in the receivables
under §723
• Characterizing the income realized by the partnership upon collection of
the receivables as ordinary under S724
• Allocating the income to the contributing partner under §704(c)
• Organization and syndication expenses; under §709 neither are deductible
• §709(b)(2) defines organizational expenses as expenditures which
• Are incident to the creation of the partnership
• Are chargeable to capital account; and
• Are of a character which, if expended in the creation of the partnership having an
ascertainable life, would have been amortized over such life
• E.g. legal and accounting fees incident to the creation of the partnership as well as
various filing fees
• Syndication expenses: those incurred in connection with selling the partnership interests
• Issuing and marketing of the partnership interests (legal, accounting, brokerage
fees)
• Not deductible
• Since both types of expenses are incurred in connection with creation of the
partnership entity, they are properly chargeable to capital
• Some relief from Congress
• §195 for business start-up expenses
• §248 for corporation organization expenses
• §709(b) a partnership may elect to currently deduct the lesser of:
• The amount of organization expenses (not syndication expenses);
OR
• $5,000 reduced by the amount by which its organization expenses
exceed $50k
• Those not deducted may be amortized over 180 months
• Syndication expenses continue to be nondeductible,
nonamortizable capital expenditures
• Chapter 3. Partnership Operations: The Basics
• Introduction
• The rules are designed to ensure that the tax consequences track the economics of
whatever deal the partners strike
• Partnership is not a taxpayer, but a partnership is treated as an entity whenever
doing so facilitates computation of the partners’ shares of income and deduction
• Otherwise it would be unduly cumbersome to require each of the partners to keep
their own set of books for the enterprise’s activities
• Partnership must adopt a taxable year, choose a method of accounting, and make certain
elections just as if it were a taxpayer
• Also required to compute its taxable income (as defined in §703a) and to file an
informational return (Form 1065), that informs the IRS and the partners about the entity’s
operations
• Partnership taxable years
• §706(a) a partner must include her distributive share of partnership income ‘for any
taxable year of the partnership ending within or with the taxable year of the partner’
• Key date is the last day of the partnership’s taxable year: on that date each partner
is treated as receiving and paying (cash method partners) or accruing (accrual
method partners) their distributive share of the partnership’s income and
deductions for the partnership’s taxable year which has just ended
• Prior to 1986: The number of months of deferral for a particular partner with respect to
partnership income is always equal to the number of months from the beginning of the
partnership’s taxable year until the end of the partner’s taxable year
• Congress amended §706(b) in reaction to the widespread use of the deferral
technique
• Amendments limit a partnership’s choice of taxable year
• Must show “valid business purpose” for choosing a particular taxable
year
• 25% test: 25% or more of the partnerships gross receipts for the
selected year earned in the last 2 months
• Facts & Circumstances test
• Insufficient
• Use of a particular year for regulation or accounting
purposes
• Seasonal hiring patterns of a business
• Administrative convenience is not sufficient
• Nor is the desire to maximize deferral
• However, a taxable year that conforms to the partnership’s
‘natural business year’ will qualify
• If no business purpose, a partnership MUST adopt its ‘required taxable
year’ in accordance with §706(b)(1)(B) unless it make an election under
§444
• MECHANICAL RULES. See pages 23-25
• First tier: if one or more partners with the same taxable
year own in the aggregate more than a 50% interest in
profits and capital
• Second tier: if all of the principal partners (5%+ ownership)
have the same taxable year, then the partnership must adopt
that taxable year
• Third tier: ‘least aggregate deferral’
• If the partnership regularly changes its composition,
then partnership must ‘test’ the validity of its
taxable year on the first day of each year, and if the
test shows the taxable year to be invalid then it must
be changed
• §444 ELECTION. Even in the absence of a valid business purpose,
for $, a partnership may elect to adopt a taxable year other than its
required taxable year as long as the year chosen does not result in
more than 3 months of deferral
• Method of Accounting
• The choice is limited by the identity of its partners
• Under §448, C Corporations are generally prohibited from using the cash method of
accounting partnerships with C corporations as partners are similarly prohibited
• Prohibition does not apply to partnerships for any year unless average annual
gross receipts of the partnership for the prior 3 years exceeds $5 million
• If a partnership comes within the definition of a ‘tax shelter’ in §461(i)(3), it must use the
accrual method regardless of its size
• The Computation of a Partnership’s Taxable Income
• Don’t forget limitations on Partnership losses §704(d) basis limitation
• In general
• §701: a partnership as such shall not be subject to the income tax imposed by this
chapter. Persons carrying on business as partners shall be liable for income tax
only in their separate or individual capacities
• §702 requires each partner to account separately for their share of (i) various
items, such as capital gains and losses; and (ii) bottom line income or loss,
computed without regard to the separately listed items
• §703(a) taxable income determined the same way as the taxable income of an
individual with certain modifications
• Items described in §702(a) are separately stated
• Two types of deductions which individuals are permitted are denied
• Deductions considered inappropriate for partnerships, such as the
deduction for personal exemptions and the additional itemized
deductions
• Deductions the benefits of which are (or have been) directly passed
through to the partners in their individual capacities
• E.g. foreign taxes and charitable contributions, because
they must be separately stated under §702(a)
• Net operating losses, because such losses will have already
been taken into account by the partners in the year that the
losses were incurred
• Depletion of oil and gas wells
• §706(a)(1)-(6). Separately stated items
• There are some items that will affect all partners the same way, without regard to
their tax profiles, and which can safely be included in the bottom line income or
loss
• Short and long term capital gains and losses
• Gains and losses from §1231 property (each partner must throw into their
individual hotchpot)
• Charitable contributions (each partner will combine with their other contributions
before applying the relevant limitations of §170)
• Dividends eligible for the dividends received deduction (available only to
corporate partners)
• Dividends that constitute net capital gain under §1(h)(11) (available only to
Noncorporate partners)
• Foreign taxes paid (each partner will separately elect to deduct or take a credit
under the rules of §901)
• ***the list is not exhaustive Treasury expanded on the list through §1.702-1(a)(8)
(i)-(ii)
• Each partner must also take into account separately his distributive share
of ANY partnership item which if separately taken into account by any
partner would result in an income tax liability for that partner different
from that which would result if that partner did not take the item into
account separately
• Partnership elections
• Sometimes necessary for administrative and accounting reasons to treat the
partnership as an entity, even though the income is ultimately taxed under the
aggregate theory to each individual partner, e.g. partnership elections
• §703(b) favors elections at the entity level, with only three exceptions, §108(b)
(5), 617, 901
• Adjustments to the Partners’ Outside Basis
• Outside basis = Partner’s contributions to the partnership (§722) – distributions from the
partnership (§733) additional adjustments to account for the operations of the partnership
• §705(a)(1) increase a partner’s outside basis by the sum of the partner’s
distributive share of
• (i) taxable income, and
• Necessary to avoid a partner paying twice on income
• (ii) tax exempt income
• Necessary in order to allow the partners the full benefit of the tax
exemption
• §705(a)(2) decrease a partner’s outside basis by distributive share of
• (i) partnership losses, and
• Necessary to prevent partners from benefiting twice from the same
loss
• (ii) §705(a)(2)(B) expenditures
• Necessary to ensure that a non-deductible item is not eventually
given the effect of a deduction on a later sale
• ***Decrease also by distribution
• Chapter 4. Financial Accounting and Maintenance of Capital Accounts
• Introduction
• A partnership’s financial accounts are commonly referred to as its ‘books’
• Treasury promulgated its own rules for maintaining capital accounts under §1.704-1(b)(2)
(iv)
• Special allocations under §704(b)
• Allocation of liabilities under §752
• Allocations of pre-contribution gain or loss under §704(c)
• The purpose of financial accounting is to reflect the economic well-being of a firm and
the relationship among its partners, and it is quite independent of determining tax liability
of the partners
• Tax law uses the financial accounts of a partnership as a surrogate for economic
reality
• Capital accounting rules are not governed by generally accepted accounting principles
(GAAP), but by tax accounting principles
• Essential elements of financial accounts
• In assessing a firm’s economic well-being = firm’s income statement + its balance sheet
• Firm’s income statement: summarizes the economic activity over various periods
of time, specifying the amount and nature of the firm’s revenue and its expenses
• Balance sheet: snapshot of the firm’s financial situation at a particular point in
time
• Assets = Liabilities + Equity
• Assets (‘book values’)
• Values used for assets are generally historical cost, adjusted for
depreciation
• Not necessarily the same as fair market value
• Equity (‘capital accounts’)
• Each partner has a separate capital account, the balance of which
represents her equity in the partnership
• The amount they would receive on liquidation if the
partnership sold all of its assets for their book value, paid
off its creditors, and distributed the net proceeds to the
partners
• Capital accounts are adjusted periodically to reflect any
contributions to, or distribution from, the partnership’s assets that
may have occurred, as well as any increase in partnership assets
caused by income or any decrease in assets caused by losses
• (Book Accounts) Basic Capital Accounting Rules (see page 504 in Regs.)
• Basic capital accounting rules are found in §1.704-(1)(b)(2)(iv)(b)
• Contributions. §1.704-(1)(b)(2)(iv)(d)
• A partner’s capital account is increased by the amount of money plus the fair
market value of any property (net of liabilities) contributed by that partners
• Contributing partner’s tax basis in the property is not relevant for this purpose
• Since liabilities are separately stated on the balance sheet, the adjustment to the
capital account is net of any liabilities on the property
• Operations
• A partner’s capital account is increased by their share of the partnership’s income
for the year, and is decreased by their share of the partnership’s losses for the year
• Tax character of the income or loss does not matter
• Tax exempt income is treated the same as ordinary
• Capital losses and passive activity losses are treated the same as ordinary
business loss
• If the book value of partnership assets increases or decreases for any reason other
than increased or decreased liabilities, a corresponding increase or decrease in
capital MUST occur
• Distributions. §1.704-(1)(b)(2)(iv)(e). Mirror-image of contributions!
• A partner’s capital account is decreased by the amount of money plus the fair
market value of any property (net of liabilities) distributed to that partner
• Based on VALUE, not tax basis, and the adjustment is made net of liabilities
• Any inherent gain or loss in the property distributed, even though not recognized
for tax purposes, must be taken into account for book purposes
• See example bottom of 35
• Liabilities. §1.704-(1)(b)(2)(iv)(c)
• Separately stated and NOT reflected in capital accounts, i.e. no adjustments are
made to capital accounts when a partnership borrows or repays a loan, and the
adjustments to capital accounts for contributed and distributed property are made
net of liabilities
• ***Outside basis does reflect each partner’s share of partnership liabilities
• See examples page 36-38
• Introduction to Tax Capital Accounts
• Tax capital = previously taxed capital
• The above capital accounts do not provide any information regarding the partners’ shares
of tax attributes of the partnership, specifically inside basis
• Generally, partners’ shares of inside basis will be consistent with their shares of
book capital, but
• Property is contributed to a partnership and is reflected on the
partnership’s books at a value that differs from its basis
• Partnership revalues its assets from historical cost to current fair market
value
• Contributions
• In the absence of liabilities
• Total balance in the partners’ tax capital accounts equals the partnership’s
inside basis
• Each partner’s tax capital account equals her outside basis
• Liabilities complicates this
• Reflected in the partnership’s inside basis and partners’ outside bases
• Not reflected in the partners’ tax capital accounts
• Necessary to reflect the different capital accounts of a partner (tax and book)
because once the contributed property is sold for fair market value by the
partnership, the partner will need to be credited for the increase in inside basis
• We maintain tax capital accounts because tax/book disparities highlight and help
keep track of §704(c) allocation problems
• Revaluations. §1.704-(1)(b)(2)(iv)(f)
• Circumstances when a partnership may revalue its existing assets, i.e. book-up (or
down) the assets to their current fair market value
• Generally limited to those transactions in which the partners have
significant non-tax reasons for determining the values of their assets, and
the partners have adverse interests
• If a partnership revalues its assets, the partnership recognizes for book, but not
tax, purposes any inherent gain or loss in its assets
• We maintain tax capital accounts because tax/book disparities highlight and help
keep track of §704(c) and “reverse §704(c)” allocation problems
• Chapter 5. Partnership Allocations: Substantial Economic Effect
• Background
• http://itech.fgcu.edu/faculty/sthompso/pship/outline/Lect4c.htm
• How the partnership’s income and loss will be divided among the various partners
• §704(a): a partnership’s distributive share of income, gain, loss, deduction or
credit, shall, except as otherwise provided in this chapter, be determined by the
partnership agreement
• But Subchapter K was not intended to permit taxpayers to circumvent general
principles prohibiting tax avoidance and assignment of income and losses
§704(b) will override 704(a)
• Substantial Economic Effect (SEE)
• Originally (1954) 704(b) provided that the partners’ agreement as to allocation of
these items was to be respected for tax purposes, unless the ‘principal purpose’ of
an allocation was tax avoidance or evasion
• Whether the allocation may actually affect the dollar amount of the
partners’ shares of the total partnership income or loss independently of
tax consequences
• Balance in each partner’s capital account is the amount that she would be entitled
to if the partnership were to sell all of its assets for their book value, pay off all its
liabilities and liquidate
• Courts found it useful to analyze capital accounts of a partnership to
determine if a particular allocation was meaningful apart from its
consequences
• If allocations were not reflected in the capital accounts, they lacked
independent significance and hence could not have substantial economic
effect
• Significance of Capital Accounts: The Orrisch Case (1970) Respect for Capital
Accounts!!!
• In this case, the partnership agreement was amended to allocate all of the
depreciation on two buildings to Orrisch.
• The agreement provided that gain on the sale of partnership property
would be charged to Orrisch’s capital account to the extent of the
depreciation allocations, and the remainder shared according to
partnership interests.
• Although the capital accounts were to reflect a chargeback in the event of a gain,
the allocation lacked substantial economic effect because the adjusted capital
accounts were not to provide the basis for liquidating distributions.
• Additionally, Orrisch was not required to make up his capital account in the event
that the property was sold at a gain less than the allocated depreciation.
• Codification of Substantial Economic Effect
• In 1976, §704(b) amended by codifying the phrase “substantial economic effect”
• A special allocation cannot be respected unless it has substantial economic
effect
• Despite the language of the original regulations treating SEE as one of
several factors to consider, there is now no other alternative
• In 1985, Treasury promulgated new regulations under §704(b)
• Extremely detailed and require an analysis much more complicated than
under earlier law
• Except for the portion dealing with nonrecourse debt, the regulations have
precisely the same underlying rationale: a special allocation will be
respected for tax purposes as long as it reflects the economics of the
partners’ deal
• If merely a device to reduce the aggregate taxes of the partners, the
allocation will not be respected and the item will be reallocated in
a manner that does reflect the true economics of the partners’ deal
• §704(b) regulations
• Structure
• Not the only provision governing allocation, but governs the vast majority of
allocations
• §704(c) governs the allocation of gain or loss inherent in contributed
property
• Additionally, §704(e) and §706(c) may play a role
• §704(b) comprised of 4 parts
• Part 1. §1.704-1(b)(2) defines SEE and establishes the safe harbor
• If an allocation has SEE it will be respected
• If it does not, the item will be reallocated in accordance with the
partners’ economic interests, i.e. in accordance with each
“partner’s interest in the partnership”
• Part 2. §1.704-1(b)(3)(e) describes what is meant by “partners’ interests in
the partnership”
• Establishes default rules for allocations which fail to meet the safe
harbor
• Part 3. Contains special rules to deal with specific situations where the
concept of SEE is inapplicable
• Nonrecourse liabilities [1.704-2]
• Revaluations of partnership assets in connection with certain
partnership transactions [§1.704-1(b)(4)]
• Part 4. Consists of very useful examples illustrating the application of the
rules set forth in the first three parts
• Pages 512-528
• 3 different ways in which a particular allocation can be sustained
• 1. If the allocation satisfies the definition of SEE
• Partnership assured that its allocations will be respected
• 2. If it is in accordance with the partners’ interests in the partnership
• 3. Allocations governed by special rules (revaluations and nonrecourse
deductions) cannot have SEE, yet will be ‘deemed’ to be in accordance
with the partners’ interests in the partnership
• Substantial Economic Effect
• In general
• Unlike before, a finding now that an allocation lacks SEE under the
current regulations means only that the partnership is outside the safe
harbor
• Then the allocation must be tested to see if it is consistent with the
partners’ interests in the partnership
• If it is not, then it will be reallocated in accordance with those interests
• §1.704-1(b)(2)(ii) Economic effect (pages 497-501)
• Allocation must be consistent with underlying economic arrangement of
partners
• Generally, an allocation will have economic effect if the partnership keeps
meaningful capital accounts and maintains them in accordance with a
strict set of rule
• §1.704-1(b)(2)(ii)(b) Basic test for economic effect
• An allocation will have economic effect only if the partnership
agreement meets the following 3 requirements
• 1. Capital Account Requirement. Partnership must maintain
its capital accounts in accordance with the rules found in
§1.704-1(b)(2)(iv)
• 2. Liquidation Requirement. Upon liquidation, liquidating
distributions must be made in accordance with the positive
balances in the partners’ capital accounts
• This is where Orrisch failed they had no plan to
liquidate in accordance with the capital accounts
• 3. Deficit Makeup Requirement. If after liquidation any
partner has a deficit in her capital account, she must be
unconditionally obligated to restore that deficit.
• Can be satisfied by a clause in the partnership
agreement or an unconditional obligation imposed
under state or local law
• Cannot be a limited deficit reduction obligation!!!
• Simply look to the partnership agreement for specific language,
absence of which will render the test not met
• Examples on pages 53-54
• Also see “Additional Problem”
• §1.704-1(b)(2)(ii)(d) Alternate test for economic effect
• Principal reason that most limited partnerships are formed is to
limit the financial exposure of its limited partners
• An unlimited deficit makeup obligation is antithetical to
that goal
• Allocations made to limited partners would never have
economic effect under the Basic Test
• The Basic Test works for general partners in a partnership,
but not for limited partners. Limited partners, by the nature
of having limited liability, do not have to pay back deficits
• An allocation is considered to have economic effect as long as
• 1. Partnership agreement satisfies first two requirements of
the Basic Test (capital account and liquidation requirements
of the Basic Test)
• 2. The agreement contains a “qualified income offset”
provision, and
• Protects the integrity of the prior allocations and the
partnership’s capital accounts by requiring the
partnership to eliminate such an unexpected deficit
as quickly as possible through income allocations
• Partners who unexpectedly receive an adjustment,
allocation, or distribution that brings their capital
account balance negative, will be allocated all
income and gain in an amount sufficient to
eliminate the deficit balance as quickly as possible
• 3. The allocation does not create (or increase) a deficit in a
partner’s capital account in excess of the partner’s
obligation to restore a deficit, as adjusted
• Have to look at every allocation on an annual basis
• Adjustments serve the purpose of taking into
account events that are reasonably expected to
reduce a partner’s capital account
• Required adjustments
• ***Any future distributions that are
reasonably expected to be made to that
partner in excess of any reasonably expected
offsetting allocations (i.e. income)
• Depletion (beyond scope of class)
• Other mandatory allocations
• Used in conjunction with limited deficit restoration
obligations
• Can be deemed
• Revenue Ruling 97-38
• Make sure that a partner’s capital account has
enough to incur expected downward adjustments
• Examples pages 54-59
• §1.704-1(b)(2)(ii)(i) Economic Effect Equivalence Test
• Designed for a general partnership that not technically comply
with the requirements of the Basic Test, but whose practices would
produce the same economic results to the partners that would have
been generated if they had complied with all of the requirements of
the Basic Test
• Careless oversight in partnership agreement drafting
• A partnership that meets this test would be unlikely to need to rely
on the safe harbor, as almost by definition the allocations would be
consistent with the partners’ interests in the partnership
• §1.704-1(b)(2)(iii) Substantiality (pages 501-504)
• Proper analysis
• Q1. Is either Partner’s capital account significantly different under
special allocation?
• Q2. Does allocation enhance after-tax consequences?
• Generally
• Rationale to identify those allocations that have little significance
except to reduce the government’s share of the partnership
operations
• The idea here is that the IRS is looking for partnerships
whose sole goal is to improve the tax situation of the
partners. This is effectively the definition of a tax shelter
• Pre-tax element: there must be a reasonable possibility that the
allocation will affect substantially the dollar amounts received by
partners independent of tax considerations
• Post-tax element: of the after-tax effect of an allocation is to
enhance the economic consequences of one or more partners
without adversely affecting any other partner, the allocation will
not be substantial
• If found not substantial, the income must be reallocated in
accordance with the partners’ interests in the partnership
• Highly subjective but guidance through provision of two common
situations where the special allocation will have a negligible effect on the
net adjustments to the partners’ capital accounts, while significantly
reducing taxes
• Shifting tax consequences (allocations that occur within a single
taxable year)
• Not substantial if, at the time the allocation(s) becomes part
of the partnership agreement, there is a strong likelihood*
that
• The net effect on the capital accounts of the partners
will not be significantly different from what it
would be in the absence of the allocations, AND
• The total tax liability of all of the partners (taking
into account their individual circumstances) will be
less than it would be in the absence of the allocation
• E.g. A+B form AB (50/50), A is in the 0% tax bracket – B
is in the 35% bracket.
• Partnership agreement satisfies the Basic Test
• B is allocated all of Partnership tax-exempt income
up to 50% share of overall income
• Year 1: Partnership has $1000 of income, $600 tax-
exempt, and $400 taxable
• B is allocated $500 tax-exempt income
• A is allocated $100 tax-exempt and $400
taxable
• Both pay $0, despite the fact that the capital
accounts are the same
• *In the absence of special allocation, B
would have $300 tax-exempt and $200
taxable income on which they would pay tax
(A wouldn’t pay tax in either case)
• *Hindsight presumption rebuttable
• Strong likelihood is presumed, can be rebutted
• E.g. new product that you honestly did not
know the accuracy of the income stream
• Transitory allocations (allocations that occur over two or more
taxable years)
• Transitory allocation occurs when a partnership makes an
“original allocation” in one year, and then cancels out the
economic effects of that allocation in a later year when the
partnership makes an “offsetting allocation”
• Not substantial if, at the time the allocations become part of
the partnership agreement, there is a strong likelihood that:
• The net effect of the original and offsetting
allocations on the partners’ capital accounts will not
differ substantially from what it would have been in
the absence of these allocations, AND
• The total tax liability of the partners will be reduced
from what it would otherwise be, THEN
• The allocations will not be substantial and the items
will have to be reallocated in accordance with the
partners’ interests in the partnership
• Two extremely important (rebuttable) presumptions
• Five-year rule
• Value-equals-basis rule
• Hindsight presumption rebuttable
• After-tax exception
• Generally this rule is an exception that results in a finding that the
allocation is not substantial, even if it met one of the pre-tax tests
• Test Economic effect of an allocation is not substantial if, at the
time the allocation becomes part of the partnership agreement
• The allocation may enhance the after-tax economic
consequences of one partner, in present value terms, AND
• There is a strong likelihood that the after-tax economic
consequences of no partner will be diminished
• *Exception focuses on the after-tax consequences to the partners,
not the pre-tax effects on capital accounts
• **In contrast with the transitory allocation rule, the exception tells
us to take present values into account
• Presumptions
• Presumption #1 Value-equals-basis (not trumped by the hindsight
presumption)
• Partnership’s assets are irrebutably presumed to have a
value equal to their (adjusted) basis
• Don’t care about what the property is actually worth
• E.g. AB partnership have a 50/50 interest in a partnership
with a single asset – a depreciable apartment building
($1M), which will likely increase in value. A is in the 35%
bracket and D is in the 0% bracket. All items are shared
equally, but A is allocated all depreciation. A is then subject
to a gain-chargeback provision
• Assume they plan to sell this building in four years
• As a result of the gain-chargeback provision there is
no change in the capital accounts or tax
• But according to value-equals-basis after-tax
• Presumption #2 Five-year rule
• There is a presumption that the economic effect of an
allocation is not transitory IF at the time the original and
offsetting
• Presume that there is a sufficient economic risk that the
transaction will never be equalized
• Applicability Value-equals-basis 5-year
• Shifting tax Yes N/A
• Transitory Yes Yes
• After-tax Yes Unclear (page 69
footnote 41)
• Taking a step back (page 70)
• Literal interpretation of substantiality test would invalidate many
allocations that appropriately are respected
• SEE regulations are so complicated and detailed, that it is easy to
focus exclusively on the rules and lose sight of their purpose
• Regulations were not intended to prevent taxpayers from forming a
partnership and allocating income and deductions in any way they deem
appropriate so long as the allocations are not simply a tax play
• Treasury was concerned with allocations made by a partnership with a
stable, predictable income stream that presents little risk of not playing out
as expected, solely to save taxes (e.g., rental payments from a long-term
lease)
• Allocations that are commercially motivated (not tax motivated)
should be respected
• §1.704-1(b)(3) Reallocation based upon the Partners’ Interests in the Partnership
(PIP)
• Reallocation needed when the allocation lacks substantial economic effect
• Generally, the item will be allocated to those partners who are actually
bearing the economic burden, or enjoying the economic benefit, of that
item, taking into account all relevant facts and circumstances
• Factors to be considered §1.704-1(b)(3)(ii)
• Relative contributions;
• Interests in economic profits and losses (if different from taxable income
and loss);
• Interests in cash flow and other non-liquidating distributions; and
• Right to distribution on liquidation
• Certain Determinations. Applies for allocations that fail to meet economic effect
because they lack the 3rd requirement of the Basic Test the deficit make up
requirement
• Compare the amount that each partner would receive if the partnership
were liquidated at the end of the current year with what each would have
received if the partnership were liquidated on the last day of the prior year
• However, this only applies if the allocations are “substantial”
• Works the same as SEE but happens to not meet safe harbor, i.e. even
though you failed SEE we are not going to make you reallocate everything
• See Slide “Example – Baseline Comparison”
• Will respected pre-tax impact (capital accounts) but will adjust
• Drafting Allocation Provisions: A Real World Perspective
• Frustration with the complexity of drafting partnership agreements that satisfy the
requirements of the regulations has led many practitioners over the last decade to
look for alternative ways to draft allocation provisions that focus more on the
economics of the deal and less on tax items
• Targeted allocations
• In contrast with traditional tax allocation provisions, targeted allocations
focus on those provisions in the partnership agreement dealing with cash
flows (i.e. contributions and distributions), and simply state that the
taxable income and loss of the partnership will be allocated among the
partners as necessary to conform their capital accounts to the amounts that
they would be entitled to receive if the partnership liquidated at year end
• Although likely that such allocations do not come within the safe harbor, it
is likely that they would be respected as consistent with Partners’ Interests
in the Partnership (PIP)
• Limitation – Family Partnerships – Avoiding Assignment of Income Consequences
• Even though a partnership complies with all of the requirements of §704(b), its allocation
still might not be respected if it is a family partnership
• Rationale in a progressive rate structure, taxpayers have come up with devices to
split income among family members
• Assignment of Income Doctrine
• Income must be taxed to the person who earns it, or to the person who owns the
income-producing capital
• Commissioner v. Culbertson (1949) the appropriate question is whether,
considering all the facts and circumstances . . . the parties in good faith and acting
with business purpose intended to join together in the present conduct of the
enterprise
• §704(e)(1) provides that a person shall be recognized as a partner if they own a
capital interest, no matter how acquired
• §704(e)(2) limits the extent to which income allocations can be made to such
partners
• If one family member has acquired a capital interest from another, by gift
or purchase, the donee may report their distributive share as long as the
donor has received reasonable compensation for all services rendered to
the partnership
• **Kiddie tax: taxing the income of minor children at the parents’ rate
• Conclusion
• Those partnerships which choose to avail themselves of the safe harbor know precisely
what they must do to accomplish that
• Those partnerships remaining outside the safe harbor have more guidance than ever
before on what the term “partners’ interests in the partnership” means
• Chapter 6. The Allocation of Nonrecourse Deductions
• §704(b) Regulations has 4 distinct parts
• Safe harbor
• Partners’ interests in the partnership
• Special rules where SEE is inapplicable e.g. nonrecourse
• Cannot satisfy SEE will be deemed
• Background
• When partnership property is pledged as security for a nonrecourse loan, it is the lender,
not the partnership, who bears the economic risk that the value of the property will
not satisfy the loan
• Accordingly, the allocation of the deduction generated by the property to the
partners cannot have substantial economic effect allocations of nonrecourse
deductions must be allocated in accordance with the partners’ interests in the
partnership
• The Code permits the owner of property to take depreciation and other deductions
which may be economically borne by a nonrecourse lender
• The most common type of nonrecourse deduction is depreciation on
property which is acquired or improved with the proceeds of nonrecourse
financing
• ***In a recourse loan, allocation would be tested under Safe Harbor/SEE
• Until the taken depreciation actually meets the nonrecourse loan, it is
treated just like recourse and tested similarly
• Crane Tufts
• Crane when property is purchased with proceeds of a nonrecourse mortgage, the
purchaser is the sole owner of the property, and the purchaser is therefore the only
party entitled to deduct depreciation with respect to the property
• It is now law that when property is purchased with the proceeds of a nonrecourse
mortgage, the purchaser is the sole owner of the property, and the only party
entitled to deduct depreciation with respect to it
• These deductions must be taken by the partnership as the sole owner of the
property, even though none of the partners are economically at risk
• In theory, the partnership might allocate the deductions among the partners
in any way they see fit no allocation scheme would be more rational than
another, since none would be anchored to the economic burden borne by
any partner
• Tufts
• When property subject to a nonrecourse mortgage is disposed of in a
taxable transaction, the full amount of the liability must be included in the
amount realized, regardless of the value of the property
• Since a nonrecourse mortgage was treated as “true debt” when it was
incurred, the mortgage must be treated as true debt when it is discharged
• “Minimum gain” the difference between the principal amount of the
mortgage and the partnership’s adjusted basis
• Regulations Allocations attributable to nonrecourse liabilities §1.704-2 (pages 535-557)
• Introduction
• Permits partnerships to allocate nonrecourse deductions in virtually any way the
partners agree, so long as the minimum gain is allocated in the same fashion!
• Like SEE there is safe harbor if the partnership agreement complies with all of
the requirements of the safe harbor, then the allocations of nonrecourse
deductions will be respected, i.e. the allocations will be deemed to be in
accordance with the partners’ interests in the partnership
• If partnership does not comply with the requirements of the safe harbor
Service has the authority to reallocate the deductions under the facts and
circumstances rules of §1.704-1(b)(3) until 2009 the reallocation would
be made in accordance with partners’ share
• Practical issue this test focuses on the economics of the partners
agreement, however it is not clear how rules would apply, as risk
of nonrecourse deductions are actually borne by the lender
• Nonrecourse Safe Harbor Test §1.704-2(e) safe harbor requirements which must
be met
• 1. The partnership agreement must satisfy either the basic or the alternate
test for economic effect
• ***Safe harbor within safe harbor if the partnership chooses not to
comply with the safe harbor for SEE under §1.704-1, then the
nonrecourse debt safe harbor is unavailable
• 2. Nonrecourse deductions must be allocated by the partnership
agreement in a manner that is ‘reasonably consistent’ with allocations of
some other ‘significant’ partnership item attributable to the property
securing the debt
• Example
• Partnership agreement provides that income/loss will
initially be divided 90/10
• Agreement provides that when profits exceed losses (as
expected), income/loss will be divided 50/50
• Each of these allocations have SEE
• Permissible allocations of nonrecourse liabilities
• Range: 90/10 50/50
• I.e. 95/5 allocation would fail!
• 3. Partnership agreement must contain a ‘minimum gain chargeback’
provision; AND
• I.e. requires those partners who received allocations of nonrecourse
deductions to report an offsetting amount of gain when the
partnership disposes of the property
• E.g. AB purchase property for $1000, nonrecourse liability of
$800. Depreciation $100/year, all allocated to A
• Year 3 depreciation is a nonrecourse deduction
• A must be allocated $100/income or gain in the future
• [4. All other material allocations and capital account adjustments must be
respected under §1.704-1(b)]
• Seems redundant given requirement #1
• If #1-4 are not met, the partnership nonrecourse deductions will be
allocated in accordance with the partners’ interests in the partnership
• Definitions
• Basis $400 Nonrecourse liability of $750 Sell for $1000
• $350 is Partnership Minimum Gain to be allocated for nonrecourse
purposes
• $250 would be allocated differently
• Partnership Minimum Gain (PMG) §1.704-2(d)
• A.k.a. Tufts gain, the minimum amount of gain that the partnership would
realize were it to make a taxable disposition of property secured by
nonrecourse financing
• Normally, at any given time that gain is the excess of the amount
of the loan over the property’s basis
• Future ‘Tufts’ Gain amount of gain the partnership will realize
when it disposes of the property securing the nonrecourse
liabilities in full satisfaction thereof and no other consideration
• Reasons why PMG is important
• Regulations measure the amount of nonrecourse deductions for a
given year indirectly by reference to the increase in PMG during
the year
• A decrease in a partner’s share of PMG may trigger a minimum
gain chargeback
• Two events which will cause PMG to increase
• 1. Cost recovery deductions (depreciation
• If depreciation reduces the partnership’s adjusted basis in
the secured property faster than the principal of the
nonrecourse liability is repaid
• 2. Secondary financing
• I.e. if a partnership borrows funds without incurring
personal liability, using its property as security for the loan
• E.g. AB Partnership has land with FMV of $500 and a basis
of $200 and borrows $350, secured by the land
• To the extent that the loan exceeds the basis is PMG
$150
• If the proceeds of such a borrowing are distributed to the
partners, then to the extent that the borrowing caused an
increase in PMG ($150), it will be considered nonrecourse
distribution
• Amount of PMG at any time represents the total of deductions taken by
the partnership and distributions made by the partnership for which the
lender has borne the burden
• Although partnership can take these deductions, and permitted to
make the distributions, it must upon the disposition of the
underlying property recognize an offsetting minimum gain
• Nonrecourse Deductions (NRDs) §§1.704-2(c)
• Measured annually and equal to the net increase in the partnership’s
minimum gain during the taxable year, less any nonrecourse distributions
made during the year
• NRDs are comprised of the cost recovery deductions on the encumbered
property
• However, the cost recovery deductions of the partnership may be
less than the increase in PMG
• Accordingly, regs. create an ordering rule to determine which of
the partnership’s deductions are characterized as nonrecourse:
• Depreciation or cost recovery with respect to the
encumbered property, and
• If necessary, a pro rata portion of the partnership’s other
expenses [including deductible items and non-deductible
§705(a)(2)(B) expenses] for the year, and
• If there are insufficient deductions for the year, the excess
nonrecourse deductions are carried over to the following
year
• Partner’s Share of Partnership Minimum Gain §1.704-2(g)(1)
• The ultimate objective of the regulations is to ensure that each partner will
eventually report an amount of income or gain equal to their share of
nonrecourse deductions and distributions
• Regulations require partnerships to keep track of each partner’s share of
PMG
• If there has been a net decrease in PMG during the year, it will allocated
among the partners and may trigger the minimum gain chargeback
provision
• ****At any given time each partner’s share of the total PMG of the
partnership will be equal to the excess of:
• The sum of the NRDs allocated to the partner and nonrecourse
distributions received OVER
• That partner’s share of net decreases in PMG
• Minimum Gain Chargeback Provision §1.704-2(f)
• Generally: if there is a net decrease in PMG for a taxable year, each
partner must be allocated an amount of income or gain equal to their share
of the decrease
• Most common cause of a decrease in PMG is disposition of the
encumbered property
• Partners must be allocated the applicable share of the
current Tufts gain resulting from the disposition equal to
their share of the PMG decrease
• Loan repayment in excess of any annual depreciation taken on the
secured property
• Partners must be allocated a pro rata share of other items of
partnership income or gain
• Causes which decrease PMG but inappropriate to trigger the chargeback
• Conversions and refinancing
• Decrease in PMG can result from the conversion of a
nonrecourse obligation into one on which one or more of
the partners are personally liable no reason to trigger
chargeback for those partners since they are not actually
bearing the economic burden associated with the
deductions they have already taken
• Contributions of capital
• Partner’s contribution of capital that is used either to repay
the principal of a nonrecourse liability or to make a capital
improvement to the encumbered property
• The decrease is caused by an actual investment in the
property
• Revaluations
• Revaluations have the effect of converting each partner’s
share of PMG into §704(c)-type gain for which the partners
remain personally responsible
• Waiver
• Under circumstances when it can be demonstrated that the
chargeback actually is distorting the economic
arrangement, the partnership may request a waiver
• Illustrations (pages 83-89)
• ***See Example #3 Alternative #3
• What happens if one of the partners personally guarantees the mortgage?
• Mortgage changes its character from a partnership nonrecourse liability to
a partner nonrecourse debt
• A partner nonrecourse debt is one that is nonrecourse with respect to the
partnership, but is recourse with respect to one or more of the partners
• Conclusion
• Safe harbor gives partnerships enormous flexibility in allocating nonrecourse deductions
among their partners if partnership does not come within the safe harbor then allocated
in accordance with the partners’ interests in the partnership since the burden represented
by these deductions is being borne by the lender, and not the partnership, there is no
certainty as to exactly how these deductions will be allocated
• Many partnerships are now using targeted allocations which may or may not have SEE
• Chapter 7. Contributions of Property: §704(c) and Its Principles
• Introduction
• However a partnership allocates its book items, it must allocate its corresponding tax
items in the same manner tax must follow book
• When a partnership purchases an asset and reflects it on the books at cost for both
tax and book purposes easily met, i.e. the partnership’s gain, loss or depreciation
with respect to that asset will be the same for book and tax purposes, so that the
partnership can comply with the tax follows book mandate
• Two events which create a disparity between a partnership’s book and tax accounts
• 1. The contribution to a partnership of §704(c) property, i.e. property whose fair
market value differs from its basis (resulting in built-in gain or built-in loss
• 2. Revaluation of a partnership’s assets as permitted by §1.704-1(b)(2)(iv)(f)
• The book/tax disparity resulting from revaluing partnership assets is so
much like that caused by the contribution of §704(c) property, allocations
with respect to revalued assets are referred to as reverse §704(c) allocation
• The disparity is created because at the time of contribution or revaluation, the property
must be reflected on the partnership’s books at its FMV even though no gain or loss is
recognized for tax purposes
• When the partnership makes a taxable disposition of the property there will be tax
gain (or loss) for which there is no corresponding book gain (or loss)
• In the case of depreciable property, the partnership’s book depreciation will not
match its tax depreciation
• Tax cannot follow book and it is impossible for the tax allocations to have
substantial economic effect governed by the special rules of §704(c) and
the corresponding regulations
• When a partnership revalues its assets as permitted by capital accounting
rules, §704(c) principles require that the built-in gain or loss be allocated
to the partners to whom the gain or loss was allocated for book purposes at
the time of the revaluation
• Contributions of Property
• Introduction
• §704(c) requires that tax items with respect to contributed property must be
shared so as to take into account the built-in gain or loss at the time of
contribution
• The regulations state that the partnership may use a reasonable method which is
consistent with the purpose of §704(c)
• Traditional method
• Traditional method with curative allocations
• Remedial allocation method
• ***if you don’t use one of the three methods, the burden is on you to
demonstrate that the method is reasonable
• Nondepreciable property
• Traditional method §1.704-3(b) (page 561)
• The noncontributing partner is effectively treated as though she purchased
an undivided interest in the property for its FMV, and allocations of tax
items are made consistent with that treatment
• When property is nondepreciable, only tax gains (or losses)
corresponding to book gains (or losses) will be allocated to her
• Ceiling Rule limitation prohibiting shifts in built-in gain
• To the extent anyone is hurt by the ceiling rule someone else is
benefited
• Assets Capital Accounts
Basis Book Tax Book
Cash $100 $100 A $60 $100
Land $60 $100 B $100 $100
$160 $200 $160 $200
But the land goes down in value and AB sells it for $70 although AB has a
book loss of $30, it has a tax gain of $10
Assets Capital Accounts
Basis Book Tax Book
Cash $170 $170 A $70 $85
B $100 $85
• §704(c)(1)(C) Built-in Loss Special Rules SEE SLIDES
• Rule 1. Contributing partner: if a partner contributes
property to a partnership with a built-in loss, then the
partnership must allocate any tax item related to that loss to
the contributor, AND
• Rule 2. Non-contributing partner: to determine the amount
of any item with respect to built-in loss property that is to
be allocated to a noncontributing partner, the partnership
shall be treated as having an initial tax basis in the property
equal to its FMV on the date of contribution
• ***Purpose cannot shift built-in losses
• Under the traditional method the book/tax disparity once formed will
never be cured until the partnership interest is liquidated!!!
• Traditional method with curative allocations §1.704-3(c) (page 563)
• Partnerships using this method may elect to make reasonable curative
allocations to eliminate ceiling rule distortions
• Curative allocation = an allocation of an item for tax purposes that
differs from the allocation of the corresponding book item
• Meant to cure the disparities caused by the ceiling rule and
available only if the ceiling rule creates an initial book/tax
disparity
• ***Must have an additional item to offset the disparity (as opposed to
remedial allocation)
• See variation #4 on page 97
• Remedial Allocation Method §1.704-3(d) (page 568)
• Provides an alternative method of curing ceiling rule distortions
• Permits partners to ignore the ceiling rule: tax allocations will
always be available to match book allocations to the non-
contributors because the partnership is permitted to manufacture
them
• These allocations are fictitious or notional their only role is to precisely
eliminate any disparities between book and tax accounts created by the
ceiling rule
• Since notional they have no effect on the partnership’s taxable
income or adjusted bases
• But treated as actual tax items by the partners and may affect both
their tax liability and outside bases
• Depreciable property
• Unlike the case of nondepreciable property, simply waiting until sale to allocate
the gain or loss will not ordinarily accomplish the purpose of taxing the
contributing partner on the built-in gain
• Because depreciable property does not generate gain on sale if held for its
useful life instead its value is realized by the owner during the property’s
life in the form of the ordinary income that it generates
• The only way to ensure that the contributor will be taxed on the built-in
gain is to increase her share of current income from the property
• Accomplished under the traditional method by allocating
depreciation away from the contributing partner: i.e., the
noncontributing partner receives tax depreciation up to her share of
book depreciation, and only if tax depreciation remains thereafter
is it allocated to the contributing partner
• Two additional rules (page 100)
• Rule #1: When a partner contributes depreciable property to a
partnership, the partnership steps into the shoes of the partner for
purposes of cost recovery the partnership must recover its
transferred basis in the property over the remaining recovery
period using the same method as the contributor
• Rule #2: For book purposes under the capital accounting rules, a
partnership must recover the same percentage (proportion) of basis
for book purposes as it does for tax purposes
• Traditional Method
• General intent to treat noncontributing partners as if each purchased an
undivided interest in contributed property for cash, the noncontributors are
