Corporate Tax

William Kratzke
Professor of Law
The University of Memphis

CALI® eLangdell® Press 2021

About the Author
Professor William Kratzke is a Cecil C. Humphreys Professor of Law at the University of
Memphis. He received his B.A. in Political Science and the Far Eastern & Russian Institute
from the University of Washington in 1971. This naturally caused him to be interested in
attending law school. He received his J.D. from Valparaiso University in 1974 and was a
member of the Valparaiso University Law Review’s editorial board. He received his
LL.M. from Georgetown University in 1977.
Professor William Kratzke teaches tax law courses at the University of Memphis. He has
been a faculty member there since 1979. He has taught courses across the curriculum. In
addition to tax courses, he has taught trademarks, torts, civil procedure, world trade law,
economic analysis, and other courses. He visited Santa Clara University and the University
of Mississippi. He received Fulbright Teaching Awards in 1997 (Moldova) and 2001-2002
(Russia).
Professor Kratzke has written in the areas of tax law, trademark law, tort law, and antitrust
law.

i

Notices
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William Kratzke, Corporate Tax, Fourth Edition, Published by CALI eLangdell Press.
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ii

About CALI eLangdell Press
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iii

Instructions to the Student
Students should have an abridged edition of the Code and Regulations.
References to the Code are either IRC § x or simply as § x. References to a regulation are
Reg. § _.xxx-x.
This material assumes the student has taken a course in Basic Income Tax.
-WPK

Note from eLangdell® Press:
This material also includes suggestions for interactive lessons posted at CALI’s website.
Access to the lessons requires membership, either through your law school or an individual
membership. Students can confirm that their law school is a member here. Additional
information about membership is available at CALI’s website.

iv

Preface
This book is a basic corporate tax text. I intend the text to be suitable for a three-hour
course. I hope that the text is accessible to law students with widely different backgrounds.
I assume that students who take the course already have taken a course in basic income
tax.
I have relied heavily on CALI exercises by Professor James Edward Maule (Villanova
University). These exercises review and teach a little substance. Each exercise zeroes in
on a specific topic and should take a student about twenty minutes to complete. A student
who works through the exercises should be able to determine whether she adequately
understands the material.
My use of pronouns referring to non-specific persons alternates between the feminine and
masculine chapter by chapter.
I benefitted greatly from the comments of anonymous reviewers, and I thank them for their
efforts.
WPK
Memphis, Tennessee, August 2018

v

List of Suggested CALI Lessons
Chapter 1: Preliminary Considerations ............................................................................... 1
Chapter 2: Forming the Corporation and Adding to Its Capital ........................................ 46
Corporate Taxation: Formation: Formation of C Corporations: Advanced Issues. ...... 73
Corporate Taxation: Formation: Formation of C Corporations: The Effect of Liabilities.
....................................................................................................................................... 87
Corporate Taxation: Formation: Formation of C Corporations: Basic Issues. ............. 89
Chapter 3: Dividends ....................................................................................................... 120
Corporate Taxation: Distributions: Distributions of Cash by C Corporations. ........... 128
Corporate Taxation: Distributions: Calculation of C Corporation Earnings and
Profits. ......................................................................................................................... 149
Corporate Taxation: Distributions: Distributions of Property by C Corporations. ..... 149
Chapter 4: Redemptions of Stock.................................................................................... 158
Corporate Taxation: Redemptions: Constructive Ownership of Stock. ...................... 163
Corporate Taxation: Redemptions: Consequences of Redemptions Under Section
302. .............................................................................................................................. 173
Corporate Taxation: Redemptions: Redemptions Not Equivalent to Dividends: Section
302(b)(1). .................................................................................................................... 173
Corporate Taxation: Redemptions: Substantially Disproportionate Redemptions:
Section 302(b)(2). ....................................................................................................... 179
Corporate Taxation: Redemptions: Redemptions Terminating Shareholder's Interests:
Section 302(b)(3). ....................................................................................................... 199
Corporate Taxation: Redemptions: Redemptions in Partial Liquidations: Section
302(b)(4). .................................................................................................................... 220
Corporate Taxation: Redemptions: Redemption Through the Use of Related
Corporations: Section 304. .......................................................................................... 226
Chapter 5: Distributions of Stock .................................................................................... 228
Corporate Taxation: Distributions: Distributions of Interests by C Corporations. ..... 263
Corporate Taxation: Distributions: Defining Section 306 Stock. ............................... 275
Corporate Taxation: Distributions: Section 306 Exceptions. ...................................... 275
Corporate Taxation: Consequences on the Disposition of Section 306 Stock. ........... 275
Chapter 6: Liquidations ................................................................................................... 276
vi

Corporate Taxation: Liquidations: Corporate Liquidations: Effects on Shareholders:
Sections 331 & 334(a). ................................................................................................ 298
Corporate Taxation: Liquidations: Distributions of Property in Complete Liquidations:
Section 336. ................................................................................................................. 298
Corporate Taxation: Liquidations: Subsidiary Liquidations: Section 332. ................. 314
Chapter 7: Subchapter S .................................................................................................. 315
S Corporation Taxation: Formation and Qualification: Eligibility as Small Business
Corporation. ................................................................................................................ 326
S Corporation Taxation: Formation and Qualification: S Corporation Elections. ...... 328
S Corporation Taxation: Taxation of the Shareholder: S Corporation Separately Stated
Items. ........................................................................................................................... 351
S Corporation Taxation: Distributions: Distributions of Cash by an S Corporation. . 351
S Corporation Taxation: Taxation of the S Corporation: S Corporation Built-in Gains:
General. ....................................................................................................................... 369
S Corporation Taxation: Taxation of the S Corporation: S Corporation Built-in Gains:
Computation of the Tax. ............................................................................................. 370
S Corporation Taxation: Taxation of the S Corporation: S Corporation Tax on Passive
Investment Income. ..................................................................................................... 373
S Corporation Taxation: Taxation of the Shareholder: S Corporation Entity Level
Determinations. ........................................................................................................... 373
S Corporation Taxation: Taxation of the S Corporation: S Corporation LIFO Recapture
Rules. ........................................................................................................................... 373
S Corporation Taxation: Termination of the S Election: The Termination of S Election
by Revocation.............................................................................................................. 375
S Corporation Taxation: Termination of the S Election: The Termination of S Election:
Causes. ........................................................................................................................ 375
S Corporation Taxation: Termination of the S Election: The Termination of S Election:
Consequences. ............................................................................................................. 379
S Corporation Taxation: Termination of the S Election: The Post Termination Transition
Period of an S Corporation. ......................................................................................... 379
Chapter 8: Taxable Acquisitions ..................................................................................... 380
Chapter 9: Reorganizations ............................................................................................. 404
Corporate Taxation: Reorganizations: A Reorganizations: Definition. ...................... 425
Corporate Taxation: Reorganizations: Tax Consequences of A Reorganizations. ..... 425
vii

Corporate Taxation: Reorganizations: B Reorganizations: Definition. ...................... 446
Corporate Taxation: Reorganizations: Tax Consequences of B Reorganizations. ..... 446
Corporate Taxation: Reorganizations: C Reorganizations: Definition. ...................... 453
Corporate Taxation: Reorganizations: Tax Consequences of C Reorganizations. ..... 453
Corporate Taxation: Reorganizations: G Reorganizations: Definition. ...................... 454
Corporate Taxation: Reorganizations: D Reorganizations: Definition. ...................... 469
Corporate Taxation: Reorganizations: D Reorganizations: Tax Consequences of
Acquisitive D Reorganizations. .................................................................................. 469
Corporate Taxation: Reorganizations: D Reorganizations: Definition. ...................... 494
Corporate Taxation: Reorganizations: Tax Consequences of Divisive D
Reorganizations. .......................................................................................................... 495
Corporate Taxation: Reorganizations: Tax Consequences of A Reorganizations. ..... 508
Corporate Taxation: Reorganizations: E Reorganizations: Definition. ...................... 512
Corporate Taxation: Reorganizations: F Reorganizations: Definition. ....................... 514

viii

Table of Contents
About the Author .................................................................................................................. i
Notices ................................................................................................................................. ii
About CALI eLangdell Press ............................................................................................. iii
Instructions to the Student .................................................................................................. iv
Preface ................................................................................................................................. v
List of Suggested CALI Lessons ........................................................................................ vi
Chapter 1: Preliminary Considerations ............................................................................... 1
I. Choosing Whether and When to Incorporate ............................................................... 4
II. The Corporation’s Capital Structure: Getting Money Out of the Corporation Through
Payments of Loan Principal and Interest ........................................................................ 8
Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (5th Cir.), cert. denied, 409
U.S. 1076 (1972) ................................................................................................... 11
Note on § 385 ........................................................................................................ 23
Note on § 163(j) .................................................................................................... 24
III. Getting Money Out of the Corporation Through Deductible Payments ................. 25
A. Employment ......................................................................................................... 25
Menard, Inc. v. Commissioner, 560 F.3d 620 (CA7 2009)................................... 25
B. Sale of Property .................................................................................................... 34
Burr Oaks Corporation v. Commissioner, 365 F.2d 24 (7th Cir. 1966), cert. denied,
385 U.S. 1007 (1967) ............................................................................................ 34
C. Loans to Shareholders .......................................................................................... 38
Bergersen v. Commissioner, 109 F.3d 56 (1st Cir. 1997)...................................... 38
Chapter 2: Forming the Corporation and Adding to Its Capital ........................................ 46
I. Transfer of Property to the Corporation..................................................................... 51
James v. Commissioner, 53 T.C. 63 (1969) .......................................................... 51
II. Control “Immediately After the Exchange” ............................................................. 57
Intermountain Lumber Co. v. Comm’r, 65 T.C. 1025 (1976)............................... 57
III. The Transferor Group.............................................................................................. 65
Kamborian v. Commissioner, 56 T.C. 847 (1971), aff’d, 469 F.2d 219 (1st Cir.
1972) ..................................................................................................................... 65
ix

IV. Boot and Derivative Issues ..................................................................................... 73
A. Transfer of Multiple Properties ............................................................................ 73
Rev. Rul. 68-55, 1968-1 C.B. 140 ......................................................................... 73
B. Assumption of Liabilities ..................................................................................... 79
Drybrough v. Commissioner, 376 F.2d 350 (6th Cir. 1967) .................................. 80
C. Non-Qualified Preferred Stock ............................................................................. 87
D. Boot and the Installment Method ......................................................................... 89
V. Including Transferor Shareholder’s Promissory Note in Transferor’s Stock Basis . 92
Peracchi v. Commissioner, 143 F.3d 487 (9th Cir. 1998) ..................................... 92
VI. Section 351 and Assignment of Income ............................................................... 104
Hempt Bros., Inc. v. United States, 490 F.2d 1172 (3d Cir. 1974) ..................... 104
Rev. Rul. 80-198, 1980-2 C.B. 113 ..................................................................... 109
VII. Contributions to Capital ....................................................................................... 112
Commissioner v. Fink, 483 U.S. 89 (1987) ........................................................ 112
Chapter 3: Dividends ....................................................................................................... 120
I. A Corporation’s Earnings and Profits ...................................................................... 122
Rev. Rul. 74-164, 1974-1 C.B. 74 ....................................................................... 124
II. Distributions “With Respect to [Shareholder’s] Stock” ......................................... 129
III. Disguised Dividends ............................................................................................. 129
A. Use of Corporate Property .................................................................................. 129
Tanner v. Commissioner, 45 T.C.M. 1419 (1983), T.C. Memo 1983-230 ......... 129
B. Corporate Payment of Personal Obligations ...................................................... 132
Sullivan v. United States, 363 F.2d 724 (8th Cir. 1966) ...................................... 132
Rev. Rul. 69-608, 1969-2 C.B. 42 ....................................................................... 134
C. Bargain Sales to Shareholders ............................................................................ 137
Honigman v. Commissioner, 466 F.2d 69 (6th Cir. 1972)................................... 137
D. Below-Market Loans, § 7872, and Other Ploys ................................................. 142
IV. Corporate Distributions: Tax Consequences to Shareholder ................................ 144
V. Income Tax Consequences to Corporation of Distributions to Shareholders and Their
Effect on Earnings and Profits, § 312 ......................................................................... 145
VI. Corporate Shareholders ......................................................................................... 149
x