allocated (if possible) the same amount of cost recovery for tax purposes
as they are for book purposes
• If the partnership’s cost recovery deduction exceeds the
noncontributors’ share, the contributing share, the contributing part
must be allocated the balance
• Traditional Method with Curative Allocations
• Under the traditional method, the built-in gain in the property is amortized
over the life of the property, as it produces income
• When the ceiling rule applies, in the absence of curative allocations, the
noncontributor is reporting more than his economic share of the property’s
income
• Allows reasonable allocation to offset the disparity
• Remedial allocation method
• If method is adopted, the partnership must use a special rule (NOT ON
EXAM) to determine the amount of book depreciation with respect to that
property
• Partnership then uses the traditional method to allocate the related
tax items, i.e. tax allocations will follow book allocation
• If the ceiling rule prevents the noncontributing partner from
receiving a tax allocation equal to the corresponding book
allocation, the partnership makes offsetting remedial allocations of
the appropriate character and amount to both the contributing and
noncontributing partners
• Special rule the contributing partner sold the property on a deferred basis
to the partnership on the date of contribution for its FMV
• Choice of methods
• Partnerships are permitted to choose a “reasonable method”
• Choice of allocation may be made on a property-by-property basis, so that
a partnership is not bound to use one method with respect to all
contributed or revalued property
• However, the overall method or combination of methods must be
reasonable based on the facts and circumstances and consistent with the
purpose of §704(c)
• Factors to consider in choosing method
• Tax profiles of the individual partners
• Generalizations
• Each of the three methods yields precisely the same amount of annual net
tax depreciation differ only in how that net amount is allocated among the
partners
• If all partners are in the same tax bracket, both the government and
the partnership should not care which method is adopted
individual partners however may care greatly
• If different brackets, partnership will choose the method that
results in the largest aggregate tax savings for its partners
• If A is in a relatively high bracket as compared to B, the
traditional method will generate the most savings
• If a is in a relatively low bracket, then the traditional
method with curative allocations is best
• Anti-abuse rules §1.704-3(a)(10)
• An allocation method is NOT reasonable if the contribution of property . . . and
the corresponding allocation of tax items with respect to the property are made
with a view to shifting the tax consequences of built-in gain or loss among the
partners in a manner that substantially reduces the present value of the partners’
aggregate tax liability
• An appropriate reading of the rule would limit it to situations like those in the two
examples illustrating the rule, where the noneconomic capital accounting rules
have the effect of accelerating a ceiling rule shift of income, or permitting the
noncontributory to expense her investment
• Revaluations [reverse §704(c) allocations]
• The second common event that predictably creates a disparity between book value and
tax basis is the revaluation of partnership assets in connection with a contribution (or
distribution) of money or other property to (or from) a partnership in exchange for an
interest in that partnership
• When a revaluation occurs, all of the partnership’s existing built-in gains and losses are
recognized for book purposes and allocated among the existing partners in accordance
with their agreement the corresponding tax items are not recognized
• Reverse §704(c) allocations are to be made in accordance with §704(c) principles
• The only difference from §704(c) is that the existing partners, not the contributor,
are credited with the unrealized appreciation from the revaluation
• See three allocation methods at work pages 111-113
• Chapter 8. Partnership Liabilities
• Introduction
• For income tax purposes: when a person uses borrowed funds to purchase an asset or pay
a deductible expense, she is treat just as if the funds were hers outright: she is given full
basis credit for purchases, and is entitled to deduct the expense, even though the funds are
excluded from the tax base at the time of receipt, and will only be included if and when
the taxpayer is relieved of the liability
• Applies whether or not the borrowed funds are recourse or nonrecourse
• §752 functions to apply that understanding within the partnership context
• Treats changes in a partner’s share of partnership liabilities as contributions and
distributions of cash to and from the partnership
• Liabilities are included in a partner’s outside basis under §722
• §704(d) a partner cannot deduct partnership losses in excess of her outside
basis
• If a partner receives a distribution of cash from a partnership which
exceeds her outside basis, she will have gain under §731(a)(1)
• Until the early 1980s
• Recourse liabilities are shared by general partners in accordance with their shares
of partnership losses
• Nonrecourse liabilities are shared by all partners in accordance with their profit
shares
• However, due to commercial lending practices becoming more sophisticated it became
harder to distinguish between recourse and nonrecourse debt
• E.g. Raphan v. United States (1985)
• GL is a limited partnership to which GP and LP each contribute $50
• LP has no obligation to contribute more capital to the partnership or to
restore any deficit
• GP and LP agree to share profits and losses equally to the extent of each
partner’s basis
• If LP’s basis is reduced to zero, GP will be allocated all future
losses
• GL acquires a building for $1k by paying $100 in cash and giving $900
nonrecourse mortgage for the balance the lender insists that GP personally
guarantee the mortgage recourse or nonrecourse?
• The Court held that despite the guarantee, the mortgage should be treated
as nonrecourse decision permitted limited partners to deduct losses borne
economically by the guaranteeing general partner
• Congress enacted legislation to overrule Raphan current §752
• What is a liability?
• Two types of liabilities
• §1.752-1 liability, defined as only those obligations that when incurred
• 1. Create or increase basis directly (e.g. a purchase money mortgage) or
indirectly (e.g. a second mortgage or unsecured loan); or
• 2. Give rise to a deduction (e.g. accrued but unpaid expenses of [only] an
accrual method partnership); or
• 3. Give rise to expenditures described in §705(a)(2)(B) (i.e. expenses that
cannot either be deducted or capitalized, e.g. syndication fees)
• §1.752-7 liability, defined as any partnership obligation that is not governed by
the general rules
• Often contingent and includes:
• Contingent liabilities
• Environmental obligations
• Tort obligations
• Contract obligations
• Pension obligations
• Various obligations that may arise under derivative financial
instruments
• Although not reflected in basis, these liabilities do reduce the value of the
property to which they relate
• *Similar to built-in losses
• Governed by §704(c)
• Not reflected in either the partner’s or the partnership’s basis
• Reflected solely in the partner’s capital account, creating the same
type of disparity that would result from contributing property with
a built-in loss
• Contributing partner, upon subsequent sale of burdened asset, is
allocated the tax loss
• E.g. Land with FMV/Basis of $100k; burdened by $20k environmental
liability
• Partner’s tax capital account/basis $100k
• Partner’s book capital account $80k
• Regulations governing §1.752-1 liabilities (pages 698-700)
• Introduction
• Two sets of rules
• Recourse liabilities recourse to the extent that ANY partner (or related
person) bears the economic risk of loss associated with that liability
• Must be shared among partners in the same way that they share the
economic risk of loss represented by the liability
• Nonrecourse liabilities nonrecourse to the extent that NO partner (or
related person) bears the economic risk of loss, the partnership liability is
a nonrecourse liability
• Must be shared in a manner consistent with the allocation of
nonrecourse deductions, so that the partners to whom those
deductions are allocated will have enough basis to use them
• Economic risk of loss
• Serves two purposes
• 1. If the economic risk of loss associated with a liability is borne by one or
more of the partners liability is recourse
• 2. If recourse shared among the partners in the same manner that they
share the economic risk of loss associated with it
• WHO will ultimately bear the economic risk of loss? Look to and assess:
• 1. Partnership agreement
• 2. Obligations created by other contractual arrangements (if any)
• 3. Obligations imposed by local law (if any)
• E.g. joint liability for partnership obligations, which combine to
create the equivalent of an unlimited deficit makeup obligation for
general partners
• De minimis exception
• Permits commercial lenders to hold minor interests (10% or less) in
partnerships to which they lend money on a nonrecourse basis without the
loan being recharacterized recourse only applies if the loan would
constitute qualified nonrecourse financing
• Sharing recourse liabilities
• Partners share partnership recourse liabilities in the same way that they share the
economic risk of loss associated with that liability
• The determination of who bears the economic risk of loss for any liability
is based upon whose pocket the money would come from to satisfy the
liability if the partnership went ‘belly up’ constructive liquidation
• Constructive liquidation (page 119), during which the following 5 events are
deemed to occur
• 1. All partnership liabilities become due and payable in full
• 2. All partnership assets, including cash, become worthless
• *Except certain property held by the partnership in name only for
the purpose of securing indebtedness
• 3. All partnerships assets are disposed of in taxable transactions for no
consideration
• *other than satisfaction of nonrecourse liabilities secured by the
property
• 4. The partnership allocates all items of income, gain, loss or deduction
for its last taxable year ending on the date of the constructive liquidation
• 5. The partnership liquidates
• ***Following this, if and to the extent that a partner is ultimately
responsible for paying a partnership liability, either directly to the creditor
or by way of a contribution to the partnership or to her other partners, that
partner bears the economic risk of loss for the liability and shares in the
liability to that extent
• Key assumption all parties are assumed to live up to their
obligation
• Impact if general partner has a right to contribution from
other partners, we assume this happens even if we know the
other partners are not able to do so
• Illustration – recourse liabilities (pages 120-124) (CL-1 – CL-3 walks through
constructive liquidation
• Greg’s example. A+B form AB (excel problem CL-1)
• A contributes $60 / B contributes $40
• Profits/loss will be shared 60/40
• Basic test for economic effect satisfied
• Upon formation AB immediately purchases land for $1k, taking out $900
recourse mortgage (no principle or interest payments for 5 years)
• Intuitive result recourse will be allocated 60/40 ($540/$360)
• Scenario #1 (variation #3 in book). Any impact if mortgage is fully recourse and
A personally guarantees the partnership obligation?
• NO we assume all parties live up to obligations, thus partnership will pay
and As guarantee is never called
• Scenario #2 (variation #5 in book). Mortgage is nonrecourse, but B personally
guarantees the loan? (excel CL-2)
• Partner nonrecourse liability (never applies when we have a full recourse
liability)
• Step #4 of constructive liquidation is different, the partner
guaranteeing it will be allocated the entire loss therefore all goes
into that partner’s outside basis
• Scenario #3 (variation #6 in book). Recourse mortgage, but B agrees to indemnify
A for any losses in excess of capital contribution ($60). (excel CL-3)
• Can only allocate $60 loss to A because otherwise it would fail Basic Test
and Alternate Test
• Partners providing property as security for partnership debt
• Sometimes a lender may require security for a loan in addition to the personal
liability of the partner or beyond the property which the partnership has pledged
as collateral, and in lieu of a personal guarantee one of the partners may pledge
her individual property as collateral
• Sharing of nonrecourse liabilities
• No partner bears the economic risk of loss
• Constructive liquidation is of no use in determining how to allocate
nonrecourse liabilities
• §1.752-3(a) partner’s share of a partnership’s nonrecourse liabilities is equal to
the sum of:
• 1. Partner’s share of partnership minimum gain
• Generally equal to the sum of the nonrecourse deductions allocated
to that partner, plus any nonrecourse distributions made to her
• Ensure that
• A partner will have sufficient outside basis to prevent a
nonrecourse deduction from being suspended under
§704(d) and
• A nonrecourse distribution will not trigger gain under
§731(a)(1)
• 2. Partner’s share of §704(c) minimum gain
• The amount of gain that would be allocable to the partner under
§704(c) if the encumbered property were disposed of for no
consideration other than satisfaction of the liability
• Excess of nonrecourse liabilities encumbering contributed property
over basis
• 3. Partner’s share of the excess (residual) nonrecourse liabilities, i.e. those
nonrecourse liabilities not allocated under (1) and (2)
• §1.752-3(a)(3) Excess nonrecourse liabilities the balance of
nonrecourse liabilities remaining after each partner has been
allocated her share of those liabilities based on partnership
minimum gain and §704(c) minimum gain
• Permissible sharing arrangements extremely flexible
approving multiple possible sharing arrangements
• 1. General rule sharing based on profit shares
• 2. Also allowed for partners to agree to share nonrecourse
liabilities in the same ratios that they share nonrecourse
deductions
• Most common because allows the partnership to not
have to calculate on a year to year basis, because
they will remain constant
• 3. If the liability encumbers contributed property, the
regulations allow the partners to allocate the excess
nonrecourse liabilities first to the contributor, in an amount
of any §704(c) gain in excess of the §704(c) minimum gain
that is allocated under §1.752-3(a)(2)
• See slides, e.g. nonrecourse liability allocation – example
• Limitation on partnership losses (see slides Day #4 pages 8-11)
• Basis limitations §704(d) (Review)
• A partner’s distributive share of partnership loss, including capital loss,
• At-risk limitations (when partners are accorded outside basis adjustments based solely on
nonrecourse)
• Simply mention if on exam
• §465 operates to limit a taxpayer’s deductible losses from a broad range of business and
investment activities to the amount the taxpayer is at-risk with respect to those activities
• Partnership setting the at-risk rules are applied on a partner by partner by basis (not
partnership level)
• Cash contributions to the activity
• Adjusted basis of property contributed by the partner to the activity
• Amounts borrowed for use in the activity for which the partner is personally liable
or which are secured by property of the partner (not otherwise used in the activity)
• Sounds like outside basis
• Nonrecourse liabilities of the partnership will increase a partner’s outside
basis, but a taxpayer is not considered at risk with respect to nonrecourse
loans and similar arrangement where the taxpayer has no economic risk
• Result loss allowable under §704(d) may be deferred by §465
• Any loss disallowed by §465 may be carried over and deducted when
• The partner becomes at risk
• The partnership disposes of the activity
• The partner disposes of his PSP interest
• *Outside basis is reduced by the amount of the loss, even if it is deferred
by §465
• Rules generally applies to each activity in which a partnership is engaged
• Types of debt
• Recourse at-risk
• Deficit capital account restoration obligation
• Qualified nonrecourse financing exception
• Passive loss limitations (not tested)
• Enacted to restrict taxpayers from using deductions and other losses generated from
certain passive investment activities to ‘shelter’ income from other sources (i.e. regular
business income, compensation, dividends & interest)
• General impact disallows the current deductibility of losses and the use of credits from
“passive activities”
• Passive loss limitations are applied on a partner by partner basis, not at the partnership
level
• Applied only after application of the §704(d) and §465 limitations
• Income and loss from each of a taxpayer’s passive activities are first computed and then
all are combined; in any taxable year, passive activity losses can be deducted only to the
extent of the taxpayers income from passive activities for that year
• Excess losses if losses from passive activities exceed income, then excess may be
carried forward and deducted against future net income from passive activities
• Test: Material Participation Standard
• Chapter 10. The Sale of a Partnership Interest
• Overview
• What issues arise?
• What are the consequences of sale to the transferor
• What are the consequences of sale to the transferee
• Tension between aggregate and entity approaches
• Basic rules
• Rule #1. The seller must recognize gain/loss on the sale of her interest equal to
the difference between her amount realized and her outside basis
• The character of that gain or loss will be capital (§741)
• Except to the extent it is attributable to certain ordinary income
assets, §751(a)
• The seller is entitled to use the installment method of reporting gain under
§453, with some modifications
• Rule #2. The buyer of a partnership interest takes a cost basis in that interest.
• The buyer generally inherits the seller’s capital accounts (both tax and
book) and her share of inside basis*
• *Not true if the selling partner contributed property with a built-in
loss to the partnership under §704(c)(1)(C), no one other than the
contributor can benefit from this loss
• In almost all cases this will result in a disparity between the buyer’s
outside basis and her share of inside basis
• Due to depreciation or fluctuation in value of the asset
• Rule #3. If the partnership makes (or has previously made) an election under
§754, or if the partnership has a substantial built-in loss, the partnership will
make a special basis adjustment under the rules of §743(b) and §755 that is
intended to eliminate the disparity between the buyer’s outside basis and her
share of inside basis
• Purpose eliminate the disparity between the buyer’s outside basis and
share of inside basis
• This adjustment impacts only the buying partner’s basis and has no effect
on the partnership’s common basis in its assets!
• Substantial built-in loss if the aggregate ( ) exceeds the FMV by $250k
• Rule #4. Unless the sale results in a termination of the partnership under §708,
there are no other tax consequences to the partnership
• Under §708(b)(1)(B), a termination occurs if there is sale of 50% or more
of the total interests in partnership profits and capital within a 12 month
period
• Statutory Scheme
• §741 characterizes gain/loss from the sale of a partnership interest as capital
• §743(a) sale of a partnership interest has no effect on the inside basis of partnership
assets
• §751(a) partially overrides §741, by treating gain/loss as ordinary if attributable
partnerships ordinary income assets
• §743(b)-(d) if there is a substantial built-in loss or partnership has made a §754 election,
there is a special adjustment to the basis of partnership assets to take into account amount
actually paid for interest
• Impact on The Seller (a.k.a. transferor)
• Statutory Scheme
• §741 states that the sale or exchange of a partnership interest is treated as the sale
or exchange of a capital asset, except as otherwise provided in §751
• §751(a) states that any portion of a selling partner’s amount realized attributable
to:
• Unrealized receivables, or
• Inventory items
• Shall be treated as being an amount realized from the sale or exchange of a
noncapital asset (i.e. ordinary income)
• §751(a) Property
• History
• §751 originally enacted to prevent taxpayers from using partnerships to
convert ordinary income into capital gain or to shift ordinary income from
one taxpayer to another
• Had limited reach of inventory items, applying only if
• Gain rather than loss on inventory items, and
• Gain was ‘substantial’
• Now
• §751(a) property: unrealized receivables and inventory items
• §751(b) property / hot assets: substantially appreciated inventory
• §751(c) Unrealized Receivables defined very broadly
• Generally, those amounts earned by a cash method taxpayer, but not yet
received or reported as income
• Under §751(c) three types of unrealized receivables
• If the partnership holds rights to payments for either
• Type 1 Goods delivered or to be delivered or
• Type 2 Services rendered or to be rendered
• And if the partnership has not yet included those amounts
in income under its method of accounting, then the rights
are categorized as unrealized receivables
• If already included we’ve already reported income
on it
• Type 3: essentially a list of Congressional exceptions carved out to
the preferential treatment afforded capital gains
• §1245 (and §1250) recapture most significant
• I.e. §751(c) includes as an unrealized receivable any
amount that would be recaptured as ordinary
income if the partnership had sold its property for
its fair market value
• §1245 recapture to the extent that gain upon the sale or
disposition of an asset represents depreciation taken on the
asset, that gain will be treated as ordinary income
• §1245 property personal property (as opposed to
real property) used in a taxpayer’s trade or business
• Excludes: (i) real estate; (ii) buildings; (iii)
doesn’t apply to dispositions by gift or death
transfers
• §1250 recapture any additional depreciation (depreciation
deductions which exceed the deduction allowed under S/L)
is recognized as §1250 recapture
• Unrecaptured §1250 gain any gain that is above the
adjusted basis under the S/L method but below the
original cost of the real property, is taxed at 25%
• Not an unrealized receivable Look-through
rule
• §1250 property depreciable real property
• §751(d) Inventory Items all inventory items of a partnership (both loss/gain)
• 1. Property of the partnership of the kind described in §1221(1)
• I.e. classic inventory and other property held for sale to customers
• 2. Any other property of the partnership which, on sale or exchange by the
partnership, would be considered property other than a capital asset and
other than property described in §1231
• I.e. Any property which if sold would not be considered a capital
asset or property described in §1231
• §751(a) Computation
• If a partner in a partnership which holds §751(a) property sells or exchanges her
interest in the partnership, a portion of the gain will be taxed as ordinary income
under §751(a)
• The mechanism
• Step 1. Determine the total gain or loss realized by the selling partner from
the sale of her partnership interest (i.e. the difference between her total
amount realized and her outside basis)
• Total amount realized – Outside basis = gain/loss
• Step 2. Calculate the gain or loss from §751(a) property which would be
allocated to the selling partner if the partnership sold all of its assets for
their FMV immediately prior to the sale of the selling partner’s interest
(the ‘hypothetical transaction/ liquidation’)
• That amount of the seller’s total gain or loss is characterized as
ordinary by §751
• Step 3. Subtract the amount characterized as ordinary in Step 2 from the
selling partner’s total gain in Step 1
• This is the amount of capital gain or loss determined under
§741
• Different rates for different types of capital gains
• §1(h) collectibles taxed at a maximum rate of 28%
• §1250 capital gain at a maximum rate of 25%
• All other capital gains taxed at a maximum rate of 15%
• Look-through rule
• Requires the seller of a partnership interest to determine if any part
of her §741 capital gain is allocable to either:
• Collectible gains (max 28%) or
• §1250 capital gain (max 25%)
• I.e. Lukewarm Assets
• See excel 751-1, 751-2, 751-3
• Installment Sales of Partnership Interests
• §453 provides for installment method reporting of gains when at least one
payment for the sale of property is received after the close of the year in which the
sale takes place
• Generally, allows the taxpayer to report gain proportionately to receipt of
payments
• §453(d) permits a seller to elect out of the installment method of reporting
and report all gain in the year of sale
• Gain from certain sales, e.g. inventory, accounts receivable, recapture, and
securities traded on an established exchange, is not eligible for the installment
method and must be report in the year of sale essentially §751(a) property is not
eligible
• The Buyer (See rules #2 and #3 above)
• (Rule #2) Ideally, a partnership’s aggregate inside basis should equal the sum of the
partners’ outside bases, and each partner’s share of that inside basis should equal her
outside basis
• However, the sale of a partnership interest will almost always result in a disparity
between inside basis and outside basis
• Caused by the fact that, even though the buying partner has an outside basis equal
to her cost, the sale of an interest in the partnership generally has no effect on the
partnership’s inside basis in its assets
• The buying partner succeeds to the seller’s share of inside basis, which
does not reflect the gain or loss realized on the sale of the purchased
interest this does not reflect the gain/loss realized on the sale of the
purchased interest
• As a result the buyer can be under/over taxed
• Only temporary, as outside basis does reflect the actual amount
paid, but only corrected upon sale of interest
• (Rule #3) If a partnership makes a §754 election or if it has a substantial built-in loss this
disparity between inside and outside basis will be resolved, so that the buying partner will
be treated as if she had purchased an undivided interest in each asset
• Once a partnership makes a §754 election with respect to one transaction, the
election remains in effect with respect to all future transactions and it can be
revoked only with the consent of IRS
• EXCEPTION when a partner contributes property with a built-in loss to a partnership,
only that partner is entitled to take the build-in loss into account
• Buyer’s share of inside basis is equal to the seller’s less any amount of §704(c)
loss inherent in the property at the time of purchase
• Substantial built-in loss defined as when the partnership’s adjusted basis in its property
exceeds the property’s fair market value by more than $250k
• Purpose don’t want a new buyer to come in and recognize a huge loss despite the
fact that since joining the economics have not changed
• If substantial built-in loss than partnership must make §743(b) adjustments
• The adjustment is made only if the partnership makes or has previously
made an election under §754, or the partnership has a substantial built-in
loss
• The amount of the adjustment is determined under §743(b) and it is equal
to the difference between the buyer’s outside basis and her share of inside
basis
• The regulations under §743 provide a means of calculating the
buyer’s share of inside basis
• §755 provide rules for allocating the adjustment among the partnership’s
assets
• The goal of these rules is to give the buying partner a cost basis in
her share of each asset. This prevents the buying the partner from
being over/under taxed.
• The basis adjustments made by the partnership apply only with respect to
the transferee partner, so that they have no impact on future allocations of
income, deduction, gain or loss to the other partners
• Calculating the overall §743(b) adjustment
• The adjustment under §743(b) is equal to the difference between the buyer’s
outside basis and her share of inside basis, and has the effect of equating these
two amounts
• If the buyer’s outside basis is higher than her share of inside basis the
adjustment is +
• If the buyer’s outside basis is less than her share of inside basis the
adjustment is –
• Buyer’s outside basis is simply the amount she paid for her interest, i.e. her cost
(including her share of liabilities, if any)
• Buyer’s share of inside basis = sum of her
• 1. Share of previously taxed capital AND
• Previously taxed capital page 157 hypothetical transaction a
cash by the partnership of all of its assets for FMV immediately
after the transfer of the partnership interest
• Partner’s share of previously taxed capital is equal to the
sum of
• 1. The amount of cash the partner would receive on
liquidation following the hypothetical transaction,
plus
• 2. The amount of any taxable loss allocated to the
partner from the hypothetical transaction, less
• 3. The amount of any taxable gain allocated to the
partner as a result of the hypothetical transaction
• 2. Her share of liabilities
• *In most cases a partner’s share of previously taxed capital is simply the
balance in her tax capital account
• Allocating the §743(b) adjustment among the partnership’s assets
• The rules for allocating the §743(b) adjustment among the partnership’s assets are
found in §755 and the regulations thereunder
• Step One. Divide the adjustment between two classes of assets
• Ordinary income property
• Capital gain property
• Step Two. Allocate the §743(b) adjustment among the assets in each class
• Use the same ‘hypothetical transaction’ first for calculating the
seller’s ordinary income under §751(a) and later for purposes of
calculating the buyer’s share of previously taxed capital
• Goodwill
• How do we allocate basis adjustment if new partner paid an amount in
excess of seller’s share of total FMV of the assets on the balance sheet
• Likely reason goodwill/going concern value
• Application utilize the “residual method” if purchase price exceeds . . .
• Effect of the Adjustment
• Having calculated the adjustment and allocated it among the various partnership
assets, question remains of what to do with it
• The adjustment is not reflected in capital accounts, nor does it enter into
the common basis of the partnership’s assets
• The partnership making the adjustment will compute its taxable income,
gain, loss and deduction without regard to the adjustment and then allocate
those amounts among all of the partners under the principles of §704(b)
• ***Now the adjustment comes into play
• Partnership will adjust the transferee partner’s distributive share of
income, gain, loss and deduction to reflect the adjustment
• If the partnership has sold an asset with respect to which a partner has a
special basis adjustment, the amount of that adjustment will reduce (or
increase, if the adjustment is negative) the transferee partner’s distributive
share of the gain or loss from the sale of the asset
• Related Matters - §§706(c) and (d)
• Shifts in partnership interest can be created by a variety of transactions, including the
withdrawal of an old partner, the admission of a new one, or the sale of all or a portion of
an interest in the partnership
• Under §706(c) the shift in interest may close the partnership’s taxable year with
respect to one or more partners
• Under §706(d) the partnership must allocate its income, gain and loss for the year
of change to take into account the varying interests of the partners
• Closing a Partnership’s Taxable Year
• §706(a) a partner must take into account items of partnership income, etc. for any
partnership taxable year ending within or with the taxable year of the partner
• If the partnership year was to close early, that could shift the partner’s share of
income for that year into an earlier year of the partner
• §706(c)(2) Two circumstances when the partnership’s year will close
prematurely (other than liquidation)
• 1. In the event of a partnership ‘termination’ as defined under §708(b)(1)
• A termination will occur if the partnership ceases to do business, or
if within a 12 month period there is a sale/exchange of 50%+ of the
total interests in partnership capital and profits
• 2. Sale/exchange/liquidation of a partner’s entire interest in the
partnership, or the death of a partner. In that event, the partnership’s year
will close SOLELY with respect to the terminated partner, who will be
required to include her share of income for the year in their current taxable
year. Transfer or liquidation of less than a partner’s entire interest does
NOT trigger a premature closing of the partnership’s taxable year unless,
of course, the transfer would otherwise trigger a termination under §708
• Allocation of Income for the Year of Change
• §706(d)(1) enacted during the tax shelter heyday
• Partnerships would admit a limited partner at the end of the partnership’s
taxable year, and allocate to the new partner a full year’s share of the
venture’s deductions and losses
• In order to avoid this, now if one or more partners’ interest in a partnership
varies during a year, either because of a sale or liquidation of a partner’s
interest, the death of a partner, or any other transaction having that effect,
the partnership must take into account these variations in determining its
partners’ shares of partnership items for the year
• Proposed Regulations
• Two methods for accomplishing this result
• Both methods divide the year into segments representing periods
of time during which the partners’ interests in the partnership
remain constant when a variation in interest occurs that segment
ends
• For any given taxable year, the partnership can only use
one method, and whichever chosen, must be used
consistently by all partners and the partnership
• Interim closing method (default)
• Two ways to determine the end of a segment
• Calendar day convention
• A segment would end on the actual date that
the partner’s interest changes
• Semi-monthly convention
• The date the segment ends is basically
rounded back to the last day of the prior
month or the 15th day of the current month
• Proration method
• Calendar day convention required
• The partnership simply waits until the end of the taxable
year and prorates its annual income on a daily basis
between or among the segments
• Exceptions excusing the partnership from the cumbersome bookkeeping
• Permissible changes among contemporary partners
• Existing partners may reallocate items among themselves during
the course of a year as long as the allocations would otherwise be
respected
• Service partnerships
• Allowed to take into account varying interests using any
reasonable method provided that the partnership’s allocations are
respected under §704(b)
• Publicly traded partnerships
• Chapter 11. Distributions: The Basics
• Overview
• §§731-737 provide the general rules for partnership distributions
• Just like with contributions, the rules reflect the Congressional policy of deferring
recognition of gain/loss by partners and partnerships whenever possible
maximum nonrecognition
• General rule neither partner nor partnership recognize gain/loss on a distribution of cash
or property
• Only when deferral is impracticable or when it would result in a change of
character that gain/loss is recognized upon a distribution
• Current distribution one made to a partner whose interest in the partnership continues
after the distribution, although perhaps at a reduced share
• Liquidating distribution one or more distributions that terminate a partner’s interest
• Although the rules are not different to apply, they can create disparities between inside
and outside basis
• To reduce or eliminate these disparities, §734(b) provides a basis adjustment for
those partnerships with a §754 election in effect
• Preliminary Issues
• §§ 706(c) and (d)
• Just like a sale of a partnership interest may close a taxable year of the
partnerships with respect to the selling partner and require the partnership to take
into account the varying interests of the partners for the year of sale, the same
rules generally apply to any distribution that has the effect of changing the relative
interests of the partners
• Capital Accounting Rules
• Whenever property is distributed by a partnership, the partnership MUST
recognize any gain or loss inherent in the distributed property for book, but not
tax, purposes
• Accomplished by
• Adjusting all partners’ capital accounts to reflect the way in which the
partners have agreed to share in the inherent book gain or loss in the
distributed property
• The balance of the distributee’s capital account must be reduced by the net
FMV of the distributed property
• A partial or complete liquidation of a partner’s interest is one of the circumstances
in which the capital accounting rules permit the partnership to revalue all of its
assets and restate capital accounts to reflect that revaluation
• Character and Holding Period of Distributed Property
• §735(a) provides special rules regarding the character of certain types of
distributed property
• Functions similarly to §724 which guides the contribution of property
• Principal purpose prevent conversion of partnership ordinary income into
partner capital gain simply by distributing property to a partner
• According to §735(a), a distributee partner will realize ordinary income if she
sells or exchanges certain property previously distributed to her by a partnership
• 1. Previously distributed inventory items which are sold or exchanged
within 5 years of the distribution
• In effect, treat the transferee as succeeding, for 5 years, to the
transferor’s purpose in holding primarily for sale to customers in
the ordinary course, regardless of the transferee’s actual purpose in
holding the property
• 2. Unrealized receivables, regardless of when they are sold
• §735(b) provides that when property is distributed by a partnership, the
distributee’s holding period in the property includes the period during which the
partnership held the property
• The tacking ensures that long term capital gain property distributed by a
partnership retains its character
• Doesn’t apply for purposes of the 5-year rule of inventory items
• Basis of Partnership’s Undistributed Property
• §734(a) provides that unless §754 election is in effect or there is a ‘substantial
basis reduction’* the partnership’s basis in its property is unaffected by a
distribution
• Substantial basis reduction is defined as one that would require the
partnership to reduce the basis it has in its property by more than $250k
• If §754 election is in effect or there is a substantial basis reduction, the basis of
partnership property must be adjusted (in the manner prescribed in §755) by the
amount determined under §754(b)
• Recognition of Gain or Loss
• Unless the distribution is recharacterized, the partnership never recognizes gain or loss,
and the distributee partner will recognize gain only under very narrow circumstances
• In the case of cash distributions, the distributee simply reduces their outside basis
by the amount of money received, preserving any inherent gain/loss in her
partnership interest
• In the case of property distribution, the distributee’s outside basis is allocated
among both the properties received and her continuing interest in the partnership
(if any)
• Any predistribution inherent gain/loss in the distributee’s partnership
interest is preserved either in the property received or in her continuing
interest in the partnership
• Only when deferral is impracticable or would change the character of income/loss must
gain/loss be characterized
• Generally treated as though it arose from the sale or exchange of the partnership
interest, i.e. capital gain/loss
• Recognition of gain
• Distributions trigger gain to the distributee only under one circumstance if a
partner receives a distribution of money in excess of her outside basis, §731(a)(1)
requires that partner to recognize that excess as a gain
• *Whether in a current or liquidating distribution
• A reduction in a partner’s share of partnership liabilities is treated as
distribution of $
• When a partnership distributes property to a partner, the inherent gain/loss in the
partner’s interest can be preserved by adjusting the basis of the distributed
property
• §731(c) contains a special rule applicable to distributions of marketable securities
by partnerships, other than investment partnerships
• The marketable securities are treated as cash to the extent of their fair
market value, reduced by the distributee’s share of net appreciation in
those securities
• The basis of the securities in the hands of the distributee is the bases
determined under the normal rules §732 plus any gain recognized by the
distribuee
• Both the distributee’s outside basis and the partnership’s basis in its
remaining assets are determined as if no gain were recognized
• Recognition of loss
• A partner recognizes a loss ONLY in a liquidating distribution and then only
under narrow circumstances a loss is never recognized in a current (non-
liquidating) distribution
• When liquidating distribution consists of only cash, unrealized receivables, and
inventory, if the distributee’s outside basis exceeds the sum of money distributed
plus the partnership’s basis in the distributed property, she must recognize a
capital loss
• Necessary because the partner receives no capital asset in which to defer
the loss
• The basis of the cash received cannot be adjusted to defer the loss, and
adjusting the basis of the ordinary income assets to postpone the loss until
they are sold will result in conversion of the capital loss inherent in the
partnership interest into an ordinary loss
• Basis of Distributed Property
• §§732 and 733 work in tandem to determine both the basis of the distributed property in
the hands of the distributee as well as the appropriate adjustments to her outside basis
• §732 provides different rules depending on whether the distribution is a current or
a liquidating distribution
• Current Distributions (nonliquidating)
• Procedure/Mechanism
• 1. Begin with the distributee’s outside basis and reduce that amount by any
distributed, including liability relief, to determine her “reduced outside
basis”.
• If the distributee receives cash in excess of her outside basis, she
will recognize gain in the amount of that excess
• Otherwise, no gain/loss will be recognized by either the
partnership or the distributee
• 2. As long as the distributee’s ROB equals or exceeds the partnership’s
basis in the distributed property, she simply takes a transferred basis in
that property
• The balance of the ROB, if any, becomes her continuing outside
basis
• 3. If the distributee’s ROB is insufficient to give her a transferred basis in
the distributed property, then the distributee must divide her ROB among
the distributed property under the rules of §752(c). The distributee’s
continuing outside basis will be zero
• See examples on pages 176-178
• Liquidating Distributions
• The rules have to be different than they for current contributions because the
distributee is closing out her investment in the partnership she will not have a
continuing basis after the distribution
• The goal allocate the distributee’s reduced outside basis among the distributed
properties
• Procedure/Mechanism
• 1. Assign to each asset distributed a basis equal to that which the
partnership had in the asset
• Since the sum of these bases will invariably be more or less than
the distributee’s reduced outside basis, the bases must be adjusted
• Congress enacted special rules under §732(c) in order for the
adjustments to in the aggregate be equal to the distributee’s
reduced outside basis
• Allocation of outside basis among distributed properties
• The reduced outside basis is first allocated to any distributed §751(a)
property (i.e. unrealized receivables, inventory) in an amount equal to (but
not more than) the partnership’s bases in these assets
• The remaining balance, if any, is then allocated among all other
contributed properties
• Section 751(a) property
• In most cases the distributee simply takes a transferred basis in the
property (i.e. the basis the partnership had in the distributed
property)
• Except when the distributee’s reduced outside basis is less
than the sum of bases of the distributed §751(a) property
• In that case it is necessary to reduce the bases the
distributee would otherwise take so that the sum
equals the distributee’s reduced outside
• ***The transferred basis in §751(a) property will NEVER
be increased if the distributee’s reduced outside basis is
greater than the transferred basis the excess will either be
• Allocated to other property received, or
• Treated as a capital loss under the rules of §731(a)
(2)
• Other property
• 1. Distributee takes a transferred basis in the other property
• However, the distributee’s remaining reduced outside basis
(after reduction for any §751(a) property distributed in the
same transaction) will be more or less than the sum of the
partnership’s bases in the distributed properties
• If the remaining balance is less than the sum decrease the
basis of the distributed property by that amount
• If the remaining balance exceeds the sum increase the
basis of the distributed property by that amount
• 2(a) Decrease Problem 45
• Can occur in the context of a current or a liquidating
distribution and can apply to §751(a) property or to other
property
• Decrease is first allocated (proportionately) to those
properties that have unrealized depreciation*
• Used first to reduce or eliminate any inherent losses
that may be present
• *Depreciation is solely referring to loss in value,
not cost recovery
• If a further decrease is required, then, it is allocated among
all properties in proportion to their respective bases
(after reduction for any unrealized depreciation)
• See example #6 on page 180
• 2(b) Increase
• Can only occur in the context of a liquidating distribution
and then only in the case where
• The distributee receives at least one item of other
property AND her reduced outside basis is greater
than the sum of the transferred bases of the
distributed properties
• Only the basis of other property can be increased
• The basis in §751(a) is never increased,
because if the distributee receives cash and/
or §751(a) property and still has
unrecovered basis, she will recognize a loss
under §731(a)
• Increase is first allocated (proportionately) to those
properties that have unrealized appreciation
• Used first to reduce or eliminate any inherent gain
that may be present
• If a further increase is required, then it is allocated
among all other property in proportion to their
fair market values
• Procedure/Mechanism for analyzing a liquidating distribution
• Step 1. As with current distribution, begin with the distributee’s outside
basis, and reduce that amount by any cash distributed, including liability
relief, to determine her reduced outside basis.
• If the distributee receives cash in excess of her outside basis, she
will recognize gain in the amount of the excess
• If not, then the distributee must allocate her ROB among the
properties she received in the distribution in accordance with
§732(c)
• Step 2. Under §732(c), the ROB is first allocated to any §751(a) property
distributed in an amount equal to the partnership’s basis in that property.
• The balance must be allocated to other property.
• If there is a balance and the partner received no other property,
then she recognizes a capital loss in the amount of her balance.
• Step 3. If the partner receives other property in the distribution, then the
remaining ROB must be divided among those assets.
• As a starting point, these assets are assigned a transferred basis,
which is then adjusted under §732(c)(2) & (3) so that in the
aggregate their bases will equal the partner’s remaining ROB.
• See examples on pages 183-184
• Special Rule under §732(d)
• A purchasing partner’s §743(b) special basis adjustments are taken into account in
determining the basis of property distributed to her
• If partnership does not make §754 election purchaser of a partnership
interest is not entitled to a special basis adjustment in the partnership’s
assets
• May result in an unintended windfall or hardship to a partner who
receives property distribution after purchasing her partnership
interest
• §732(d) special rules
• Rule #1. If a partner acquired her interest by transfer (i.e. by purchase or
by reason of the death of a partner) during the two years prior to a
distribution, that partner may elect to be treated as if there had been a §754
election in place at the time of transfer
• Rule #2. No matter when the distribution occurs, and even if the
purchasing partner makes no §732(d) election, under certain
circumstances the regulations make the application of §732(d) mandatory
• Intended to prevent the shifting of basis from nondepreciable to
depreciable assets
• §732(d) enables the partner to step-up their basis in the distributed property, even
though the partnership, for whatever reasons, is unwilling to make a §754 election
• Partnership Termination
• §708(b) provides that a partnership will terminate if it ceases to do business, or if there is
a sale or exchange of 50%+ of the total interests in partnership capital and profits within a
12 month period
• In 1997 Treasury amended the regulations under §708 to minimize the tax consequences
of a termination
• Currently
• If a partnership terminates by reason of a sale or exchange of a partnership
interest, the partnership is deemed to contribute all of its assets and liabilities to a
new partnership in exchange for an interest in the new partnership
• The terminated partnership then makes a liquidating distribution of partnership
interests in the new partnership to its partners in proportion to their respective
interests
• To eliminate as many of the tax consequences of terminations as possible, following rules
• Rule #1. The capital accounts of the terminated partnership carryover to the new
partnership; the purchasing partner assumes the capital accounts of the selling
partner
• Rule #2. No §704(c) property will be created by the termination. The only
§704(c) property of the new partnership will be that held by the terminated
partnership
• Rule #3. If the terminated partnership had a §754 election in effect for the year of
termination, this election applies to the new partnership. Therefore, the purchaser
would be entitled to a §743 adjustment
• In the end the main tax consequences of a termination is the closing of the
taxable year
• Chapter 12. Optional Basis Adjustment - §734(b)
CLASSIFICATION
Partnerships & LLCs: unlike corporations, not federal taxpaying entities. Gains and
losses flow through to partners. Losses can be used as flowing through as deductions as
against other items of income. Capital losses of partnership flow through to returns of
partners. These losses retain their character as capital losses. Unused losses in current
year can be carried forward indefinitely.
Limitations: (a) 465: a taxpayer can use a loss from an activity to offset or
shelter other unrelated income only to the extent that the TP was economically at risk in
the losing activity. Generally, not considered to be at risk w.r.t. nonrecourse debt,
because no economic exposure to pay back debt. (b) 469: “passive activity” loss rules.
We'll see this later.
S Corporation § 1361
Single taxation scenario.
Business losses can flow through by S Corp to its SHs for use by SHs on their own
individual returns subject to 465 and 469
S Corps are limited to corporations that have 100 or fewer Shs
each SH has to be an individual who is either (a) a US Citizen or (b) a US Resident
all SHs will share all gains, losses, deductions, etc. based on % of outstanding stock
owned
Distribution of appreciated property by S Corp to SHs subject to gain recognition rule
discussed earlier. While S nontaxable corp, will flow through to SHs.
General Rules: Check-the-Box System Reg. 1.7701-3 ?????

→ this is response to gov't attacking status of unincorporated business and arguing that
since it functions so similarly to a corporation it should be taxed as a corporation
Separate Entities
General Rule: A noncorporate business entity (an “eligible entity”) with at least two (2)
members is classified as a partnership unless an election is made for the entity to be
classified as an association
If an organization recognized as a separate entity for federal tax purposes is not a trust, it
is a “business entity” under the regulations
Certain business entities are automatically classified as corporations
Single-Owner Organizations
A single-owner entity is disregarded for tax purposes and treated as an extension of its
owner (i.e. sole proprietorship) unless the entity elects to be classified as an association
and thus taxed as a C corporation
includes single owner LLCs
Publicly Traded Partnerships § 7704
Classification
Corporations
Definition
Any partnership whose interests are
Traded on an established securities market, or
Readily tradable on a secondary market (or its substantial equivalent
An interest is “readily tradable” if taking into account all of the facts and circumstances,
the partners are readily able to buy, sell, or exchange their partnership interests in a
manner that is comparable, economically, to trading on an established securities market
Exception
Provided for partnerships if 90 percent or more of their gross income consists of certain
passive-type income items (e.g., interest, dividends, real property rents, gains from the
sale of real property and income and gains from certain natural resources activities)
FORMATION OF A PARTNERSHIP
Background: Tax consequences of contributions of cash and property to a partnership in