Litton Indus., Inc. v. Commissioner, 89 T.C. 1086 (1987) ................................. 150
Chapter 4: Redemptions of Stock.................................................................................... 158
I. Introduction .............................................................................................................. 158
II. Attribution Rules, § 318 ......................................................................................... 161
III. Interest-Reducing Redemptions: § 302(b)(1, 2, and 3) ......................................... 163
A. Section 302(b)(1): Distributions Not Essentially Equivalent to a Dividend ...... 164
United States v. Davis, 397 U.S. 301 (1970) ...................................................... 164
B. Section 302(b)(2): Substantially Disproportionate Redemption of Stock .......... 173
Rev. Rul. 87-88, 1987-2 C.B. 81 ......................................................................... 174
C. Section 302(b)(3): Complete Termination of Interest ........................................ 179
1. Intergenerational Transfers of Business .......................................................... 179
Lynch v. Commissioner, 801 F.2d 1176 (9th Cir. 1986) .................................... 180
Hurst v. Commissioner, 124 T.C. 16 (2005) ....................................................... 189
2. Transfers of a Business When There is Intra-Family Hostility ....................... 199
3. Waiver of Family Attribution by an Entity ..................................................... 201
4. Transfers in the Context of a Divorce Settlement ........................................... 203
5. Redemptions in the Context of an Acquisition ............................................... 206
Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954) ................................................. 206
6. Redemptions from Corporate Shareholders; Increasing the Interest of Remaining
Shareholders ........................................................................................................ 209
Holsey v. Commissioner, 258 F.2d 865 (3d Cir. 1958) ...................................... 210
IV. Partial Liquidations: § 302(b)(4)........................................................................... 213
Imler v. Commissioner, 11 T.C. 836 (1948), acq................................................ 215
V. Section 302(b)(5) .................................................................................................... 220
VI. Redemptions to Pay Death Taxes: § 303 .............................................................. 221
VII. Redemptions Through Related Corporations, § 304 ........................................... 223
VIII. Consequences of Redemptions to Corporation .................................................. 227
Chapter 5: Distributions of Stock .................................................................................... 228
I. Concerns about Converting Ordinary Income into Capital Gain and Changing a
Shareholder’s Relative Interest in a Corporation: From Macomber to §§ 305, 306 and
307 ............................................................................................................................... 228
Koshland v. Helvering, 298 U.S. 441 (1936) ...................................................... 231
xi

II. Section 305 ............................................................................................................. 235
A. Section 305(b)(1) ................................................................................................ 236
Rev. Rul. 78-375, 1978-2 C.B. 130 ..................................................................... 237
Frontier Savings Ass’n v. Commissioner, 87 T.C. 665, aff’d sub nom. Colonial
Savings Ass’n v. Commissioner, 854 F.2d 1001 (CA7 1988), cert. denied, 489 U.S.
1090 (1989) ......................................................................................................... 242
B. Section 305(b)(2) ................................................................................................ 252
Rev. Rul. 78-60, 1978-1 C.B. 81 ......................................................................... 253
C. Section 305(b)(3) ................................................................................................ 258
D. Section 305(b)(4) ................................................................................................ 259
E. Section 305(b)(5) ................................................................................................ 259
F. Section§ 305(c): Deemed Stock Distributions .................................................... 261
III. Section 307: Basis in Dividend Stock ................................................................... 263
IV. Section 306 Stock.................................................................................................. 265
A. Dispositions of Section 306 Stock: Tax Consequences ..................................... 266
B. Definition of Section 306 Stock ......................................................................... 267
Rev. Rul. 75-236, 1975-1 C.B. 106 ..................................................................... 267
Rev. Rul. 81-186, 1981-2 C.B. 85 ....................................................................... 270
C. Exceptions .......................................................................................................... 273
Chapter 6: Liquidations ................................................................................................... 276
I. Introduction .............................................................................................................. 276
II. Nonsubsidiary Liquidation ..................................................................................... 277
Norwalk v. Commissioner, T.C. Memo 1998-279 .............................................. 278
Rev. Rul. 85-48, 1985-1 C.B. 126 ....................................................................... 287
Rendina v. Commissioner, T.C. Memo. 1996-392 ............................................. 289
III. Liquidation of Subsidiary ...................................................................................... 299
Granite Trust Co. v. United States, 238 F.2d 670 (1st Cir. 1956)........................ 302
Rev. Rul. 70-106, 1970-1 C.B. 70 ....................................................................... 310
Rev. Rul. 75-521, 1975-2 C.B. 120 ..................................................................... 311
Chapter 7: Subchapter S .................................................................................................. 315
I. Introduction .............................................................................................................. 315
xii

II. Conditions of Qualification for S Corporation Status ............................................ 318
A. Counting Shareholders: Whom to Count ........................................................... 318
B. Who Can Be a Shareholder ................................................................................ 319
C. One Class of Stock ............................................................................................. 322
D. Making the Election and Terminating the Election............................................ 326
Kean v. Commissioner, 469 F.2d 1183 (9th Cir. 1972) ....................................... 328
A.W. Chesterton Company, Inc. v. Chesterton, 128 F.3d 1 (1st Cir. 1997) ........ 333
III. Income Tax Rules Applicable to S Corporations and Their Shareholders ........... 339
A. Tax Rules Applicable to S Corporations ............................................................ 339
B. Section 199A: Qualified Business Income Deduction ....................................... 340
C. Income Tax Rules for S Corporations and Shareholders’ Basis ........................ 350
D. Subchapter S and Cancellation of Indebtedness Income .................................... 352
E. Corporate Indebtedness and Shareholder Basis .................................................. 353
Estate of Leavitt v. Commissioner, 875 F.2d 420 (4th Cir.), cert. denied, 493 U.S.
958 (1989) ........................................................................................................... 354
IV. From C to S ........................................................................................................... 363
V. S Corporation Taxes ............................................................................................... 367
A. Tax Imposed on Built-in Gains .......................................................................... 367
B. Tax on Passive Investment Income .................................................................... 371
C. LIFO Recapture Tax ........................................................................................... 373
VI. Fringe Benefits, Employee Matters ...................................................................... 373
VII. Termination Matters ............................................................................................ 374
A. Termination of Election...................................................................................... 374
B. Termination of Election: S Short Year and C Short Year .................................. 376
C. Post Termination Transition Period .................................................................... 377
D. Suspended Losses and Distributions During the Post-Termination Transition
Period ...................................................................................................................... 378
Chapter 8: Taxable Acquisitions ..................................................................................... 380
I. Introduction .............................................................................................................. 380
II. The Immediate Tax Consequences of an Acquisition of Assets for Cash.............. 382
Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945) ......................................... 383
xiii