return for an ownership interest. Also tax consequences for owners who contribute
services to the business in return for an ownership interest in the partnership.
In problems, we want to keep track of not only tax consequences but also book/financial
consequences resulting from the contributions made to the business. To do this, we
create a financial statement for the business that keeps track of both tax and financial
consequences. Partnership’s book value will reflect assets at their FMV @ time of
contribution. Partners' individual book capital accounts represent their financial
interests in the business, and equal FMV of what partner contributed to business (i.e.
economic-financial interest; tells us what partner would get if business were to liquidate
and sell off all of its assets for their book values and pay off all of the businesses'
liabilities).
Contributions of Property
→ rules do NOT apply to contributions of services
Nonrecognition
Section 721(a) provides that not gain or loss shall be recognized to a partnership or to any
of its partners on a contribution of property to the partnership in exchange for an interest
in the partnership
EXCEPTION: Section 721(b) provides for recognition of gain when a partner
contributes property to a partnership which would be treated as an “investment
company” (within the meaning of Section 351) if the partnership were incorporated
Investment company - a partnership form of a mutual fund where the contributor is
seeking diversification of its investments AND more than 80% of the business assets are
in marketable securities.
Property
The term is broadly defined to embrace money, goodwill, and even intangible service-
flavored assets such as accounts receivable, patents, unpatented technical know-how and
favorable loan or lease commitments embodied in a letter of intent secured through the
efforts of the contributing partner.
Does not include services rendered to the partnership and a partner who receives a
partnership interest in exchange for services generally realizes ordinary income under
Section 61.
Control
Section 721 does not require the transferors of property to be in “control” of the
partnership immediately after the exchange
Noncompensatory Option
A noncompensatory option includes a call option or warrant to acquire a partnership
interest, the conversion feature in a partnership debt instrument, and the conversion
feature in a preferred equity interest in a partnership
Under the regulations, Section 721 does not apply to the transfer of property to a
partnership in exchange for a noncompensatory option, but it does apply to the exercise
of that option
Generally, an individual holding a noncompensatory option to acquire a partnership
interest is not treated as a partner for purposes of allocating partnership income but if the
option provides the holder with rights substantially similar to the rights afforded a
partner, then the option holder is treated as a partner in allocating income
Basis and other Tax Attributes
Property Contributed to the Partnership (Inside Basis)
Section 723 provides that the partner’s basis in the contributed property = adjusted basis
that contributor had in that property (i.e. carryover)
Section 1223(2) provides that the partner’s holding period in the property carries over to
the partnership
Section 724 provides that, in certain situations, the partnership will recognize the same
character of gain or loss that the contributing partner would have recognized on a sale of
the property
Section 704(c)(1) generally prevents the precontribution gain or loss from being shifted
to the other partners by requiring the partnership to allocated that gain or loss solely to
the contributing partner when it subsequently disposes of the property or distributes it to
another partner
depreciable property
note: §168(i)(7): partnership inherits whatever depreciation method contributing partner
was using and continue to use of whatever is left of contributing partner’s recovery
period.
Unrealized receivables
haven't taken it into income yet; no income upon immediate contribution (outside &
inside basis of 0)
when collected, for book purposes, cash increases; tax wise, 100 income to pship; no
change to book cap accts of partners b/c aggregate value of assets remained unchanged b/
c collected cash and got rid of receivables
724(a): contributed receivable (ordinary asset in partner's hands) retains character as
ordinary property when in partnership's hands; contribution of unrealized receivables will
cause the partnership to realize ordinary income upon a later disposition of that
receivable
inventory assets
ordinary asset and will retain its status as ordinary asset to the partnership for the first 5
years.
Partnership Interest Received by Partner (Outside Basis)
Basis
Section 722 provides that a partner’s basis in his partnership interest = the sum of the
cash and adjusted basis of any property contributed to the partnership
Holding Period
significant sometimes; might need to determine whether LT or ST cap asset; this becomes
significant if/when partner sells partnership interest (§741 generally treats resulting gain
from sale of partnership as though it arose from sale of a capital asset)
The partner’s holding period in the partnership interest is determined by Section 1223(1),
which permits the partner to tack his holding period for the contributed property if that
property was a capital or Section 1231 asset.
Recall: 1231 property is real property and depreciable property that had been used in A’s
business and held for more than one year
To the extent the contributed property consists of cash or ordinary income assets, the
holding period begins on the date of the exchange.
For this purpose, recapture gain (e.g., under Section 1245) is treated as a separate asset
which is not a capital or Section 1231 asset
If the partner contributes a mix of assets, the holding period in the partnership interest is
fragmented in proportion to the fair market value of the portion of the interest received
for the property to which the holding period relates, divided by the fair market value of
the entire interest.
Ex: A contributes 10 cash and 90 land (fmv). 90% of A’s partnership interest would
include A’s holding period for the land. But A’s holding period for other 10% starts fresh.
So, assume A sold his partnership interest 9 months after acquiring the partnership
interest. Then 90% of the interest would be considered long term capital asset, then 10%
short term. If he sold it after 16 months, then since he held all of it for more than 1 year,
all of it is a long term capital asset.
Depreciation Recapture
Recall 1245(a) says if section 1245 property is disposed of: ordinary income = lesser of
(B’s recomputed basis OR B’s amount realized) minus adjusted basis.
Recomputed basis = adjusted basis @ disposition + all depreciation deductions taken
1245(b)(3) says that in a section 721 transaction, the partner only has to report the
recapture income to the extent that the partner had to recognize gain in this transaction
apart from section 1245
Operation of the Rules – Revenue Ruling 99-5
A is single owner of LLC, which is disregarded as an entity separate from its owner
Situation 1
Facts
B purchases 50% of A’s ownership interest in the LLC for $5,000.
A does not contribute any portion of the $5,000 to the LLC
A and B continue to operate the business of the LLC as co-owners of the LLC
Application
The LLC is converted to a partnership when the new member, B, purchases an interest in
the disregarded entity from A
B’s purchase of 50% of A’s ownership interest in the LLC is treated as the purchase of a
50% interest in each of the LLC’s assets, which are treated as held directly by A
Immediately thereafter, A and B are treated as contributing their respective interests in
those assets to a partnership in exchange for ownership interests in the partnership
so, when A sells interest, A is treated as having sold 50% stake interest in each asset to B;
this is a taxable sale of assets
A would have to recognize gain or loss on sale under §1001 and B at least initially
viewed as owner of 50% of each asset, and would take a cost basis of 5k, representing
50% of each asset. After accounting for sale, we value A & B each contributing 50%
interest of each asset to a new partnership in return for a 50% partnership interest. This
contribution governed by 721-23
Situation 2
Facts
B contributes $10,000 to the LLC in exchange for a 50% ownership interest in the LLC
The LLC uses all of the contributed cash in its business
A and B continue to operate the business of the LLC as co-owners of the LLC
Application
The LLC is converted from an entity that is disregarded as an entity separate from its
owner to a partnership when a new member, B, contributes cash to the LLC
B’s contribution is treated as a contribution to a partnership in exchange for an ownership
interest in the partnership
B takes basis under 722 of 10k
A is treated as contributing all of the assets of the LLC to the partnership in exchange for
a partnership interest
A takes basis to whatever basis old LLC had
new pship's basis in assets contributed straight up carryover (723)
bottom line: no immediate gain recognition
Treatment of Liabilities
Impact of Liabilities on Partner’s Outside Basis
General Rule
Section 752(a) treats any increase in a partner’s share of partnership liabilities as if it
were a cash contribution by the partner to the partnership, increasing the partner’s outside
basis under Section 722.
Section 752(b) treats any decrease in a partner’s share of liabilities, including the
partnership’s assumption of a partner’s liability, as if it were a cash distribution to the
partner, decreasing his outside basis under 705(a) and 733.
Note: Suppose partner contributes encumbered property to partnership. As a result, other
partners will get an outside basis increase to the extent of their respective dollar share of
the new partnership liability. At the same time, contributing partner generally having his
share of the debt reduced b/c of the contribution. B4 contribution, partner was 100%
responsible for debt, but after contribution, partner is sharing responsibility of debt w/
other partners. One way to look at it is net benefit for contributing partner is constructive
cash distribution to that partner under §752(b). What happens is two-fold: constructive
cash distribution reduces that partner’s outside basis under §733 and then there’s the
possibility that to extent partner received a benefit that exceeded what otherwise his
outside, that benefit beyond his outside basis can produce immediate gain recognition by
that partner under § 731. §731(a) creates gain recognition to a partner upon cash
distribution only to the extent it exceeds partner’s outside basis in his partnership interest.
In effect, when a partner contributes encumbered property, three things happen
simultaneously: (1) partner gets §722 basis derived from basis he had from contributed
asset; (2) partner increases his outside basis by his “share” of what is now the
partnership’s liability (§752(a)); and (3) §752(b) effect in that partner will have to reduce
outside basis by total debt that partnership is taking off his hands.
Scope of “Liability”
For purposes of Section 752, liabilities that would be deductible when paid (e.g.,
accounts payable of a cash basis taxpayer) are disregarded
Section 752(c) provides that a liability to which property is subject shall be treated as a
liability of the owner, at least to the extent of the fair market value of the property
Share of Partnership Liability
A partner’s share of partnership liabilities for purposes of Section 752 generally depends
on the status of the partner (general or limited) and nature of the liability (recourse or
nonrecourse)
Nature of Liability
Recourse
A partnership liability is a recourse liability to the extent that any partner bears the
economic risk of loss for the liability
Nonrecourse
If no partner bears the economic risk of loss, the liability is classified as nonrecourse
A partner’s share of recourse liabilities equals the portion of the liability for which the
partner bears the economic risk of loss
A partner bears the economic risk of loss to the extent that the partner (or a person related
to the partner) would be required to pay the liability if the partnership were unable to do
so
This determination is made by asking who would be obliged to pay the liability if all the
partnership’s liabilities are payable in full and all of the partnership’s assets, including
cash, are worthless
basically decrease capital accounts of partners by amount of assets divided up and see if
there is a negative balance in individual accounts; if so, and obligated to pay (i.e. general
partner), that amount required to pay off liability is their share in the partnership's
liability (these are hypothetical losses). This is the amount partner's outside basis
increases when pship takes on a liability.
453B Installment obligations
Context: selling property before contributing to business, at a gain under circumstances
were sale proceeds were to be received from buyer in a later taxable year; can defer
recognition until payments received
§453B says when you dispose an installment obligation of a buyer’s, at that point, gain
has to be recognized.; reg says 721 (nonrecognition) trumps 453B
Contributions of Encumbered Property
In General
The regulations under Section 722, incorporating the approach taken by Section 752,
recharacterize such a contribution as a cash transaction
To the extent that a contributing partner is relieved of a liability, he is treated as having
received a distribution of cash from the partnership
A deemed distribution of money resulting from a decrease in a partner’s share of the
liabilities of a partnership is treated as an advance or drawing of money to the extent of
the partner’s distributive share of income for the partnership’s taxable year. An amount
treated as an advance or drawing of money is taken into account at the end of the
partnership taxable year.
Under Sections 731 and 733, a distribution of cash is considered a return of capital,
which reduce the partner’s outside basis (but not below zero) by the amount of the
distribution
If the amount of the liability exceeds the basis of the property contributed, Section 731(a)
treats the excess of the constructive cash distribution over the outside basis as gain from
the sale or exchange of the newly acquired partnership interest, which is treated as capital
gain under Section 741.
The portion of debt from which the contributing partner is relieved is then allocated to the
other partners, who are considered to have contributed cash to the partnership, and the
outside basis of each is increased accordingly
Nonrecourse Liabilities
The regulations allow the partners to specify their interests in partnership profits for
purposes of allocating nonrecourse liabilities, and those interests will be respected if they
a reasonably consistent with allocations of other significant items of partnership income
or gain that are respected for tax purposes
The section 752 regulations provide that a partner who contributes property encumbered
by nonrecourse debt is first allocated that portion of the liability equaling the gain that
would be allocated to that partner under section 704(c) if the property were sold at the
time of the contribution for an amount equal to the liability
The balance of the liability is allocated under the flexible general rule—that is, in
accordance with the partners’ share of partnership profits
Contributions of Services
Introductory note: not w/in 712 b/c services are not property; instead compensation w/in
gross income
Receipt of a Capital Interest for Services
Capital Interest
An interest in both the future earnings and the underlying assets (i.e., the “capital”) of the
partnership.
A partner who has a capital interest will be entitled to a share of the partnership’s net
assets in the event the partner withdraws or the partnership is liquidated
Consequences to Partner
A service partner who receives a capital interest realizes ordinary income in an amount
equal to the value of the interest less the amount, if any, paid for the interest
Current Reg 1.721-1(b)
if a partner gives up his right to be repaid his contributions of property to pship in favor
of another partner as compensation for services, 721 (nonrecognition) does NOT apply
e.g. D joins existing pship w/ A, B, and C and obtains ¼ interest in return for services; A,
B, C give up ¼ of their capital to D in return for D's services
1.722-1 says D takes a basis in pship interest equal to income D had to recognize upon
receipt (so he's not taxed again)
value of capital interest shifted to service provider is gross income
Proposed Reg 1.721-1(b)
transfer of any partnership interest in return for services is governed by §83 (next bullet
goes into this)
The timing of the income is determined under Section 83
If the interest is received without restrictions
Income is realized upon its receipt
If the interest is transferred subject to substantial restrictions
Section 83(a) provides that its fair market value is included in gross income when the
restrictions lapse.
The amount to be included in income is the excess of the fair market value of the interest
at the time the partner’s rights have vested over the amount, if any, paid for the interest.
A transferee of restricted property is permitted to elect to include the value of the
property in income at the time of its receipt. If the election is made, the transferee may
not take any deduction (except for the amount actually paid) if the property is
subsequently forfeited
valuing the interest (similar stuff in previous two bullets)
partnership can elect that the interest transferred for services would be treated as having
an FMV equal to its liquidation value
Liquidation value is amount of cash service provider would receive if business
immediately liquidated, assets were sold for then FMV and then creditors paid off and
distributed remainder in accordance w/ partnership agreement
83(h) deductions
compensation paid often deductible; see more on allocations later
Consequences to Partnership
Proposed Reg 1.721-1(b)(2)
no gain or loss is recognized by partnership itself on the transfer of a compensatory
Deduction
The partnership may take an ordinary and necessary business deduction, unless the
services were for the formation of the partnership
Gain Potential
The transfer is viewed as a two-step transaction
The transfer of an undivided interest in partnership assets from the partnership to the
service partner, and
The contribution of that interest back to the partnership by the service partner
Receipt of a Profits Interest for Services
Profits Interest
A share of future earnings (including, perhaps, gain on the sale of property) but no
current right to a distribution of a share of the partnership’s capital in the event of a
withdrawal or liquidation
Consequences – Revenue Procdure 93-27
Other than as provided below, if a person receives a profits interest for the provision of
services to or for the benefit of a partnership in a partner capacity or in anticipation of
being a partner, the IRS will NOT treat the receipt of such an interest as a taxable event
for the partner or the partnership; tax consequences deferred until profits actually earned
in future and allocated to partner pursuant to partnership agreement
This does not apply
If the profits interest relates to a substantially certain and predictable stream of income
from partnership assets, such as income from high-quality debt securities or a high-
quality net lease;
If within two years of receipt, the partner disposes of the profits interest; or
If the profits interest is a limited partnership interest in a publicly traded partnership
Disguised Sales
Section 707(a)(2)(B) (& 1.707-3) provides that if (1) a partner transfers money or other
property to a partnership, (2) there is a related transfer by partnership to partner, and (3)
transfers viewed together are properly characterized as a sale, then the two transfers shall
be treated as a sale or exchange of property between the partnership and partner acting in
a nonpartner capacity, or between the two partners acting as outsiders (i.e. it's a sale)
In the case of simultaneous transfers where it is clear that the partnership would not have
made a distribution if the partner had not made a contribution, the transactions are likely
to be viewed as a sale
A transfer will not be treated as the first step in a disguised sale if, based on all the facts
and circumstances, the transferring partner is converting equity in the property into an
interest in partnership capital and the transfer is subject to the entrepreneurial risks of the
enterprise
Transfers within two (2) years of each other are presumed to be a sale while transfers
made more than two years apart are presumed not to be a sale. Both presumptions are
reubuttable.
If the consideration treated as transferred to a partner in a sale is less than the fair market
value of the property transferred to the partnership, the transaction is treated as part sale /
part contribution, and the transferring partner must pro rate his basis in the property
between the sale and contribution portions
If a liability incurred by a partner in anticipation of a transfer is assumed (or taken subject
to) by a partnership, the partnership is treated as transferring consideration to the partner
(as part of the sale) to the extent that responsibility for repayment is shifted to the other
partners. The same two-year presumptions exist for liabilities.
The regulations require disclosure on a prescribed form when a partnership transfers
money or property to a partner within two years of a transfer of property by the partner to
the partnership and the partner has treated the transfer as other than a sale for tax
purposes
PARTNERSHIP ACCOUNTING
General
The partners’ interests in the assets of the partnership, their responsibility for partnership
liabilities, and their respective rights to profits and losses and to operating and liquidating
distributions, are determined by the partnership agreement.
The financial condition of a partnership on formation and each partner’s ownership
interest in the firm are depicted on an opening day balance sheet which lists the
partnership’s assets on the left and the liabilities and partners’ capital on the right side
Under the principle of “Fundamental Equation,” the two sides must always be equal that
is Assets = Liabilities + Net Worth
Terminology
Book Value
On the left side of the balance sheet, partnership assets are recorded at their “book value”
During the life of the partnership, book value is not necessarily the same as fair market
value or basis
It will not change until some event occurs that warrants a revaluation of the partnership’s
assets
Capital Account
Each partner’s interest in partnership assets is reflecting in the partner’s “capital account”
The capital account represents the partner’s equity in the firm
It generally identifies what each partner would be entitled to receive upon liquidation of
his interest in the partnership
A partner’s capital account begins with the amount of money and fair market value of any
property contributed to the partnership by the partner, and is increased by the partner’s
share of profits of the firm and is decreased by the partner’s share of partnership losses
and the amount of cash and the fair market value of any property distributed to the
partner
The Partnership as an Entity