III. Purchase of Stock Treated as Asset Purchase and the § 338 Election .................. 388
Kimbell-Diamond Milling Company v. Commissioner, 14 T.C. 74 (1950), aff’d
187 F.2d 718 (5th Cir.), cert. denied, 342 U.S. 827 (1951) ................................. 388
IV. Introduction to Triangular Mergers: Forward and Reverse Cash Mergers ........... 402
Chapter 9: Reorganizations ............................................................................................. 404
I. Introduction .............................................................................................................. 404
II. Common Law Requirements .................................................................................. 406
A. Continuity of Business Enterprise (COBE)........................................................ 407
1. Business Continuity......................................................................................... 408
2. Asset Continuity .............................................................................................. 408
B. Continuity of Proprietary Interest (COPI) .......................................................... 409
Rev. Rul. 66-224, 1966-2 C.B. 114 ..................................................................... 410
C. Business Purpose ................................................................................................ 412
Gregory v. Helvering, 293 U.S. 465 (1935) ........................................................ 412
III. Acquisitive Reorganizations ................................................................................. 416
A. “A” Reorganizations........................................................................................... 418
Rev. Rul. 2000-5, 2000-1 C.B. 436 ..................................................................... 419
B. “B” Reorganizations ........................................................................................... 425
Chapman v. Commissioner, 618 F.2d 856 (1st Cir. 1980) .................................. 427
Rev. Rul. 79-4, 1979-1 C.B. 150 ......................................................................... 440
Rev. Rul. 98-10, 1998-1 C.B. 643 ....................................................................... 442
C. “C” Reorganizations ........................................................................................... 446
Rev. Rul. 70-107, 1970-1 C.B. 78 ....................................................................... 448
Rev. Rul. 88-48, 1988-1 C.B. 117 ....................................................................... 450
D. Bankruptcy: G Reorganizations ......................................................................... 453
E. Triangular Reorganizations................................................................................. 454
1. B Triangular Reorganizations ......................................................................... 456
2. C Triangular Reorganization ........................................................................... 456
3. Forward A or G Triangular Reorganizations: § 368(a)(2)(D) ......................... 457
4. Reverse A Triangular Reorganizations: § 368(a)(2)(E) .................................. 458
F. Acquisitive “D” Reorganizations ........................................................................ 459
xiv

Rev. Rul. 2002-85, 2002-2 C.B. 986 ................................................................... 462
G. Multi-Step Transactions, Forced B Reorganizations, Double Dummy
Transactions, Etc. .................................................................................................... 469
King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969) ................. 470
Rev. Rul. 67-448, 1967-2 C.B. 144 ..................................................................... 477
Rev. Rul. 84-71, 1984-1 C.B. 106 ....................................................................... 480
IV. Divisive (“D”) Reorganizations and § 355 Distributions ..................................... 482
Rev. Rul. 2003-79, 2003-29 I.R.B. 80 ................................................................ 490
V. The Tax Rules for Reorganizations: §§ 354, 355, 356, Boot, and 381 .................. 495
A. Section 354 ......................................................................................................... 495
Commissioner v. Clark, 489 U.S. 726 (1989) ..................................................... 495
B. Sections 381, 382, and 383: Tax Attributes........................................................ 506
VI. Single Entity Reorganizations: Recapitalizations and Changes in Identity, Form, or
Place of Organization .................................................................................................. 508
A. “E” Reorganization............................................................................................. 508
Rev. Rul. 86-25, 1986-1 C.B. 202 ....................................................................... 509
B. “F” Reorganization ............................................................................................. 512

xv

Chapter 1: Preliminary Considerations
A corporation is a “person” and – except for S corporations1 – subject to the income tax
rules that govern taxation of any person. Most – but not all – of those rules are the subject
of a course on Basic Income Tax. Of course, the corporation is an inanimate entity – and
for that reason the Code uses the word “individual” in rules applicable only to living
people. There are, as well, rules in the Code that apply only to corporations.
This course considers the tax consequences of dealings between corporations and their
owners, i.e., their shareholders. Shareholders form the corporation, typically by
transferring property or services in exchange for shares. Corporations may pay
nondeductible dividends to their shareholders from their after-tax profits. Corporations
may purchase, i.e., redeem, shares of itself from their shareholders. A corporation may
distribute shares of its stock to its shareholders. The tax consequences of these corporationshareholder transactions fall mainly on the shareholders. The consequences of some
transactions fall directly on the corporation, e.g., liquidation, sale of assets, merging with
another corporation. In all these cases, tax consequences will matter to shareholders.
We study in this course the basic tax consequences of treating a corporation as a taxpayer
separate and apart from the shareholders who own it. As a taxpayer separate and apart
from its shareholders, the corporation accounts for its own income and losses. Thus, for
income tax purposes, the shareholder of a corporation that suffers a loss can derive no
income tax benefit from those losses.2 On the other hand, once the corporation has paid
income tax on its profits, it may retain those profits; shareholders owe no tax until the
corporation distributes its profits to them, and the corporation determines the timing of
any distribution.
Because shareholders and the corporations that they own are separate persons, a
corporation and its shareholders may transact with each other as if transacting with third
persons. A shareholder may be an employee of the corporation, may lend money to or
borrow money from the corporation, may sell assets to or buy assets from the corporation,
etc. Such transactions generate their own tax consequences. Many of the corporations
whose affairs we examine are closely-held, and the interests of the corporation’s managers
and its shareholders are very closely aligned. If transactions between corporation and
shareholder are not arm’s length transactions, some adjustments may be in order.
Corporations may share their after-tax profits with shareholders by paying them dividends.
Corporate payments of dividends are not deductible to the corporation. This means that

1 These are pass-through entities that are discussed in chapter 7.
2 Of course, a shareholder of a corporation that is losing money would probably see the value of her shares decline.

This provides a tax advantage to shareholders only upon a recognition event, e.g., sale of the shares.

1

income that passes through the corporation to shareholders is subject to two levels of
income tax: first to the corporation itself and then, upon payment of the dividend, to the
shareholder. This double tax on corporate income has been subject to criticism from the
beginning. Nevertheless, the United States Supreme Court held it to be constitutional. Flint
v. Stone Tracy Co., 220 U.S. 107, 151-52 (1911) (Constitution does not require “excise
upon the particular privilege of doing business in a corporate capacity” to be apportioned
according to population). The double tax on corporate profits that shareholders receive
drives many decisions concerning the structure of payments from corporations to
shareholders.
Let’s assume that our corporations are all (fabulously) profitable and that their
shareholders want to enjoy those profits. (This is much more interesting than studying
corporations with no income, and therefore no choices of what to do with it.) Naturally,
shareholders want to share as little of these profits with the government as possible. To
succeed at this, those who control the corporation must pay close attention to the rates at
which corporate income and individual income are taxed.
Corporate Investment of Retained
Earnings: An investor – whether
an individual or a corporation –
invests after-tax money. If a
corporation pays less in income
tax than an individual on the
same amount of income, the
corporation can invest a greater
portion of the same amount of
income than an individual. The
greater investment hopefully
produces
greater
income,
thereby enhancing the value of
the shareholder’s shares.

If the corporate tax rate is (much) lower than the
individual tax rate, the shareholder may accumulate
more wealth by having it accumulate inside a
corporation than if she had simply earned and
accumulated the same wealth in a sole proprietorship.
Consider:
•The shareholder does not own the corporation’s profits
but rather owns shares in the corporation. The
shareholder gains/loses only by selling her shares and
relinquishing to that extent her interest in the
corporation. Whatever long-term gain an individual
shareholder eventually realizes from the sale or
redemption of her shares will be subject to income tax
at capital gains rates, which are lower than those
applicable to ordinary income.
•Illustration: A owns all the shares in X Corporation for which she paid $100
directly to X Corporation. A pays a marginal tax rate of 37% on her income. A
pays a marginal tax rate of 23.8% on her long-term capital gains. X Corporation
pays a marginal tax rate of 21% on all its income.
•If A engages in a trade or business and earns $100 of income, she will have
$63 to spend (or invest) in the year she earned it after paying $37 of income
tax.
•If X Corporation engages in the same trade or business and earns $100 of
income, it will have $79 to invest after paying $21 of income tax.
•X Corporation can invest its $79 of after-tax profit to generate
more taxable income.
2

•When A sells her shares many years later, she must pay up to
23.8% on the total amount of gain on the shares she sold.
•The present value of $79 minus the present value of 23.8% of
future gains derived over many years may be more than $63. The
time value of money will effectively reduce the burden of any
subsequent income tax that a shareholder eventually has to pay.
•This difference in present values increases as the difference
between the higher individual tax rates and the lower corporate rates
increases, and/or as the time for which the corporation retains its
earnings increases.
Prior to enactment of the Tax Cuts and Jobs Act in December 2017, corporate tax rates
were progressive. Surtaxes on higher amounts of income eliminated the progressivity. At
more than $18,333,333 of taxable income, both the marginal and effective tax rates on
corporate income were 35%.3 The Tax Cuts and Jobs Act makes the corporate tax rate a
flat 21% on all taxable corporate income. § 11(b).4 The highest marginal tax rate on an
individual’s taxable income is now 37%, down slightly from 39.6%. The highest marginal
income tax rates for individuals and corporations are now 16 percentage points apart, up
from 4.6 percentage points. The increase in this spread may drive some taxpayers to form
corporations, have the corporation earn income, and have the corporation retain and invest
its after-tax profits.
A corporation’s ability to retain its profits is not without limit. Congress addressed these
matters in the Personal Holding Company Tax (§§ 541-47) and the Accumulated Earnings
Tax (§§ 531-37). The Tax Cuts and Jobs Act likely increased the relevance of these taxes.
Personal Holding Company Tax, §§ 541 to 547: A closely-held (as specifically defined, §
542(a)(2)) corporation that derives at least 60% of its “adjusted ordinary gross income”
(as specifically defined, § 543(a)) from “personal holding company income” (as
specifically defined, § 543, to include mostly investment income) is subject to a 20% tax
on its undistributed personal holding company income (§ 541). The tax rate not
coincidentally is the highest marginal tax rate on an individual’s qualified dividend
income. The United States Supreme Court has stated that –
[t]he object of the personal holding company tax is to force corporations which are
“personal holding companies” to pay in each tax year dividends at least equal to
the corporation's undistributed personal holding company income – i.e., its
3 The Tax Cuts and Jobs Act also eliminated the alternative minimum tax on corporations.
4 The individual tax rate on taxable income is now subject to federal income tax at seven different rates (eight if

we count zero). The highest rate is 37% (previously 39.6%). There is a rate preference for taxable income that is
net capital gain, with a maximum rate of 20% (plus a surtax of 3.8% for very high-income taxpayers). The tax
brackets are indexed for inflation.