Section 703(a) requires a partnership to determine its own taxable income and provides
rules designed to preserve the character of capital gains, charitable contributions, foreign
taxes and other items that may be subject to special treatment in the hands of the partners
Section 702(b) provides that the character of a partnership item taxed to the partners is to
be determined as if such item were realized directly from the source from which realized
by the partnership, or incurred in the same manner as incurred by the partnership
Section 703(b) provides, with limited exception, that the partnership will select its
accounting method and make various elections affecting the computation of taxable
income
The partnership will have its own taxable year, which may be separate from the taxable
years of some of its partners
Note: Pship could use accrual accounting method notwithstanding fact that
partners use cash. Can pship use cash method? 448 requires certain pships to use
accrual. §448(a)(2): prohibits use of cash method when partnership has a C corporation
as one of its partners. Exception to prohibition in 448(b)(3): permits a “small”
partnership to use cash method even if it has C corporations as partners. Exception
applies if partnerships’ average annual gross receipts over last three years don’t exceed
$5M.
The Taxable Year

Section 706(a) requires a partner to include his share of partnership income, losses and
other items in his tax return for the taxable year in which the partnership’s year ends
Section 706(b)(1)(B) generally requires a partnership to determine its taxable year by
reference to a series of mechanical rules related to the taxable years of its partners unless
the partnership can establish a “business purpose” for using a different taxable year.
Under the mechanical rules
If one or more partners having a majority (greater than 50 percent) interest in partnership
profits and capital have the same taxable year, the partnership must use that year
If partners owning a majority interest in partnership profits and capital do not have the
same taxable year, the partnership must use the same taxable year as all of its “principal
partners” (i.e., those having a 5 percent or more interest in profits or capital)
If nether of these first two rules applies, the regulations require the partnership to use the
taxable year that results in the least aggregate deferral of income to the partners
Alternatively, partnership may use a different year if it can establish a business purpose
Tax Consequences to the Partners

Reporting Requirements
Section 703(a) provides that a partnership computes its “taxable income” in the same
manner as an individual except that certain items described in Section 702(a) must be
separately stated and certain deductions are disallowed
three categories of separately stated items
variable effect items
The most common separately stated items are capital and Section 1231 gains and losses,
tax exempt interest, dividends taxed as net capital gain, charitable contributions, and
foreign taxes. (702(a)(1)-(8))
Recall §1231 says if total §1231 gain exceeded losses, result in capital gain, but if
flipside true, then ordinary loss
special consideration for 1231: suppose partner used it and sold it at a profit but is a
dealer in the equip, i.e. he sells it to customers in the ordinary course of his own business.
This is inventory and does not fall w/in 1231. Ordinary income. 1231 gains treated as
LTCG. Issue: does A’s dealer status affect partnership’s characterization of its gain
resulting from sale of equipment, i.e. is character determined at partnership level, or do
we look through partnership by asking what character of asset would be if held by
individual partner. General rule: characterization generally determined at partnership
level. Reg 1.702-1(b): character determined by status of asset to partnership. So if §1231
to partnership, then §1231 gain to all partners, including dealer in similar types of
equipment.
exception to rule in previous bullet: 724: character of gain or loss on contributed
unrealized receivables, inventory items, and capital loss property. 724(b): if a partner
contributes an inventory item in his or her own hands, and then partnership later sells it,
all resulting gain or loss from disposition is ordinary. 724(a): if partner contributes
unrealized receivables to partnership and it later disposes or collects, retains ordinary
status. Difference between (a) & (b): in (a), retains ordinary status forever, in (b)
contributed status retains ordinary status 5 years following contribution. So if item
contributed had been inventory held for more than 5 years, it will lose its automatic
ordinary status and instead will be instead based on partnership. Still inventory to
partnership or not at that point.
Similar idea in 724(c): applies if a partner contributes capital loss property to
partnership. If partnership uses land in business with basis upon acquisition of 100 for a
period of time and ultimately sells the land for $60, when it sells the land, loss of 40.
724(c) address character. Another 5 year rule: if partnership later sells property at a loss
w/in 5 years of contribution, then loss recognized up to the amount of the “built in” loss
at contribution, continues to be characterized as a capital loss regardless of property’s
status to the partnership. Since built in loss was $40, all of that $40 loss later recognized
treated as a capital loss. After 5 years, land used in partnership’s business, b/c it is a
§1231 loss, and possibly an ordinary loss depending on partner’s other §1231
transactions
§702(a)(5) dividends: different tax rules apply to dividend income depending on whether
an individual or corporation receiving the dividend income. Individual partners taxed on
partner’s dividend income at 15% (i.e. NCG treatment). Corporate partners do NOT get
capital gain tax rate preference. But, corporate recipient of dividend income entitled to a
“dividends received deduction” under §243
specially allocated items
I.e. anything allocated among partners in a way that is different from partnership’s
general allocation method amongst partners
E.g. If in AB partnership, they share everything 50-50, except that all depreciation is
allocable to A, has to be separately stated
(a)(8)
any remaining items of gross income and deductions which are not otherwise separately
stated are just combined into a net income or loss figure that is then allocated among
various partners
ordinary income or loss b/c already separately stated all items that would qualify for
preferential tax treatment.
Any items of partnership income or loss which may have potentially different tax
consequences to the partners, or any other person, are commonly referred to as
“separately stated” or “variable effect” items, and each partner must separately take into
account his or her distributive share of such items. The regulations also require that any
specially allocated items must be separately stated. (this is what was just discussed in last
few bullets)
All remaining partnership items of income or loss are combined into one aggregate
income or loss amount, and each partner reports his or her distributive share of that lump
sum amount ((a)(8) again)
Tax Effect
A partner is taxed on his distributive share of partnership income or loss in his taxable
year in which the partnership’s tax year ends
distributive does NOT mean “distributed”; picks up income whether or not actually
distributed to partner; think of distributive more like “allocable”
Taking into account, distributive share, partner has to separately account for his or her
share of partnership’s items listed in §702(a)(1)–(8)
Basis Adjustment
Section 705(a) provides that a partner’s outside basis is increased by his share of the
partnership’s (1) taxable income, and (2) tax-exempt income, and decreased (but not
below zero) by (1) distributions from the partnership as provided in Section 733, (2) the
partner’s share of partnership loss, and (3) his share of partnership expenditures which
are not deductible in arriving at taxable income and are not properly capitalized.
Advances or draws are treated as current distributions made on the last day of the taxable
year
When making basis calculations at the end of the year, make all the increases first, then
all the decreases except for losses second, then do the losses
731(a) says have to report gain to extent distribution exceeds outside basis immediately
before the distribution
some relief: 1.731-1(a)(1)(ii) says advances or drawing against the partners share of
income will be treated as if they were distributions made on the last day of the pships
taxable year – so if in fact this is an advance or draw agains this partners income for the
year, then we treat it as a distribution made on the last day of the year
One of the treatise writers (McKee) – says that this regulation is prob limited only to
situations where t he partner getting the advance against income agrees to return the
distribution to the pship to the extent that the distribution turns out to exceed what turns
out to be her share of pship income for the year.
we increase the outside basis when reporting income and having tax-exempt so when he
won't get taxed when he disposes his partnership interest
PARTNERSHIP ALLOCATIONS
SPECIAL ALLOCATIONS
In General
Section 704(a) provides that a partner’s “distributive share” of income, gain, loss,
deduction or other tax items shall be determined by the partnership agreement
This permits partners to make “special allocations,” which are allocations that differ from
the partner’s respective interests in partnership capital
If there is no allocation agreement Section 704(b) provides that distributive shares are
determined for tax purposes in accordance with the partner’s interest in the partnership,
taking into account all facts and circumstances
The Section 704(b) Regulations: Basic Rules