3

adjusted taxable income less dividends paid to shareholders of the corporation, see
§ 545 – thus ensuring that taxpayers cannot escape personal taxes by accumulating
income at the corporate level. This object is effectuated by imposing on a personal
holding company both the ordinary income tax applicable to its operation as a
corporation and a penalty tax of [20%] on its undistributed personal holding
company income. See §§ 541, 545, 561. Since the penalty-tax rate equals or
exceeds the highest rate applicable to individual taxpayers, see … § 1, it will
generally be in the interest of those controlling the personal holding company to
distribute all personal holding company income, thereby avoiding the [20%] tax at
the corporate level by reducing to zero the tax base against which it is applied.
Fulman v. United States, 434 U.S. 528, 531 (1978). When the highest personal and
corporate income tax rates were comparable in the burdens they imposed, there was little
advantage outside of the international arena to resorting to personal holding companies to
shelter income. The Tax Cuts and Jobs Act changed that.
Accumulated Earnings Tax, §§ 531 to 537: Congress has also imposed a 20% tax (§ 531)
on a corporation’s “accumulated taxable income” (§ 535), i.e., accumulations “beyond the
reasonable needs of the business” (§ 533(a)).
The accumulated earnings tax is one congressional attempt to deter use of a
corporate entity to avoid personal income taxes. The purpose of the tax “is to
compel the company to distribute any profits not needed for the conduct of its
business so that, when so distributed, individual stockholders will become liable”
for taxes on the dividends received.
United States v. Donruss Co., 393 U.S. 297, 303 (1969) (citation omitted). An
accumulation of earnings and profits “is in excess of the reasonable needs of the business
if it exceeds the amount that a prudent businessman would consider appropriate for the
present business purposes and for the reasonably anticipated future needs of the
business[.]” Reg. § 1.537-1(a). During the recent period of multi-billion dollar losses that
some corporations have absorbed and marginal tax rates on corporate and individual
incomes that were not significantly different, the Accumulated Earnings Tax was not often
on the minds of business persons who simply wanted their businesses to stay afloat. The
Tax Cuts and Jobs Act might change that thinking.

I. Choosing Whether and When to Incorporate
When one or more persons wish to engage in business, they initially determine the entity
through which they will conduct their business. They might choose to do business as a

4

sole proprietorship, a partnership, a limited liability company, a subchapter S corporation,5
or a C corporation.6 One policy of the Code is that the immediate tax consequences of the
choice itself should not drive the choice. The reality is that the Code taxes the profits of
different types of entities differently. Specifically, it taxes the profits of C corporations at
a flat 21% rate and then taxes dividends upon their distribution.7 It taxes the profits of
other entities at progressive rates applicable to individual taxpayers, up to 37%. 8 The
double tax on corporate profits has influenced business owners in their decision whether
and when to incorporate. For many businesses, it has been a no-brainer: do not incorporate
and instead do business in a form for which state law accords limited liability and thereby
avoid the double tax on business profits while enjoying limited liability.
Election to do business in one form rather than another does not preclude electing another
form later. Once the business-owners have made a choice, it is easy to “go up the ladder”
(i.e., to convert from a sole proprietorship to a partnership, LLC, or an S corporation, and
then to a C corporation). However, for a C corporation – except for converting from a C
corporation to an S corporation – it can be quite costly to come down. This is because there
are tax consequences to liquidating the C corporation itself, but not to liquidating any of
the other entities. (This is not to say that there would not be tax consequences to the owner
of another liquidating entity.)
Whether to incorporate is a determination that will turn on many considerations. The Tax
Cuts and Jobs Act has made this a more nuanced determination. Some considerations
relevant to the decision whether to incorporate – not all related to the Tax Cuts and Jobs
Act – include the following:
•The tax rate applicable to C corporations is now a flat 21%. The tax rates
applicable to individual taxpayers (including the owners of so-called pass-through
entities) are progressive and top out at 37%. Obviously, taxpayers who are
considering incorporation as a C corporation would want to determine the likely
relative tax burdens of incorporating or of not incorporating.
•Tax rates apply to losses and deductions as well as to income. As a separate
taxpayer, a corporation’s losses do not provide a tax benefit to its shareholders. A
taxpayer saves more when losses or deductions offset income that is (or would be)
subject to a higher rate of tax. This may lead a taxpayer who anticipates losses in
the early years of a business to defer incorporating until the business is profitable.
•The Tax Cuts and Jobs Act created a deduction for pass-through entities of up to
20% of their trade or business income. § 199A. A C corporation may not avail
5 A “small business corporation.” § 1361(a)(1).
6 A corporation that is not a “small business corporation.” § 1361(a)(2).
7 We will assume that the dividends are “qualified” under § 1(h)(11)(B) and so subject to income tax at the capital

gain rates when individuals are the taxpayers.
8

The deduction for “qualified business income” (§ 199A) can reduce this rate.

5

itself of this deduction. A taxpayer should consider the realistic availability and
likely amount of a § 199A deduction. For the moment, we can note that this will
depend on how much taxpayer pays in W-2 wages and/or the unadjusted basis of
its depreciable property. See chapter 7 (subchapter S corporations).
•The double tax on corporate income only applies upon the distribution of a
dividend. Shareholder(s) of a closely-held corporation can time the distribution of
a dividend to suit themselves and exploit the time value of money to reduce the
burden of an income tax on the distribution.
•The assets that an individual taxpayer transfers to a corporation are probably more
secure from the claims of the individual’s creditors than when held by another
entity.
•Corporations can pay dividends to passive investors. This can effectively permit
income splitting among family members.
•A C corporation has a perpetual existence. The death, incapacity, retirement,
divorce, etc. of a business’s owners do not affect the continued existence of a
corporation the way such matters might affect a sole proprietorship or a
partnership.
•Ownership of a C corporation is manifested by shares. This can be convenient
when transferring an ownership interest, whether by sale or inheritance. Ownership
of shares may facilitate the implementation of a step-up in basis under § 1014.
•C corporations may have readier access to capital markets. Raising capital, either
through debt or equity, may be easier for a C corporation.
•For some taxpayers, a C corporation may better accommodate their concern with
anonymity.
•A C corporation can have an unlimited number of shareholders who reside
anywhere in the world. This might not be true of other entity forms.
•The Tax Cuts and Jobs Act curtailed an individual taxpayer’s employee and
nonbusiness profit-seeking deductions. § 67(g) (no miscellaneous deductions
allowed until 2026). These limitations do not apply to C corporations.
•The Tax Cuts and Jobs Act makes the dividends paid to domestic corporations by
foreign subsidiaries fully deductible. § 245A. If a taxpayer is likely to seek profits
in international markets, she should consider doing business as a corporation,
whether as an S corporation or as a C corporation. Otherwise, she is subject to U.S.
income taxation on her worldwide income, including dividend income derived
from foreign corporations they might own.
This is not an exhaustive list of matters that a business owner should consider when
deciding whether to incorporate. The list should serve as a reminder that the decision of
whether to incorporate is not always obvious. And as noted, the choice of entity is not
immutable. It may be that only over time, factors that lead to a decision to incorporate may
emerge.

6

The Code defines a “corporation” that is subject to the federal income tax to include an
association, joint-stock company, and insurance company. § 7701(a)(3). At one time, the
“double tax” on corporate income led many to resist IRS classification of their business
entities as one of the entities included within the ambit of the term “corporation.” The
regulations now alleviate much of the litigation over classification by giving an “eligible
entity” a choice of the tax treatment it wishes. Reg. § 301.7701-3(a). There are certain
entities that the regulations classify as per se corporations; hence, they may not elect to be
taxed as an entity other than a corporation. Reg. § 301.7701-3(a). Such entities include –
•entities organized under laws describing them as corporations, joint-stock
companies, or joint-stock associations;
•insurance companies;
•entities engaged in banking activities;
•entities wholly owned by a State or political subdivision or by a foreign
government; and
•various foreign entities organized under the laws of other jurisdictions.
Reg. § 301.7701-2(b).
From a tax perspective, the decisions whether and when to incorporate will often depend
initially on whether the owners of a business can take advantage of business deductions.
Because a corporation is a separate taxpayer, business losses may be “locked inside the
corporation” – and reduce no one’s taxable income until the entity is profitable.
Recall (or learn, if necessary) now some basic principles. Basis is money that won’t be
subject to income tax, usually because it has already been taxed. Basis then becomes a
means by which taxpayer keeps score with the Government. A taxpayer can get basis with
borrowed money. While the proceeds of a loan are not subject to income tax, taxpayer will
repay the loan with after-tax income; in this way the proceeds of a loan are subject to
income tax. A taxpayer may only claim deductions against income that has been subject
to income tax. Deductions reduce taxable income – they “untax” it – and so taxpayer must
reduce basis by the amount of deductions that actually reduce taxpayer’s taxable income.
If taxpayer wants to deduct business expenses from taxable income, taxpayer must have
basis against which to claim those deductions. See, e.g.¸ Peracchi v. Commissioner, 143
F.3d 487, 491 (CA9 1998) (negative basis not allowed). Taxpayer individually may get
that basis with borrowed money, but cannot get it with money that a corporation borrows,
even if taxpayer is the sole shareholder. The corporation is a different taxpayer.
Moreover, a taxpayer may engage an agent to procure a loan. Taxpayer would be just as
liable for repayment of the loan as if he had procured the loan himself. Indeed there are
businesses whose trade is to act as agents to procure loans for others. There’s nothing
special about any of this. But now suppose: state law has made it illegal to loan money at
market rates to an individual, but not to a corporation. State law has deemed the market
7

rate of interest to be usurious. It would seem that the individual taxpayer has no choice but
to engage the services of a corporation to procure a loan. And suppose further that an
individual taxpayer (or a partnership) forms a corporation to procure the loan and to hold
title to the property securing the loan as agent for our individual taxpayer (and his
partners).
In Commissioner v. Bollinger, 485 U.S. 340 (1988), individual taxpayers claimed interest
deductions in such an arrangement. The Commissioner argued that in the absence of an
arm’s length relationship between principal and agent, only the corporation as title holder
could claim interest deductions. The Supreme Court disagreed:
[T]he genuineness of the agency relationship is adequately assured, and taxavoiding manipulation adequately avoided, when the fact that the corporation is
acting as agent for its shareholders with respect to a particular asset is set forth in
a written agreement at the time the asset is acquired, the corporation functions as
agent and not principal with respect to the asset for all purposes, and the
corporation is held out as the agent and not principal in all dealings with third
parties relating to the asset.
Id. at 349-50. Bollinger and his partners constructed apartment complexes. During
construction and shortly thereafter, they could anticipate losses and expenses. The agency
arrangement made it possible for losses to reduce their taxable income.

II. The Corporation’s Capital Structure: Getting Money Out of the
Corporation Through Payments of Loan Principal and Interest
A corporation is an entity separate and apart from those who own it. The corporation pays
tax on its income. The owners of a corporation pay tax on their income, and that income
includes the after-tax profit that the corporation chooses to share with them in the form of
dividends. Thus corporate income is subject to two levels of income tax if the corporation
distributes any of its after-tax profits to its shareholders.
A corporation must of course have capital to operate. The manner in which the owners or
managers choose to raise capital will determine how the corporation will share its profits
with those who have a stake in the corporation. That in turn will affect the amount of income
on which they must pay tax. In the broadest possible sense, corporations may capitalize
themselves either by selling ownership interests in itself (equity) or by borrowing money
(debt).

8

•Equity: A corporation may raise capital by selling ownership (equity) interests in itself.
In the case of a typical corporation, this (usually) takes
the form of stock. Owners of stock have, to one degree Shareholder contributions to
or another, the rights to control the corporation through capital: Taxpayer may acquire
directly
from
the
the exercise of voting rights, to share in the shares
corporation’s after-tax profits, to enjoy benefits derived corporation in exchange for
from the corporation’s growth, and to share in the money and other property. Such
to
capital”
proceeds of a liquidation. The value of any of these “contributions
generate
no
immediate
tax
rights depends on the profitability of the corporation.
There are no guarantees that a corporation will be consequences to the corporation.
profitable. If the corporation is not profitable, the value IRC §§ 118(a), 1032(a).
of the stock that shareholders own may be nominal.
There are no tax benefits to owning stock that is losing value.
•A corporation may choose to sell equity interests that give the investor less than
all the rights of stock ownership just noted. For example, some equity investors
may purchase stock that gives them the right to receive dividends, but not the right
to vote (control) on corporate matters. Or, some investors may purchase an equity
interest that gives them the right to vote (control), but only a subordinate right to
receive dividends.
•The Code contemplates that corporations may issue common stock and preferred
stock. Owners of common stock usually have the greatest right to control the
corporation through voting. However, their rights to share in the profits of the
corporation are often subordinate to the rights of others. In the case of a highly
profitable corporation, this is not a problem. Things are different if the corporation
is not profitable.
“The term ‘preferred stock’ generally refers to stock which, in relation to
other classes of stock outstanding enjoys certain limited rights and
privileges (generally associated with specified dividend and liquidation
priorities) but does not participate in corporate growth to any significant
extent.” Reg. § 1.305-5(a) (3rd sentence).
•Owners of preferred stock are preferred with respect to the payment of dividends
that are usually limited in amount.
•Corporations share profits with shareholders by payment of dividends – whose
source is the after-tax profit of the corporation. A corporation may not deduct a
dividend that it pays to a shareholder. Receipt of a dividend does not diminish the
shareholder’s interest in the corporation.
•Debt: Alternatively, a corporation may borrow capital. The corporation must repay
borrowed money and will usually do so from after-tax profits. The creditor does not own
an interest in a corporation but is (usually) entitled to be paid before shareholders are paid.
Corporate payments of interest to a creditor reduce the corporation’s profits subject to tax.
§ 163. The interest income that the creditor receives is included in her gross income. §
61(a)(4). Receipt of the loan principal is not income to the borrower. Extension of a loan
9