In general: book capital accounts are financial measuring rods that keep track of each
partners equity interest in the business
book capital accounts measure the book value of the partners equity intrest in the
business
they are not measuring rod for fmv bc typically they do not include the unrealized
appreciation that assets may have had while held by the pship
The balance in these accts tell us what a partner would receive if the pship sold all its
assets for their book value, took the resulting cash from that sale …paid of the pships
creditors and then distributed whatever cash remained to the partners in a liquidating
distribution for the business
Maintenance of Partners’ Capital Accounts
Capital accounts are considered properly determined and maintained only if each
partner’s capital account is increased by:
(1) the amount of money contributed to the partnership by the partner;
(2) the fair market value of property contributed by the partner to the partnership (net of
liabilities securing the property that the partnership is considered to assume or take
subject to under Section 752); and
(3) allocations to the partner of partnership income and gain, including tax-exempt
income;
(4) liabilities assumed that partnership previously was responsible for
requirements:
1. The partner must be personally and ultimately liable for the debt, 2. the lender must be
aware of the partners assumption of liability and 3.the lender has to have a right to go
directly against the assuming partner for collection of the debt
And is decreased by
(1) the amount of money distributed to the partner by the partnership;
(2) the fair market value of property distributed to the partner by the partnership (net of
liabilities secured by the property that the partner is considered to assume or take subject
to under Section 752);
(3) allocations to the partner of partnership expenditures that are neither deductible in
computing taxable income nor properly chargeable to capital account, including Section
705(a)(2)(B) items (e.g., gambling losses, bribes, charitable contributions), Section 709
organizational and syndication expenses that are not amortized under Section 709(b) and
losses disallowed under Section 267(a)(1); and
(4) allocations of partnership loss and deduction (excluding the items listed in (3) above).
Note: just b/c can't use portion of loss for tax purposes doesn't necessarily mean you
don't decrease for book purposes
The regulations provide that a fair market value reasonably agreed to among the partners
in arm’s length negotiations will control if the partners have sufficiently adverse interests
The regulations also allow partnerships to restate assets at their current fair market value
on certain occasions if the partnership provides
Substantial Economic Effect: Brief Overview
how do we properly distribute partners' shares of income and loss? 704(a) sas partners
can allocate pship items among themselves for tax purposes in whatever proportion they
agree to (e.g. via partnership agreement). BUT, 704(b)(2) says that agreed upon
allocations must have “substantial economic effect” to be respected for tax purposes. In a
nutshell, it means that to the extent possible, the tax consequences amongst the partners
should track whats happening economically amongst the partners (***tax should mirror
book***).
If they don't have substantial economic effect, statute and regs may alter allocations so
that allocations will be based on “partners' interest in the partnership” under 704(b)
test allocations at the end of each pship taxable year
The three (3) ways for allocation to be respected 1.704-1(b)(1)
Substantial Economic Effect safe harbor (b)(2)
Economic Effect + Substantiality
Allocation consistent w/ partners' interest in partnership (b)(3)
test allocation by seeing whether it mirrors the differences in the partner’s rights on a
hypothetical liquidation of the partnership at the start of the year being examined and the
end of the year. These liquidation rights are determined by assuming the partnership will
be selling its assets at the end of yr for book value (i.e. NOT FMV).
Allocation consistent w/ special rules in (b)(4) or some parts of 1.704-2
If allocation doesn't fall into one of three methods, items reallocated so that allocation
will be consistent with each partners interest in the pship
Economic Effect
Basic Test
An allocation will have economic effect if, and only if, throughout the life of the
partnership, the partnership agreement provides that:
(1) Capital accounts must be determined and maintained in accordance with the rules of
Section 1.704-1(b)(2)(iv) of the regulations;
(2) Upon a liquidation of the partnership, or of any partner’s interest, liquidating
distributions must be made in accordance with the positive capital account balances of
the partners; AND
(3) If a partner has a deficit balance in his capital account following the liquidation of his
interest in the partnership, he must be unconditionally obligated to restore the deficit
(negative balance back to 0), if any, by the later of: (a) the end of the taxable year of the
liquidation of the partner’s interest, or (b) 90 days after the date of the liquidation.
Ultimately an unlimited AND unconditional obligation to restore deficits in the future
Alternate Test
Basic Rules
If the first two requirements of the Basic Test are met, an allocation will have economic
effect to the extent that it does not create or increase a deficit in the partner’s capital
account (in excess of any limited deficit restoration obligation that the partner may have)
and the agreement includes a provision known as a “qualified income offset.”
Limited Deficit Restoration Obligation
A partner will be treated as obligated to restore a deficit to the extent of (1) the
outstanding principal balance of any promissory note contributed by the partner to the
partnership and (2) the amount of any unconditional obligation (whether imposed by the
partnership agreement or local law) of the partner to make subsequent contributions to
the partnership
Qualified Income Offset
Provision in the partnership agreement stating that any partner who has a deficit capital
account as a result of unexpectedly receiving a distribution (or the other specialized
adjustments listed in the regulations) must be allocated items of future income or gain in
an amount and manner sufficient to eliminate any remaining deficit balance as quickly as
possible
Special Rules
The regulations provide that, for purposes of the alternate test, the partners must reduce
their capital accounts by distributions that are reasonably expected (to the extent those
distributions exceed reasonably expected offsetting increases, other than recognized
gains) as of the end of the partnership year in which the loss allocation was made
Economic Effect Equivalence 1.703-1(b)(3)
Under this final fallback, allocations are deemed to have economic effect if the
partnership agreement ensures that a liquidation of the partnership as of the end of each
partnership taxable year will produce the same economic results as if the Basic Test were
satisified.
“facts and circumstances” analysis
Substantiality
In General (3 ways)
The economic effect of an allocation is considered to be substantial if there is a
reasonable possibility that the allocation will affect substantially the dollar amounts to be
received by the partners from the partnership, independent of tax consequences
This covers first two ways: shifting & transitory (discussed below)
Notwithstanding the above rule, the economic effect of an allocation is not substantial if,
at the time the allocation becomes part of the partnership agreement:
Third way ((b)(2)(iii)(a))
(1) the after-tax economic consequences of at least one partner may, in present value
terms, be enhanced compared to such consequences if the allocation were not contained
in the partnership agreement; AND
(2) there is a strong likelihood that the after-tax economic consequences of no partner
will, in present value terms, be substantially diminished compared to such consequences
if the allocation were not contained in the partnership agreement.
In other words, an allocation fails the substantiality test if its effect is to benefit one or
more partners after taxes and not to effect adversely any partner—in both cases,
comparing the effect of the allocation to the result if no allocation had been contained in
the agreement
might see this if one partner has a net operating loss from another venture; pship will try
to allocate income first to partner who has this loss for that year, and then allocate other
income to another partner next year
see what their income tax liability would be with and without the special allocation (in
doing w/o, just follow pship agreement) and see if one is improved and other is not
adversely affected as a result of the allocation
if this happens, we’d have to reallocate w/ the facts and circumstances test of partner’s
interests in the partnership. We would still allocate the same amount of income to the
partners as per their agreement, it just won't all be allocated to one partner first
Shifting and Transitory Allocations
Shifting (1.704-1(b)(2)(iii)(b))
deals w/ allocations in a single taxable year
The economic effect of an allocation (or allocations) within one partnership taxable year
is not substantial if, at the time the allocation becomes part of the partnership agreement,
there is a “strong likelihood” that the capital accounts of the partners will be unaffected
by the allocation (normally because of and equal and offsetting allocation in the same
year), AND the total tax liability of the partners will be less than if there had been no
such allocations, taking into account any tax consequences that result from the interaction
of the allocation with tax attributes of the partner that are unrelated to the partnership
If the conditions for a shifting allocation are in fact met, then there was a presumption
that there was a strong likelihood that they would occur
Transitory Allocations (1.704-1(b)(2)(iii)(c))
deals w/ allocations over multiple taxable years
Allocations lack substantial economic effect if the partnership agreement provides for the
“possibility,” over two or more taxable years, that an “original allocation” will be largely
offset by one or more “offsetting allocations” AND, at the time the allocations became
part of the agreement, there is a “strong likelihood” that (i) the partners’ capital accounts
will emerge unaffected by the allocations (relative to what would have occurred had there
been no allocations) and (ii) the partners enjoy a reduction in their total tax liability for
the period involved.
The same presumption of “strong likelihood” applies
Assess likelihood at the time of the agreement
e.g., oil drilling risky, so not likely; leasing equipment not risky
ex: “Income chargeback provision”: costs allocable to partner A in year 1, and profits
allocable to partner A that year and subsequent years only until costs restored
Safe harbor 1 (1.704-1(b)(2)(iii)(c)(2)): An allocation and subsequent offsetting
allocation will not be considered transitory if there is a strong likelihood that the
offsetting allocation will not, in large part, be made within five years from the original
allocation
i.e. most of income from chargeback not expected to exist until five or more years after
chargeback was made. If you can reasonably make this income projection, then can be
certain that loss allocation will be considered substantial. So we should expect to see
income projections at time partnership agreement was entered into
Safe harbor 2: The regulations presume for purposes of the substantiality test that the
adjusted tax basis of partnership property will be equal to its fair market value and that
adjustments to tax basis of the property will be matched by corresponding changes in its
fair market value.
i.e. there's never a gain upon disposition of partnership property w.r.t. substantiality
analysis
ex. if the chargeback provision says that depreciation allocations will be later offset by
gain from disposition of land, we have substantiality b/c there will never be gain under
this safe harbor
Default Reallocations: The Partners’ Interest in the Partnership 1.703-1(b)(3) (objective
test: in (iii), if first two elements of basic economic effect test satisfied, but third element
failed, AND you have substantiality, in determining interest in pship, all you have to look
@ is changes in book liquidation rights—only get there if you fail economic test and
alternate test—if this test fails, but you have substantiality, then have to use “facts and
circumstances” test)
If a partnership agreement is silent as to the partners’ distributive shares OR an allocation
lacks substantial economic effect, then the partners’ share of gain, loss, deduction or
credit is determined in accordance with the partners’ interest in the partnership
There is presumption of equal interests in the partnership, which is rebuttable by the
taxpayer or the Service. Among the factors to be considered in making this determination
are
The relative contributions of the partners to the partnership
The interests of the partners in economic profits and losses if they differ from their
interests in taxable income or loss
The interests of the partners in cash flow and other nonliquidating distributions
The rights of the partners to distributions of capital upon liquidation
The regulations include a special rule if an allocation is upset because the partnership
agreement fails to include an unlimited deficit make-up provision. If the first two prongs
are met and the substantiality requirement is met, this rule provide that the partners’
interests in the partnership with respect to the disallowed portion of the allocation are to
be determined by comparing:
The manner in which distributions (and contributions) would be made if all partnership
property were sold at book value and the partnership were liquidated following the end of
the taxable year in which the allocation relates with,
The manner in which distributions (and contributions) would be made if all partnership
property were sold at book value and the partnership were liquidated immediately
following the end of the prior taxable year
Allocations of Depreciation Recapture
Allocations of depreciation recapture cannot have substantial economic effect because
classifying a portion of the gain as recapture merely changes its tax character
Under the regulations, a partner’s share of recapture gain generally is equal to the lesser
of (1) the partner’s share of the total gain from the disposition of the property, or (2) the
total amount of depreciation previously allocated to the partner with respect to the
property
Allocations of Tax Credits
Allocations of tax credits are generally not reflected in the partners’ capital accounts and,
therefore, they cannot have economic effect. As a result, tax credits and recapture of tax
credits generally must be allocated in accordance with the partners’ interests in the
partnership
Allocations Attributable to Nonrecourse Debt §704(2)

Context
When there is nonrecourse debt, creditor takes risk that if the value of security puts up for
debt falls below the outstanding nonrecourse debt, risk is that partnership debt may walk
away from the debt, and lender will get paid less than the outstanding debt. Partners in
this situation don’t bear this risk
So, as depreciation pushes prop’s AB to below amount of of outstanding nonrecourse
debt, issue is who as among the partners should get those deductions when in fact none of
them is bearing the economic risk of loss represented by that depreciation?
Code permits a loss w/o a corresponding economic loss being sustained b/c it foresees in
the future a tax gain w/o economic effect. Suppose creditor forecloses on prop when AB
is less than nonrecourse debt. There is tax gain to partners in this case under Tufts b/c
amount realized is nonrecourse debt. But there's no economic gain b/c foreclosure took
place and partners get nothing. Ultimately it's this potential lurking in the asset that
offsets the deductions taken despite
Note: this analysis doesn't come into play when prop's AB is still above amount of
nonrecourse debt b/c deductions attributable to depreciation thrown off by whatever
generated positive balances in partner's accounts I THINK.
Terms
Partnership Minimum Gain 1.704-2(d)
The amount of gain that a partnership would realize if it disposed of each of its properties
that is subject to a nonrecourse liability for no consideration other than satisfaction of the
debt—i.e., the excess of the nonrecourse liability over the adjusted basis of the property
securing the debt. Tufts.
If a partnership has more than one nonrecourse liability, total partnership minimum gain
is the aggregate of minimum gain on all properties of the partnership encumbered by
nonrecourse debt
Partnership minimum gain is created in two situations:
As the adjusted basis of the encumbered property is reduced below the amount of the
nonrecourse liability, or
As the amount of the nonrecourse liability is increased in excess of the adjusted basis of
the property
Nonrecourse Deductions 1.704-2(c)
All of a partnership’s increases and decreases in minimum gain during a taxable year are
netted to determine it there is a net increase in minimum gain. Both nonrecourse
deductions and nonrecourse distributions only arise if there is a net increase in
partnership minimum gain during the year
Deductions that relate to a net increase in partnership minimum gain
They most commonly are cost recovery deductions that reduce the adjusted basis of
depreciable property below the amount of nonrecourse debt secured by the property
Nonrecourse deductions also can arise on a refinancing where the proceeds of a
nonrecourse liability are not distributed (or treated as not distributed) by the partnership.
Since these proceeds are not distributed, the regulations assume that they will be spent by
the partnership and generate deductions that are attributable to the additional nonrecourse
borrowing
Distribution of Nonrecourse Liability Proceeds Allocable to an Increase in Minimum
Gain
Where the proceeds of a nonrecourse loan are distributed, the minimum gain generated
by the borrowing is allocated to the partners to whom the loan proceeds are distributed
A Partner’s Share of Partnership Minimum Gain
A partner’s share of partnership minimum gain at the end of any taxable year is equal to
the sum of the nonrecourse deductions allocated to the partner throughout the life of the
partnership and the partner’s share of distributions of nonrecourse liability proceeds
allocable to an increase in minimum gain, reduced by the partner’s share of any prior net
decreases in minimum gain
Minimum Gain Chargeback Provision
For any taxable year in which there is a net decrease in a partner’s share of minimum
gain, that partner must be allocated in the same year, by a provision in the partnership
agreement, income and gain in an amount equal to the net decrease
The most obvious transaction that triggers a decrease in partnership minimum gain is the
disposition of property subject to nonrecourse debt
Any minimum gain chargeback consists first of gains recognized from the disposition of
partnership property subject to a nonrecourse liability.
Only where the gain from the disposition of the property is less than the decrease in
partnership minimum gain for the year does the partnership need to allocated income or
gain from other sources
If the amount of the minimum gain chargeback exceeds the partnership’s income and gain
for the year, the excess carries over
A decrease in partnership minimum gain also can occur when the principal amount due
on a nonrecourse liability is reduced or when a partnership liability is converted from
nonrecourse to recourse. In those situations the rules operate differently
The regulations provide that a partner is not subject to a minimum gain chargeback to the
extent that the decrease in the partner’s share in minimum gain is attributable to the
partner’s own capital contribution that is used to pay the partnership’s nonrecourse debt
When partnership debt is converted from nonrecourse to recourse as a result of guarantee
or similar arrangement, there is not minimum gain chargeback to a partner to the extent
that the partner bears the economic risk of loss for the new recourse liability
Under a final exception, a minimum gain chargeback is not triggered if it would cause a
distortion in the economic arrangement among the partners and there is insufficient other
income to correct the distortion
Safe Harbor (a special partners' interest in the partnership rule when 1.707-2 applies)
Allocations of “nonrecourse deductions will be respected if the following four
requirements are satisfied: (Reg 1.704-2(e))
(1) Throughout the life of the partnership, the partnership agreement must satisfy the
requirements of the basic or alternative test for economic effect
(2) Beginning in the first taxable year in which the partnership has nonrecourse
deductions and thereafter for the life of the partnership, nonrecourse deductions must be
allocated in manner that is reasonably consistent with allocations (having substantial
economic effect) of some other significant partnership item attributable to the property
securing the liabilities of the partnership (other than allocation of minimum gain)
Where the partnership allocated all other items relating to a property 90:10, and then
50:50, any proportion in that range would be reasonably consistent
(3) Beginning in the first year in which the partnership has nonrecourse deductions or
make a distribution of proceeds of a nonrecourse liability allocable to an increase in
partnership minimum gain, the partnership agreement must contain a minimum gain
chargeback
(4) All other material allocations and capital account adjustments under the partnership
agreement must comply with the basic Section 704(b) regulations
ALLOCATIONS WITH RESPECT TO CONTRIBUTED PROPERTY
General 704(c) Allocation Principles

Section 704(c)(1)(A) provides that items of income, gain, loss and deduction with respect
to property contributed by a partner to a partnership shall be shared among the partners so
as to take account of the variation between the basis of the property to the partnership and
its fair market value at the time of contribution.
Because this is a tax allocation that lacks substantial economic effect, it is not
accomplished by any change in the partners’ capital accounts
The regulations permit these allocations to be done under three methods, each subject to a
general anti-abuse provision
No more than one method may be used with respect to each item of Section 704(c)
property and, although a different method may be used with respect to different items of
property, a partner and partnership must use a method or combination of methods that is
reasonable under the facts and circumstances
In general, Section 704(c) must be applied on a property-by-property basis except that
property with identical tax characteristics may be aggregated for purposes of determining
whether built-in gains and losses exist
A partnership may disregard or defer the application of Section 704(c) in a single year if
there is a “small disparity” between the book value and the adjusted basis of the
contributed property. A “small disparity” exists if the total fair market value of all
property contributed by a partner during the taxable year does not differ from the total
adjusted basis of the property by more than 15 percent of the adjusted basis, and the total
gross disparity does not exceed $20,000.
Sales and Exchanges of Contributed Property

Section 704(c) Allocation Methods
Traditional Method 1.704-3(b)
The traditional method generally requires a partnership to allocate any built-in gain or
loss to the contributing partner
Built in gain = amount book value exceeds adjusted basis upon contribution (1.704-3(a)
(3))
by doing so, outside basis increases, and then becomes in sync with capital account
after built in gain allocated, 704(a) and (b) govern remaining gain, if any (i.e.
appreciation after contribution)
The traditional method, however, imposes a “ceiling rule,” under which the total gain or
loss allocated to the partners may not exceed the tax gain or loss realized by the
partnership. 1.704-3(b)
Comes up if partner contributes appreciated property but then prob goes down in value
but not below AB prop takes (i.e. pship sells it for a gain but for less than the original
built in gain; 704(c) says to give all built in gain to contributing partner)
Traditional Method with Curative Allocations 1.704-3(c)
The traditional method with curative allocations permits a partnership to make reasonable
“curative allocations” of other partnership tax items of income, gain, loss or deduction to
correct ceiling rule distortions
basically we want non-704(c) partner to wind up w/ tax allocations that mirror book
allocations
has to be included in pship agreement to use it
A curative allocation is an allocation made solely for tax purposes that differs from the
partnership’s allocation of the corresponding book item. As such, a curative allocation
has no economic effect and is not reflected in the partners’ capital accounts
A curative allocation is reasonable only if (1) it does not exceed the amount necessary to
offset the effect of the ceiling rule and (2) the income or loss allocated is of the same
character and has the same tax consequences as the tax item affected by the ceiling rule
Curative allocations may be made to correct ceiling rule distortions from a prior taxable
year if they are made over a “reasonable period of time” (e.g., the economic life of the
property) and were authorized by the partnership agreement in effect for the year that the
property was contributed
Remedial Method 1.704-3(d)
Under the remedial method, if the ceiling rule results in a book allocation to a
noncontributing partner that differs from the partner’s corresponding tax allocation, the
partnership may make a remedial allocation to the noncontributing partner equal to the
full amount of the disparity and a simultaneous offsetting remedial allocation to the
contributing partner
these allocations are made for tax purposes only; no affect on book capital accounts
A remedial allocation must have the same effect on each partner’s tax liability as the item
limited by the ceiling rule—for example, if the tax item limited by the ceiling rule is a
loss from the sale of a contributed capital asset, the offsetting remedial allocation to the
contributing partner must be capital gain
Characterization of Gain or Loss on Disposition of Contributed Property
Section 724 applies to three categories of contributed property: unrealized receivables,
inventory items and capital loss property. Different rules are provided for each category
Unrealized Receivables
Generally defined as rights (contractual or otherwise) to payment for goods or services
that have not been previously included in income, provided in the case of goods that the
sales proceeds would be treated as received from the sale or exchange of noncapital
assets
Section 724(a) provides that any gain or loss recognized by the partnership on the
disposition of unrealized receivables will be ordinary
Inventory Items
Broadly defined in Section 751(d)(2) to include not only the familiar category of
noncapital assets but also any other property which, upon sale by the contributing partner,
would not be considered as a capital or Section 1231 asset
Inventory items retain their ordinary income taint under Section 724(b) for five years
after their contribution to the partnership. After that period, the character of contributed
inventory items is determined at the partnership level
Capital Loss Property
Any capital asset held by the contributing partner which had an adjusted basis in excess
of its fair market value immediately before it was contributed to the partnership
If the partnership sells the capital loss property at a loss, Section 724(c) requires the built-
in loss at the time of the contribution to retain its character as a capital loss for a period of
five years from the date of the contribution. Any additional loss accruing while the
property is held by the partnership is characterized at the partnership level
Section 724(d)(3) provides that the Section 724 taint applies to any “substituted basis
property,” whether held by the transferor-partnership or a transferee unless that property
is the stock of a C corporation acquired in an exchange governed by Section 351. In the
case of substituted basis property, the five-year taint period commences as of the date that
the original property was contributed to the partnership
Depreciation of Contributed Property
Traditional Method
Under the traditional method, tax depreciation on contributed property is allocated first to
the noncontributing partner in an amount equal to his share of book depreciation to the
extent possible, and the balance of tax depreciation is allocated to the contributing
partner.
Book and tax depreciation must be computed using the same depreciation method and
recovery
i.e. uses whatever remaining useful life there is (basically stepping into partner's shoes
w.r.t. depreciable asset that has been contributed by A to pship)
use same method of depreciation for book purposes as being used for tax 1.704-1(b)(2)
(iv)(g)(3); must have same proportionate effect (so if depreciating 25% of book value per
year, must depreciate 25% of basis each year)
Allocation of depreciation under Section 704(c)(1)(A) using the traditional method also
can be affected by the ceiling rule
Traditional Method with Curative Allocations
Partnership may use another item to offset the distortion caused by the ceiling rule
The Remedial Method
Under the remedial method, ceiling rule distortions from depreciation of contributed
property are corrected by a tax allocation of additional deprecation to the noncontributing
partner in an amount equal to the full amount of the limitation caused by the ceiling rule
and a simultaneous offsetting allocation of ordinary income to the contributing partner
Under the remedial method, the portion of the partnership’s book basis in contributed
property at the time of contribution is depreciated under the same method used for tax
depreciation—generally over the property’s remaining recovery period at the time of
contribution.
The amount by which the book basis exceeds the tax basis (“the excess book basis”) is
depreciated using any applicable recovery period and depreciation method available to
the partnership for newly acquired property
Other Applications of Section 704(c) Principles

A problem analogous to allocations with respect to contributed property may arise when a
new partner is admitted to an existing partnership and there is built-in gain in the property
owned by the partnership. The Section 704(b) regulations require application of Section
704(c) principles in those situations
Partners can put into their agreement an allocation provision that when gain is recognized
from the sale of assets that were existence at the time a new partner is admitted, all of the
gain relating to the period before the new partner's entry is allocated for tax purposes to
the other partners
while the other partners will pay more in tax, in doing so their capital accounts will
increase more than if all of the gain is distributed evenly (Unit IV.B(a))
another way to do this is by “booking up” @ time of new partner's entry
partners are permitted to “book up” pship assets as well as book cap account balances to
FMV at the time someone contributes money or property to the partnership in return for a
Note: If dealing w/ an acquired property, 704(b), not 704(c), applies, BUT, 1.704-1(b)(4)
(i): if you've properly booked up partnership assets and gain is now being realized on the
sale of that booked up asset, have to allocate that gain in same manner as you make
704(c) allocations. i.e. has to reflect built-in gain of the asset as of the time of new
partner's entry
Consider: What happens if property sold for less than bookup amount? Loss occurred
subsequent to bookup, so allocated according to agreement. BUT might have a tax gain
b/c that doesn't get booked up, which will be less than built in gain. So, all of it goes to
prior partners. Thus, no loss allocated to new partner b/c of the ceiling rule. Curative or
remedial allocations, anyone?
Anti-Abuse Rules for Loss Property

Section 704(c)(1)(C) provides that if contributed property has a built-in loss then (1) the
built-in loss is to be taken into account only in determining the amount of items allocated
to the contributing partner, and (2) in determining the amount of items allocated to other
partners, the partnership’s basis in the contributed property shall be treated as being the
fair market value of the property at the time of contribution.
ALLOCATIONS OF PARTNERSHIP LIABILITIES
Context: under 752(a), any dollar increase in a partner's share of pship liabilities
considered to be a contribution of money by a partner to the partnership, i.e. constructive
cash contribution. This as a result increases partner's outside basis under 722.
Conversely, reduction in partnership liability is a constructive cash distribution to partner,
reducing partner's outside basis. Partnership assumption of a partner's liability also
decreases partner's outside basis.
Liability Defined
A “liability” is defined in 1.752-1(a)(4): for debt to be pship liability for 752, incurring
obligation has to do one of three things:
(1) it creates or increases basis of pship property, including cash;
(2) gave rise to an immediate deduction; or
(3) gave rise to an expense that is not deductible at all and does not produce
basis
Ex of (3) is an obligation to make a political contribution.
Note: incurring an obligation to pay an expense that produces a deduction only on
payment itself is NOT considered a liability for 752. Ex: cash method pships –
incurring obligations to pay deductible expenses not liabilities for 752; no
immediate deductions here.
For purposes of Section 752, all legally enforceable partnership obligations are
“liabilities” except accounts payable of a cash basis partnership, which are not deductible
until paid, and certain contingent or contested liabilities or obligations that are devoid of
economic reality
Recourse Liabilities
Economic Risk of Loss Concept
A partnership liability is a recourse liability only to the extent that a partner bears the
economic risk of loss with respect to that debt. 1.752-1(a)(1)
In the case of recourse liabilities, the extent to which a partner bears the economic risk of
loss also must be determined in order to allocate the debt
In general, a partner bears the economic risk of loss for a partnership liability to the
extent that he ultimately would be obligated to pay the debt if all partnership assets were
worthless and all partnership liabilities were due and payable. 1.752-2(b)
In determining the risk of loss, the regulations take into account not only each partner’s
obligations under the partnership agreement to pay the creditor or contribute funds to the
partnership, but also all other economic arrangements or legal obligations between
partners and between any partners and the partnership’s creditors.
Constructive Liquidation 1.752-2(b)
The regulations assume that all of the partnership’s liabilities become due and payable in
full, any separate property pledged (directly or indirectly) by a partner to secure a
partnership liability is transferred to the creditor in full or partial satisfaction of that
liability, and all the rest of the partnership’s assets (including cash) become worthless
The partnership is deemed to dispose of all of its now worthless assets in a taxable
transaction for no consideration (other than the relief of any nonrecourse debt to which
any asset is subject).
The gains and losses on these deemed dispositions, along with any actual income or loss
items as of the date of the constructive liquidation, are then allocated among the partners
in accordance with the partnership agreement; the partnership books and capital accounts
are adjusted accordingly, and the partnership is deemed to liquidate.
The regulations assume that a partner bears the economic risk of loss for the net amount
that he must pay directly to creditors or contribute to the partnership at the time of the
deemed liquidation
since a limited (L) partner's book cap account can't go below 0 unless he agrees to be
liable to an extent, general partner's book cap account takes the entire hit; we respect
shares in partnership to L only up to L's cap account balance being zeroed out
Note: If L guarantees repayment, L doesn't get basis anyway. Regs assume that each
partner will meet whatever its financial obligations are. Then, never even get to L's
guarantee. We assume G will meet its obligation.
Different result if L assumes the liability 752(a)
The amount of a partner’s gross payment obligation is reduced to the extent of any right
to reimbursement, leaving the partner’s net payment obligation as the ultimate measure of
his economic risk of loss
The amount of a partner's gross payment obligation is increased to the extent he agreed to
contribute cash to the partnership in the future.
Nonrecourse Liabilities
Def: 1.752-1(a)(2): nonrecourse to extent that no partner bears no economic risk of loss
for that liability
If a partner guarantees repayment, treat partner as if he assumed recourse debt; partner
should get entire basis derived from that liability
In General
The regulations in 1.752-3(a) adopt a three (3) step approach under which a partner’s
share of nonrecourse liabilities is the sum of
(1) the partner’s share of partnership minimum gain, if any, determined in accordance
with the Section 704(b) regulations,
(2) in the case of nonrecourse liabilities secured by contributed property (i.e. doesn't
apply to acquired property), the amount of gain that the partner would recognize under
Section 704(c) if the partnership disposed of that property in a taxable transaction in full
satisfaction of the liabilities and no other consideration; and
(3) the partner’s share of any remaining (“excess”) nonrecourse liabilities, determined in
accordance with his share of partnership profits
Partners’ Share of Partnership Minimum Gain
Where the partnership has generated minimum gain (i.e. Tufts gain-excess of the
nonrecourse liability over the adjusted basis of the property securing the debt), the rule
for allocation of nonrecourse liabilities directly follows the rule for allocation of the
deductions and distributions attributable to those nonrecourse liabilities and the
allocation of the minimum gain chargeback equals the share of nonrecourse deductions
allocated to those parties. The liabilities are first allocated in accordance with each
partner’s share of partnership minimum gain.
Significance of shifting of nonrecourse to L over time (i.e. minimum gain chargeback
increases each year is you take depreciation each year) is that L has been shifted enough
outside basis from nonrecourse debt so that 704(d) will permit L to be able to use
depreciation deductions properly allocated to L him each year.
The basis increase attributable to the allocation of the nonrecourse liability should be
deemed to occur immediately before the allocation of the nonrecourse deduction or
distribution which caused an increase in minimum gain
Partners’ Shares of Section 704(c) Gain (tier 2)
When property contributed to a partnership is subject to a nonrecourse liability in excess
of its adjusted basis, the property has a built-in gain (equal to the excess of liabilities over
basis) similar to partnership minimum gain
Under the regulations, however, the built-in gain is not partnership minimum gain under
Section 704(b) but instead is potential Section 704(c) gain.
The regulations provide that, to the extent of the minimum Section 704(c) gain, the
nonrecourse liability secured by the contributed property is allocated to the same partner
to whom this minimum built-in gain is allocated under Section 704(c)
If a partnership holds multiple properties subject to a single nonrecourse liability, it may
allocate the liability among those properties under any reasonable method, and then the
portion of the liability allocated to each property is treated as a separate loan for purposes
of determining the minimum built-in gain in the property
Partner’s Share of Partnership Profits (tier 3)
Absent any special allocations, nonrecourse liabilities simply are allocated in accordance
with the partners’ interests in the partnership (i.e. according to their agreement???)
If the partnership purchases an asset subject to a nonrecourse liability, the regulations
provide that any specification of the partners’ interests in the partnership agreement will
be respected for Section 752 purposes as long as it is reasonably consistent with an
allocation (having substantial economic effect) of any significant item of partnership
income or gain
Absent such a direction, the partners’ interests in partnership profits are determined by
taking into account all the facts and circumstances relating to the economic arrangement
of the partners
The regulations also provide some alternative methods for allocating nonrecourse
liabilities
Excess nonrecourse liabilities may be allocated in accordance with the manner in which it
is reasonably expected that the deductions attributable to those liabilities will be allocated
In the case of contributed property subject to a nonrecourse liability, the partnership may
first allocate an excess nonrecourse liability to the contributing partner to the extent that
Section 704(c) gain on the property is greater than the gain resulting from the liability
exceeding the basis of the property
The method selected for allocating excess nonrecourse liabilities may vary from year to
year
Part-Recourse, Part-Nonrecourse Liabilities

After properly bifurcating the debt, the recourse portion is allocated under the rules for
recourse liabilities, and the nonrecourse portion is allocated separately under the rules for
nonrecourse liabilities
LOSS LIMITATIONS
When can a partner use their respective shares of loss in the partnership during a given
year as a deduction against income they may have from other sources? First apply 704(b)
to see it will be respected. Then proceed...
Limitation 1: Basis Limitations 704(d)

Section 704(d) provides that a partner’s distributive share of partnership loss, including
capital loss, is allowable as a deduction only to the extent of the partner’s outside basis at
the end of the partnership’s taxable year in which the loss occurred.
In computing the adjusted basis of a partner’s interest for the purpose of ascertaining the
extent to which a partner’s distributive share of partnership loss shall be allowed as a
deduction for the taxable year, the basis shall first be increased under 705(a)(1)
(contributions) and decreased under section 705(a)(2) (distributions), except for losses of
the taxable year and losses previously disallowed
If the limitation applies (i.e. basis reduced to 0 and loss leftover), any excess loss may be
carried forward indefinitely and utilized when the partner acquires additional basis
(doesn't matter how basis is increased).
If the partnership has both ordinary and capital losses, the regulations provide that the
partner’s loss is allocated to reflect the composition of the partnership’s loss. 1-704-1(d)
Note: Don't get to 1211 and 1212 limitations for capital loss carryover until after 704(d)
is applied
It is likely that the carryover loss is generally personal to each individual partner. Thus, if
a partner sells his partnership interest, the seller’s previously deferred losses will
disappear and not carry over to the buyer. The carryover loss also apparently terminates
if a partner dies, but it is not totally certain whether a carryover loss may be sues by a
donee partner.
Limitation 2: At-Risk Limitations 465

465 limits the deduction of a taxpayer's loss from an activity to the amount that the
taxpayer has “at-risk” in that activity.
Under 465, a loss is defined as the excess of the total deductions from the activity beyond
the total income derived by that activity. This means that can always use deductions from
an activity to extent of that activities' income. But when you want to take a new loss and
use it shelter other unrelated income sources, 465 may come into play.
In the partnership setting, the at-risk rules are applied on a partner-by-partner basis rather
than at the partnership level.
In general, the rules are applied separately to each “activity” in which a partnership is
engaged, but exceptions may require certain trade or business activities to be aggregated
A taxpayer’s initial at-risk amount generally includes:
(1) his cash contributions to the activity
(2) the adjusted basis of other property contributed by the taxpayer to the activity; and
(3) amounts borrowed for use in the activity for which the taxpayer is personally liable or
which are secured by property of the taxpayer (not otherwise used in the activity) to the
extent of the fair market value of the encumbered property
A partner is considered at risk with respect to his share of recourse debt
A taxpayer is not considered at risk with respect to nonrecourse loans, except with respect
to certain nonrecourse loans secured by real property which constitute “qualified
nonrecourse financing.” The exception applies if:
It is non-convertible debt for which no person is personally liable and which is incurred
by the taxpayer with respect to the holding of real estate and is borrowed from a qualified
person
A qualified person is any person actively and regularly engaged in the business of lending
money who is not related to the borrower and is not the seller of the property, a relative of
the seller or a person who receives a fee (e.g., a promoter or broker) with respect to the
taxpayer’s investment in the real property, or a relative of such a fee recipient
A partner’s share of qualified nonrecourse financing is determined on the basis of the
partner’s share of partnership liabilities under Section 752, provided the financing is
qualified with respect to both the partner and the partnership. The amount for which
partners may be treated at risk, however, may not exceed the total amount of qualified
nonrecourse financing at the partnership level.
Any loss disallowed by Section 465 may be carried over and deducted when either the
taxpayer becomes at risk, the partnership disposes of the activity, or the taxpayer disposes
of his partnership interest
If a partner’s loss is deferred by Section 465, the partner’s outside basis is nonetheless
reduced by the amount of the loss
Limitation 3: Passive Loss Limitations 469

In General
Section 469 disallows the current deductibility of losses and the use of credits from
“passive activities”
The income and losses from each of a taxpayer’s passive activities are first computed and
then all are combined; in any taxable year, passive activity losses can be deducted only to
the extent of the taxpayer’s income from passive activities for that year
To the extent that losses from passive activities for the taxable year exceed the taxpayer’s
passive income, that excess may be carried forward and deducted (subject to the same
limitation) against future net income from passive activities
Disallowed losses from a particular activity may be deducted in full on a taxable
disposition of the entire activity
Ultimately, will be able to use passive loss, but may have to wait until you dispose of
interest in the losing activity
The passive-loss limitations are applied on a partner-by-partner basis, not at the
partnership level
The limitations are applied only after application of the Section 704(d) and Section 465
limitations
The “Material Participation” Standard
A “passive activity” is any activity involving the conduct of any trade or business in
which the taxpayer does not “materially participate”
A taxpayer materially participates in an activity only if he is involved on a regular,
continuous and substantial basis in the operation of the activity
“Participation” generally includes work done by the taxpayer in all capacities except as
an investor in the activity unless the taxpayer is directly involved in day-to-day
management or operations
A taxpayer is treated as materially participating in an activity if any one of these tests is
met
(1) the taxpayer participates in the activity for more than 500 hours during the year
(2) the taxpayer’s participation in the activity constitutes substantially all of the
participation in the activity by any individual for the year;
(3) the taxpayer devotes more than 100 hours to the activity during the year and his
participation is not less than that of any other person;
(4) the activity is a “significant participation” activity—that is, a trade or business activity
in which the taxpayer participates for more than 100 hours and the taxpayer does not
satisfy any of the other tests for material participation—and the individual’s aggregate
participation in all “significant participation” activities for the year exceeds 500 hours;
(5) the taxpayer materially participated in the activity for any five of the ten taxable years
immediately preceding the taxable year;
(6) the activity is a “personal service activity”—that is, an activity principally involving
the performance of services in fields such as health, law, engineering, architecture and
accounting—and the taxpayer materially participated in the activity for any three taxable
years preceding the taxable year; or
(7) based on all the facts and circumstances, the taxpayer’s participation in the activity
during the taxable year is regular, continuous and substantial
Rental Activities
With a few limited exceptions, Section 469 presumes that all rental activities are
“passive” regardless of the extent of participation by the taxpayer.
Exceptions
Individual taxpayers may deduct up to $25,000 of losses attributable to rental real estate
activities if they “actively participate” and own at least a 10 percent interest in the
activity
The real estate rental activities of taxpayers other than C corporations are treated as active
trades or businesses if more than half of the personal services performed by the taxpayer
in all trades or businesses during the year, and more than 750 hours, are in real property
trades or businesses in which the taxpayer materially participates
Working Interests
Regardless of the taxpayer’s material participation, a passive activity does not include a
working interest in any oil or gas well in which the taxpayer holds directly or through an
entity that does not limit the taxpayer’s liability with respect to the drilling or operation
of the property
The exception does not apply to a limited partnership in which the taxpayer is not a
general partner
Portfolio Income
Section 469 provides that “portfolio income” (interest, dividends, annuities, royalties not
derived in the ordinary course of trade and business and gains or losses from assets that
produce such income, less related expense) shall not be considered as arising from a
passive activit
Portfolio income earned by a partnership is separately stated and retains its character
when it passes through to the partners
General Partners
Whether or not a general partner’s share of income or loss is treated as derived from a
passive activity requires a separate analysis of each general partner and of each separate
activity in which the partnership engages. The critical issues narrow to:
(1) when are different pursuits of the partnership classified as separate “activities” in
which a partner must materially participate in order to avoid the passive loss limitations,
and
(2) what degree of participation by a partner in an activity is “material?”
Limited Partners
Section 469 presumes that all limited partnership interests are activities in which a
taxpayer does not materially participate
Limited partners are considered to materially participate only if
(1) they participate in the activity for more than 500 hours during the taxable year,
(2) they materially participated in the activity for any five tax years during the ten years
preceding the taxable year, or
(3) the activity is a “personal service activity” and the limited partner materially
participated in the activity for any three tax year (whether or not consecutive) preceding
the taxable year
A limited partner who is also a general partner and who meets one of the seven tests for
material participation is treated as materially participating with respect to both the limited
and general partnership interests
A limited partner’s share of income received for the performance of services is not treated
as income from a passive activity
SALES OF OWNERSHIP INTERESTS
CONSEQUENCES TO THE SELLING PARTNER
The Operation of Section 751(a)

In General
Section 741 provides that gain or loss from the sale or exchange of an interest in a
partnership shall be considered as gain or loss from the sale of a capital asset
Section 741 yields to Section 751(a) to the extent that the amount received by a selling
partner is attributable to “unrealized receivables” or “inventory items”
Mechanics
The selling partner must first apply the general rules of Section 1001(a) and compute the
total realized gain or loss on the sale
Section 752(d) includes in the amount realized the selling partner’s share of all
partnership liabilities along with the cash and fair market value of other property
received by the seller
The adjusted basis of the seller’s interest is his outside basis under Section 705(a),
adjusted to reflect the seller’s pro rata share of partnership income or loss from the
beginning of the current taxable year up to the date of sale
Although a partnership’s taxable year generally does not close when a partner sells an
interest, it closes with respect to a partner immediately upon the sale or exchange of his
entire interest in the partnership
The income or loss arising from that short taxable period then passes through to the
partner and is reflected in his outside basis
The next step is to determine what portion, if any, of the seller’s total realized gain or loss
is characterized as ordinary income under Section 751(a)
Section 751 assets include “unrealized receivables” and “inventory items,” as defined
in Sections 751(c) and (d), respectively
Unrealized receivables generally include rights (contractual or otherwise) to payment
for goods and services which have not previously been included in income, provided, in
the case of goods, that the sales proceeds would be treated as received from the sale or
exchange from non-capital assets. In addition, unrealized receivables include certain
short-term debt obligations and an array of assets to the extent that their disposition at fair
market value would trigger recapture of cost recovery and certain other prior deductions
(e.g. depreciation recapture)
could depend on whether pship uses cash or accrual method
Re: work in progress on matters not completed: Reg 1.751-1(c): unrealized receivable
includes rights to payment for work begun but incomplete at time of partner's sale, where
right to payment for that work arises under K in existence at time of partner's sale.
Re: depreciation recapture (1245): unrealized receivables includes 1245 property of
pship to the extent there would be ordinary depreciation recapture income if the pship
sold the property for its FMV at the time the partner sells his pship interest
if FMV > AB, then there's recapture (RIGHT?). B/c giving back those earlier ordinary
depreciation deductions on equipment, b/c they were premised on assumption that
equipment was going down in value equal to depreciation deductions. Yet, equipment
didn't go down at all
The term “inventory items” falls into any of the following categories:
(1) dealer property, i.e. held by pship for customers for sale in ordinary course of
business;
(2) any other property of pship that is not a capital asset, or not 1231 property (e.g.
account receivable), or
(3) property which, if held by selling partner directly, would have been inventory in
selling partner's hands, or property that is not capital asset of section 1231 property in
selling partner's hands (i.e. selling partner's status could trigger being inventory)
If unrealized receivables fall within both Section 751(c) and (d), they are treated as
Section 751(c) assets
1.751-1(a)(2): If part of the amount realized is attributable to Section 751 assets, the tax
consequences of the sale must be bifurcated by determining the amount of income or loss
from Section 751 property that would have been allocated to the selling partner if the
partnership had sold all of its property in a fully taxable transaction for cash in an
amount equal to the fair market value of such property. The fair market value of property
shall not be less than the amount of any nonrecourse debt to which the property is
subject.
The selling partner’s share of income or loss from Section 751 property in this
hypothetical sale takes into account special allocations and allocations required under
Section 704(c), including any remedial allocations
The gain or loss attributable to Section 751 property will be ordinary gain or loss
Note: No ceiling rule if sale of ordinary assets produce a loss
After determining the gain or loss under Section 751(a), the final step is to determine the
difference between the selling partner’s total gain or loss and the ordinary gain or loss
determined under Section 751(a). That difference is the selling partner’s section 741
capital gain or loss on the sale of the partnership interest
Anti-abuse rule: Multi-Tiered Partnerships
Section 751(f) provides that in determining a partnership’s Section 751 assets, the
partnership “shall be treated as owning its proportionate share of the property of any
other partnership in which it is a partner. This rule applies regardless of the number of
tiers between the selling partner and the ordinary income property.
Like-Kind Exchanges of Partnership Interests
There once was substantial controversy over whether an exchange of partnership interests
could qualify as a like-kind exchange.
Congress silenced the debate by disallowing nonrecognition on such exchanges
Transfers of partnership interests to a controlled corporation normally qualify for
nonrecognition under Section 351, but problems may arise in determining the nature of
the incorporation transaction
Capital Gains Look-Through Rule

In order to apply the Code’s different rates for taxing long-term capital gains, the
regulations apply a “look-through rule” for sales or exchanges of interests in a
partnership
As a result a partner who sells a partnership interest held for more than one year may
recognize Section 751 ordinary income and up to three different types of long-term
capital gains: collectibles gain, unrecaptured Section 1250 gain, and “residual” capital
gain
Holding Period
A partner may have a divided holding period in a partnership interest
The regulations integrate the holding period rule and the look-through rule for capital
gains by first identifying the portions of the selling partner’s Section 741 capital gain or
loss that are long-term or short-term capital gain or loss. Then a proportionate amount of
any collectibles or unrecaptured Section 1250 gain is deemed to be part of the long-term
capital gain or loss
The regulations contain a few special rules for determining the holding period of a
partner selling a partnership interest
First, if a partner both makes cash contributions and receives cash distributions during the
one-year period before the sale or exchange of the partnership interest, the partner may
reduce the cash contributions made during the year by the cash distributions on a last-in-
first-out basis, treating all cash distributions as if they were received immediately before
the sale or exchange
Also, contributions of Section 751(c) unrealized receivables and Section 751(d) inventory
items within one year of a sale or exchange of a partnership interest are disregarded for
purposes of determining the holding period of the partnership interest if the partner
recognizes ordinary income or loss on such Section 751 assets in a fully taxable
transaction. The taxable transaction can be either a sale of all or part of the partnership
interest or a sale by the partnership of the contributed section 751 asset.
CONSEQUENCES TO THE BUYING PARTNER
Introduction
Section 742 provides that a partner takes a cost basis for a partnership interest acquired
by purchase; for this purpose, cost includes the partner’s share of any partnership
liabilities
when computing buyer's share of pship liabilities, and when trying to figure out buyer's
rights should pship liquidate, buyer simply takes over seller's book capital account w.r.t.
that interest being sold. i.e. no booking up of cap accounts in this situation; just step into
shoes of seller. 1.704-1(b)(2)(iv)(l)
Section 743(a) generally provides that the basis of partnership property (i.e. inside basis)
shall not be adjusted as the result of a transfer of an interest in a partnership by sale or
exchange, subject to two exceptions:
(1) To avoid taxing the buying partner on the appreciation of his proportionate share of
partnership assets prior to the date of purchase, the partnership may elect under Section
754 to adjust the basis of its assets under Section 743(b)
A Section 754 election also may require a downward adjustment to the bases of
partnership assets which have declined in value as of the time of the sale or exchange of
the partnership interest.
Specifically, Section 742(b)(2) requires that the partnership must decrease the adjusted
bases of its assets with respect to any partner if that partner’s proportionate share of the
partnership’s total inside basis in its assets exceeds the buying partner’s outside basis.
The amount of the adjustment is the excess of that partner’s proportionate share of the
partnership’s inside bases over the partner’s outside basis in his partnership interest
Note: Once the election is made, it's binding on all subsequent transfers. Election
analysis is applied to any subsequent transfer by any partner.
(2) where partnership has a “substantial built-in loss immediately after transfer takes
place.” In this case adjustment to inside basis is mandatory. 743(d): a “substantial built-
in loss is when immediately after transfer of pship interest, inside basis of all of its assets
exceeds their total value by more than 250k.
Mandatory Inside Basis Adjustment for Partnership with Substantial Built-in Loss
Section 743 requires an adjustment to the basis of partnership property on the transfer of
a partnership interest if the partnership has a “substantial built-in loss” immediately after
the transfer
A partnership has a substantial built-in loss if the adjusted basis in its property at the time
of the sale exceeds the property’s fair market value by more than $250,000. In patrolling
the $250,000 threshold for abuse, the Service has the authority to aggregate related
partnerships or disregard acquisitions of property designed to avoid the limit
A special rule is provided for an “electing investment partnership,” such as venture
capital and buyout funds formed to raise capital from investors pursuant to a private
offering and to make and hold investments for capital appreciation.
An electing investment partnership is allowed to use a partner-level loss limitation
instead of making basis adjustments to its assets.
Under the limit, a transferee partner’s share of losses (without regard to gains) from the
sale or exchange of partnership property is not allowed except to the extent it is
established that such losses exceed any loss recognized by the transferor on the transfer
of the partnership interest
Another special rule is provided for “securitization partnerships,” which generally are
partnerships whose sole business is to issue securities backed by the cash flow of
receivables or other financial assets.
Such partnerships are deemed to not have a substantial built-in loss and thereby avoid
both adjustments to the bases of property and the loss-limitation rule
Calculating the Section 743(b) Adjustment to Inside Basis

The new partner first must determine the amount of the overall basis adjustment, which is
the difference between the partner’s outside basis (generally, the partner’s cost plus his
share of partnership liabilities) and his share of the partnership’s inside basis in its assets
(note: happens then prior to pship's sale, its assets appreciated or depreciated in value)
A transferee partner’s share of the adjusted basis to the partnership of its property = the
sum of the transferee’s interest in the partnership’s “previously taxed capital,” + the
transferee’s share of partnership liabilities.
The transferee’s interest in the partnership’s previously taxed capital is determined by
considering a hypothetical disposition by the partnership of all of its assets immediately
after the buyer became a partner in a fully taxable transaction for cash equal to the fair
market value of the assets
The transferee’s interest in the partnership’s previously taxed capital is equal to the cash
the transferee would receive on a liquidation following the hypothetical transaction (don't
forget to pay back creditors first), increased by the amount of tax loss and decreased by
the amount of tax gain that would be allocated to the transferee from the transaction
Notice: in 743(b): statute says that these adjustments to inside basis, whether positive or
negative, only affect the buyer, not the other partners.
To differentiate pship's original basis from adjustment, refer to original basis as the
“common basis.”
Allocation of the Adjustment to Partnership's Basis (for buyer only) under Section
755
Once the total Section 743(b) adjustment is determined, that adjustment must be allocated
among the partnership’s assets under Section 755
The Section 755 regulations provide that the partnership first must determine the value of
its assets
Next, the partnership’s assets are first divided into two classes:
(1) Capital assets and Section 1231(b) property (depreciable prop used in a business &
held for 1+ yr)
(2) Any other property (ordinary income property)
The basis adjustment is then allocated between those classes of property and within each
class based on the allocations of income, gain, or loss (including remedial allocations)
that the transferee partner would receive if, immediately after the transfer, all of the
partnership’s assets were disposed of in a fully taxable transaction for fair market value
The regulations specifically permit an increase to be made to one class or one property
while a decrease is made to the other class or a different property within the class
Basis is first allocated to the class of ordinary income property and then to the class of
capital gain property
Adjustments to two broad categories of properties under 755 can be conceivably positive
to one class and negative to another
Note: So, it's possible that even though a new inside adjustment is 0, can still allocate
adjustment between two types of property so long as allocated adjustments to each
property net out to zero. 1.755-1(b)
A decrease in basis allocated to capital gain property may not produce a negative basis in
any asset. Thus, if the entire decrease allocated to capital gain property reduces the basis
of those assets to zero, any excess reduces the basis of the class of ordinary income
property
Effect of the Section 743(b) Adjustment

The regulations provide that a basis adjustment under Section 743(b) is personal to the
transferee partner
No adjustment is made to the common basis of the partnership property and a Section
743(b) adjustment has no effect on the partnership’s computation of any Section 703 item
A partnership first computes all partnership items at the partnership level and each
partner, including the transferee, is allocated those items under Section 704
The partnership then adjusts the transferee’s distributive share of partnership income,
gain, loss or deduction to reflect the Section 743(b) basis adjustment
These basis adjustments do not affect the transferee’s capital account
If depreciable or amortizable property acquires an upward basis adjustment under Section
743(b), the property generally is treated as two separate assets for depreciation or
amortization purposes
The first asset retains the original depreciation remaining in the depreciable or
amortizable property prior to the adjustment
The amount of the adjustment is treated as being attributable to a newly purchased asset
for depreciation or amortization purposes
Relationship to Section 704(c) (i.e. when someone contributes appreciated property to

partnership)
The regulations generally provide that a transferee’s income, gain, or loss from the sale or
exchange of a partnership asset in which the transferee has a basis adjustment is equal to
the transferee’s share of the partnership’s gain or loss from the sale of the asset (including
any remedial allocations of gain or loss), minus the amount of any positive Section
743(b) basis adjustment or plus the amount of any negative Section 743(b) adjustment
One other aspect of Section 704(c) may also come into play in connection with the
transfer of a partnership interest. Section 704(c)(1)(C) provides that in the case of
property that was contributed to a partnership with a built-in loss, no other partner may
be allocated that precontribution loss. Thus, the purchaser of a partnership interest may
not obtain the benefit of a built-in loss contributed by the seller of the interest
→ for purposes of making allocations to other partners, basis of lost property
will be treated as being equal to property's FMV at the time of its contribution.
NON-LIQUIDATING DISTRIBUTIONS
Non-liquidating distribution occurs when partnership and partner do not get fully
liquidated.
Liquidating distribution takes recipient partner out of the partnership, either by
liquidating entire business or liquidating that partner's entire interest.
NONRECOGNITION RULES ON THE DISTRIBUTION
Distributions of Cash
Section 731(a) generally provides that a partner will recognize neither gain nor loss on a
current distribution of cash, and Section 733 provides that the partner’s outside basis will
be reduced, but not below zero, by the amount of the distribution
Section 731(a)(a) provides that the excess of cash received over the distributee partner’s
outside basis is treated as gain from the sale or exchange of a partnership interest—
normally capital gain, unless Section 751 applies
These rules embrace both actual cash distributions and transactions that are treated as
cash distributions, such as reductions in a partner’s share of partnership liabilities
731(b) general rule is that no gain or loss is recognized by pship on that distribution
Distributions of Property
Neither the partnership nor the distributee partner will generally recognize gain or loss on
an operating distribution of property
Any gain inherent in the distributed property is preserved by assigning the distributee a
transferred basis under Section 732(a)
Any gain inherent in the partner’s interest in the partnership is preserved by Section 733,
which reduces the partner’s outside basis by his transferred basis in the distributed
property
Section 732(a)(2) provides that if the partner’s share of the inside basis in the distributed
property exceeds his outside basis, reduced by any cash distributions in the same
transaction, the transferred basis is limited to that outside basis, which then would be
reduced to zero under Section 733
Allocation of Basis to Distributed Properties

If the special basis limitation rule in Section 732(a)(2) applies and several assets are
distributed, the basis to be allocated (i.e., the partner’s outside basis less cash received in
the transaction) must be allocated among the distributed properties under Section 732(c)
using a multi-step process
First, any distributed unrealized receivables and inventory items are tentatively assigned a
basis equal to the partnership’s basis in each of those assets
If the sum of the partnership’s basis in the unrealized receivables and inventory items
exceeds the basis to be allocated, the partnership’s bases in those properties must be
decreased by the amount of the excess
The reduction is achieved first by allocating basis decreases among the properties with
built-in loss (i.e., properties with an assigned basis greater than their value) in proportion
to the amounts of such loss and only to the extent of each property’s built-in loss
If needed, additional decreases are allocated in proportion to the remaining adjusted basis
of the unrealized receivables and inventory items
If the basis to be allocated exceeds the partnership’s basis in the distributed unrealized
receivables and inventory items, then each other distributed property is tentatively
assigned a basis equal to the partnership’s basis in that asset. The partnership’s bases in
those properties then must be reduced so that the sum of their basis is equal to the
remaining basis to be allocated.
Again, the reduction is accomplished by first allocating basis decreases in proportion to
the built-in loss in the properties (but only to the extent of such loss) and then in
proportion to the remaining adjusted bases of the properties
Section 732(d)
Section 732(d) provides an exception to the foregoing basis rules by permitting certain
distributee partners to elect to treat any distributed properties as though the partnership
had a Section 754 election in effect when the partner purchased or inherited his interest
As a result, assets distributed to the new partner are eligible for a Section 743(b)
adjustment, and a special inside basis then may be used to determine the partner’s basis
in the distributed assets under Sections 732(a) and (c)
This election is available only if the distribution is made within two years of the
distributee partner’s acquisition of his interest by purchase, exchange or inheritance and
the partnership had no Section 754 election in effect at the time of the acquisition of his
interest
There are some critical differences between the effects of a Section 732(d) and Section
754 election
Section 732(d) only applies for purposes of determining the bases of distributed assets
And unlike a Section 754 election, a Section 732(d) election does not apply for purposes
of partnership depreciation, depletion, or gain or loss on disposition
A Section 732(d) adjustment may be required, whether or not the distribution occurs
within two years from the partner’s acquisition of his partnership interest, if the fair
market value of the partnership property (other than money) as the time the partner
acquired his interest exceeds 110 percent of its adjusted basis to the partnership.
The regulations limit application of this rule to cases where lack of a Section 732(d)
election would cause a shift in basis from nondepreciable to depreciable property
Deemed Distributions of Money

A deemed distribution of money under Section 752(b) resulting from a decrease in a
partner’s share of the liabilities of a partnership is treated as an advance or drawing of
money to the extent of the partner’s distributive share of income for the partnership
taxable year.
An amount treated as an advance or drawing of money is taken into account at the end of
the partnership taxable year.
A deemed distribution of money resulting from cancellation of debt may qualify for
advance or drawing treatment
In a distribution of encumbered property, the resulting liability adjustments will be
treated as occurring simultaneously, rather than occurring in a particular order
Therefore, on a distribution of encumbered property, the amount of money considered
distributed to a partner for purposes of section 731(a)(1) is the amount (if any) by which
the decrease in the partner’s share of the liabilities of the partnership under Section
752(b) exceeds the increase in the partner’s individual liabilities under Section 752(a)
The amount of money considered contributed by a partner for purposes of Section 722 is
the amount of (if any) by which the increase in the partner’s individual liabilities under
Section 752(a) exceeds the decrease in the partner’s share of the liabilities of the
partnership under section 752(b)
The increase in the partner’s individual liabilities occurs by reason of the assumption by
the partner of partnership liabilities, or by reason of a distribution of property subject to
a liability, to the extent of the fair market value of such property
CONSEQUENCES ON SUBSEQUENT SALES OF DISTRIBUTED PROPERTY
Characterization
Under Section 735(a), gains or losses recognized by a distributee partner on the
disposition of “unrealized receivables” received in a distribution are treated as ordinary
income or loss, and gains or losses on the sale or exchange of distributed inventory items
suffer a similar character taint if they are sold or exchanged by the partner within five
years from the date of their distribution. In the case of unrealized receivables, the
character taint remains with the assets as long as they are held by the distributee partner
If an item is both an unrealized receivable and an inventory item, the more stringent rules
governing receivables are applicable
The Section 735 taint cannot be removed in a nonrecognition transaction or a series of
such transactions
Except in the case of C corporation stock received in a Section 351 corporate formation,
the taint carries over to the exchanged basis property received in the transaction
The Section 735(a) taint rules do not apply to recapture property. But the recapture gain
which the partnership would have recognized on a sale of the property carries over to the
distributee partner, who recognizes ordinary income on a subsequent sale or exchange.
This is accomplished through the definitions of “recomputed basis” and “additional
depreciation” in the applicable recapture provisions
Tacked Holding Periods

Section 735(b) allows the distributee partner to tack the partnership’s holding period
with respect to property with a transferred basis from the partnership, and also any
distributed property which has some special type of basis
Tacking is not permitted, however, in measuring the five-year taint applicable to
distributed property items
LIQUIDATING DISTRIBUTIONS
What changes in a liquidating distribution is that a recipient partner can conceivably

recognize a loss under 731(a)(2).
Only way to do this is if the liquidating distributing to him consists of only cash,
unrealized receivables, or inventory. If he gets anything else, he can't recognize a loss. If
he does only get cash, unrealzied receivables or inventory, 731(a)(2) says amount of loss
he can recognize will be equal to his outside basis less the sum of the cash that he
receives, plus the partner's basis in the unrealized receivables and/or inventory.
Then, last thing to focus on is his basis in distributed property. There, 732(b) applies:
basis in distributed property overall will be equal to outside basis for pship interest less
any money received. And then, if you get multiple assets, 732(c) says how to allocate the
available basis among the various assets received. It says the first thing to do is allocate
available basis to hot assets in an amount up to but not exceeding partner's basis interest
in the partnership. Then, remaining outside basis available goes to any other assets
received as a result of liquidating distribution. In terms of basis being taken, if getting
hot assets in pship, basis can never step up from partnership to hands of partner, but could
conceivably step down. As to other assets, it is conceivable to step up basis of cold assets
as they leave the pship.
If there is unused basis, recognizable loss under 731(a)(2) only if receiving cash,
unrealized receivables, and inventory.
Pro-Rata Liquidating Distributions
As with operating distributions, a partner recognizes gain on a liquidating distribution
only to the extent that the cash received exceeds the partner’s outside basis
If both cash and other property are distributed, Sections 731 and 732 work in tandem to
treat the distribution as a nonrecognition transaction
First, the partners reduces his outside basis by the cash received, and, in effect, he
exchanges his remaining partnership interest for the other assets received in the
distribution
Section 731 provides nonrecognition treatment to the partner and the partnership on the
distribution, and Section 732(b) provides the partner with an aggregate basis in the
distributed property equal to his predistribution outside basis less any cash received in the
liquidation
If more than one asset is distributed Section 732(c) once again prescribes the method for
allocating the aggregate exchanged basis to the distributee partner
If inventory items or unrealized receivables have been distributed, those properties are
first tentatively assigned a basis equal to the basis of such property to the partnership
If the sum of the partnership’s bases in the distributed unrealized receivables and
inventory items exceeds the basis to be allocated (the partner’s outside basis less cash
received in the transaction, then the partnership’s bases in those properties must be
reduced by the amount of the excess
The reduction is achieved by first allocating basis decreases among the properties with
unrealized built-in loss in proportion to the amounts of such loss and only to the extent of
the built-in loss of each property
If needed, additional decreases are allocated in proportion to the remaining adjusted
bases of the unrealized receivables and inventory items
If the basis to be allocated exceeds the partnership’s basis in the distributed unrealized
receivables and inventory items, then each other distributed property is next assigned a
basis equal to the partnership’s basis in that property
Basis increases or decreases then must be allocated to the other distributed properties if
the partner’s remaining basis (i.e., the basis remaining after any unrealized receivables
or inventory items are assigned basis equal to their bases in the hands of the partnership)
is greater or less than the sum of the partnership’s bases in those properties
If an overall increase is required, the increase is accomplished by first allocating basis
increases among the properties with unrealized appreciation in proportion to such
appreciation and only to the extent of each property’s unrealized appreciation. Any
additional increases are allocated in proportion to the respective fair market values of the
properties
If an overall decrease is required, the decrease is accomplished by first allocating basis
decreases in proportion to the unrealized built-in loss in the properties (again, only to the
extent of such loss) and then in proportion to the remaining adjusted bases of the
properties
The distributee partner may tack the partnership’s holding period under Section 735(b),
and Section 735(a) preserves the ordinary income character in the hands of the partner
indefinitely for any unrealized receivables and five years for inventory items
If the partner receives solely cash, unrealized receivables and inventory items in a
liquidating distribution, Section 731(a)(2) provides that the partner recognizes a loss to
the extent that his outside basis exceeds the sum of the cash distributed plus the partner’s
Section 732 transferred basis in the receivables and inventory items
The loss is considered as incurred on the sale or exchange of a partnership interest and
thus is a capital loss under Section 741
Where a partner receives only cash, any realized gain or loss must be recognized because
the partner may not defer recognition by way of an exchanged basis
Effects of Distributions on Adjusted Basis of Undistributed Assets
734. Issue is to what extent might a pship distribution affect pship's basis in its remaining
assets. Relevant only if pship continues after distribution takes place. It's sort of like
743, where pship adjusts basis of inside assets as a result of a sale of pship interest.
General rule 734(a): pship inside basis will not be adjusted as result of distribution
unless an election of 754 in effect by pship or unless there would be a substantial basis
reduction, i.e. reduction of more than 250k.
If basis adjustment is elected or required, then pship will adjust the inside basis of
remaining assets when one of the situations described in 734(b) exists
Problem 1
(a) A receiving cash in excess of outside basis and as a result has to recognize a gain of
$2. Pship retains two parcels w/ only B and C as partners in business. Also notice @
time of distribution, there was 6 of unrealized appreciation lurking in pship assets. On
the liquidating distribution to A, A picks up two of gain. BUT, if pship does not have a
754 election in effect, pships basis in land going forward remains unchanged. So if later
on partnership sells parcel 2 for fmv of 10, there will be 6 of gain to pship as a result of
sale allocated among B and C. So, w/o an election and adjustment to inside basis, what
had been 6 of unrealized appreciation in pship assets has transformed itself into 8 of gain;
2 to A, 6 split btw B and C. To remove that disparity, 734(b)(1)(A): assuming 754
election in place, partnership can or will increase basis of its undistributed property by
the amount of the 731 gain recognized by the recipient partner. Here, the adjustment
would be a positive one of $2. Then, have to allocate basis adjustment among the assets
remaining w/in pship under 755. Regs thereunder however say that an adjustment
resulting from gain recognized on a distribution has to be allocated to pships cap assets or
1231 property. Also, under 755 regs, basis increase is allocated among the cap assets first
to assets that have unrealized appreciation @ time of distribution. Here, 2 positive
adjustment goes to land 2 b/c has unrealized appreciation. Unlike 743, that basis
adjustment is for the benefit of all of the remaining partners. If pship thereafter sells
land, pship will only have 4 of gain, and add to it 2 gain that A reported on distributed to
him, you have the 6 gain mirroring unrealized appreciation at time liquidation
distribution was made.
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Sole Props General Partnership Limited Partnership Limited Liability Partnership

Pop for Law, accts, architects

Under RUPA §701, when a partner dies:

What does RULPA have to say about the

A limited partnership with a Corporate GP

Partnership statutes typically provide that LLP is

LLC members: both in

Some LLC statutes suggest that

Corp has centralized management

Officers: carry out policies formulated by

Shareholders elect the board. MBCA

Corporate Directors and Officers owe

Controlling shareholders: have more

Distinguishing the LLP from the LP:

The Formation of a Closely Held Corporation

installment method proposed Reg. § 1.453-1(f)(3)(ii)

Distribution earnings Results

Distributed 7/1 Accumulated As of distribution Current year current accumulated

= amount of each distribution * current e&p/total current

Who generally Corporations, Sole Sole Sole Sole Sole Sole

Can employer Yes Yes Yes No Yes No No

Who directs Employer/Trustee Individual Employer/Trustee Individual Employer/Trustee Individual Individual

IRA Yes Yes Yes Yes Yes Yes Yes

Minimum vesting Immediate on Immediate Immediate Immediate Employer Immediate Immediate

2. Liability Assumed by Corp:

Minus: Boot rec d: Cash & FMV of Non-Money Boot

Non- 1. Distribution Amount (DA) equals: 1. Non-Liquidating distribution to a Partner is Non-

5. Note: Distributions of non-money Property

Complete 1. Recognized Gain or Loss to S/H 1. Complete Withdrawal (Liquidation)

5. Becker Pass Key: Must understand the difference

Non- NBV Asset Taken Stop at Zero

Liquidating Partnership Must "Zero-

Stock 1. Redemption is Proportional = Dividend treatment

2. Redemption is Substantially Disproportionate =

Business Taxation Overview

Requirements of a Good § 351

• Payments of principal or interest on debt

Dividends and Earnings and Profit § 316

• The sole beneficiary of the estate is the mother

• Mother is sole beneficiary of Estate

• Amount of distribution, whichever is LESS.

Redemptions through Related Corporations § 304

• What if sells 60 shares of X corp to Y corp?

• What if he sold some stock of the parent to the subsidiary?

• If it participates in growth, it's common stock.

• Automatically treated as distribution covered by IRC § 301

• This would instead be treated as FMV of the note.

• Restrictions on carryover of tax attributes under IRC § 382

• Amortization of intangibles (IRC §197) - (i.e. goodwill of the business, non-compete

• Both parties must report allocation on particular IRS form

• § 362 - P takes assets with a carryover basis.

§ 361 - Corporations in a Reorganization

§ 354 - Shareholders in a Reorganization

• (A) Statutory merger/consolidation

• (C) Stock for Assets

• (D) Corporate divisions (and others)

• Boot is allowed, but it is taxed.

• Boot is allowed, but taxed