is not deductible by the creditor. Once the creditor has been paid, the creditor no longer
has any rights with respect to the corporation.
•Tax Treatment: There are critical differences in the way the Code treats equity financing
(shareholders) and debt financing (lenders). The profits from which a corporation pays
dividends to a shareholder are subject to income tax at two levels: first the corporation
pays income tax on its profits, and second, the shareholder pays income tax on the dividend
that she receives. The profits from which a corporation repays loan principal to a creditor
are subject to income tax only at the corporate level. The profits from which a corporation
pays interest to a creditor are subject to income tax only at the creditor level.
In a closely-held corporation, the same persons may be both shareholders and lenders. If
all the shareholders agree to loan money to the corporation in the same relative amounts
as the number of shares that they own, the corporation’s capital structure would not differ
no matter what amount they all agreed to lend. Suppose that five persons form a
corporation, and each purchases $100 worth of common stock. Each also agrees to loan
the corporation $100,000. The corporation has $500,500 of capital with which to operate.
It would matter little if each shareholder purchased $100,000 worth of stock and loaned
the corporation $100. The corporation would still have $500,500 of capital with which to
operate. Each shareholder would own one-fifth of the corporation in either event.
But the Code would treat the taxpayers in these scenarios quite differently – assuming we
honor the form of the transactions. We assume that the corporation will be (very)
profitable. If all the financing of the corporation were through the sale of equity interests,
all the profits that the corporation shares with the shareholders would be subject to two
levels of income tax. If the corporation borrows the money from the same individuals, the
corporate profits used to repay the creditors would be subject to only one level of income
tax. Creditors would pay income tax on interest income. The corporation of course does
not pay income tax on the income with which it pays interest. The profits that the
corporation uses to repay the principal will be subject to income tax at the corporate level,
but not at the shareholder level.
If ownership of a closely-held corporation is not likely to change, there would be no reason
not to finance the operation of the corporation with as much debt as possible. The IRS
would see things differently – viewing the interests of creditors in such situations as the
same as those of owners of equity interests. Not surprisingly, the characterization of an
investor’s interest – whether equity or debt – has been the subject of much litigation.
Whether the holder of an equity interest will be paid depends on the success of the
business. Whether the holder of a debt interest will be paid does not depend (in theory) on
the success of the business. But if the risk of non-payment is sufficiently great, the holder
of a debt instrument more closely resembles the holder of an equity interest.

10

The following case presents interesting facts. The case is still widely cited. Obviously, Mr.
Jemison received (or had received on other occasions) tax advice, and he worked
(unsuccessfully) with the tax rules that he learned to achieve a certain result. Notice the
care he exercised to make his role appear to be a creditor rather than something else. For
which of the “loans” was repayment more contingent on the success of the business?

Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (5th Cir.), cert. denied, 409
U.S. 1076 (1972)
SIMPSON, Circuit Judge
This is an appeal from a determination by the Tax Court of tax deficiencies against the
corporate taxpayer, Plantation Patterns, Incorporated (New Plantation hereinafter, to
distinguish it from an earlier corporation with the same name) for the fiscal years ending
September 30, 1963-65, for the respective amounts of $2,947.12, $51,719.69, and
$23,732.28, and against the individual taxpayers, John S. Jemison, Jr. (Mr. Jemison) and
his wife, Marie S. Jemison (Mrs. Jemison) of $28,403.91 for their taxable year 1963.
[footnote omitted]. The cases were consolidated for trial in the Tax Court as they are for
purposes of this appeal.
I. THE FACTS
....
New Plantation’s corporate predecessor, which was also called Plantation Patterns, Inc.
(Old Plantation) was engaged in the business of manufacturing wrought iron furniture ...
Prior to September 28, 1962, the stockholders of Old Plantation and the outstanding shares
therein were owned as follows:
Number of Shares
Thomas E. Jernigan
William C. Jernigan
John M. Goodwin
H. Ferrell Jernigan
James C. Stone

162,483
80,718
8,812
353
17,624

Total

270,000

Before that date Mr. Thomas E. Jernigan was president and Mr. William C. Jernigan was
vice president and secretary of Old Plantation.
11

[In 1962,] ... Messrs. Thomas E. and William C. Jernigan ... decided that it would be in
their best interests to sell the wrought iron furniture business of Old Plantation and to
develop ... [Old Plantation’s] United Chair Division’s metal office chair business.
During the summer of 1962, the shareholders of Old Plantation decided that they would
attempt to sell their interests in both the wrought iron furniture and metal office chair
businesses by sale of their Old Plantation stock. In July of 1962, Mr. Jack Parish, a member
of ... [Old Plantation’s] accounting firm ... contacted Mr. John S. Jemison, Jr., the president
and controlling shareholder of Jemison Investment Co., Inc., and inquired if he would be
interested in purchasing or finding a purchaser for the stock of Old Plantation.
… Mr. Jemison was an experienced investment banker, having been in that business for at
least twenty years. ...
….
... Parish arranged for negotiations in July and August, 1962, between Messrs. Jemison
and Thomas E. Jernigan concerning the sale of Old Plantation. These negotiations led to a
general understanding between Messrs. Jemison and Thomas E. Jernigan that a
corporation would be formed to purchase all the stock of Old Plantation and that Old
Plantation would sell its United Chair Division’s metal office chair business to Messrs.
Thomas E. and William C. Jernigan.
A letter addressed to Mr. Thomas E. Jernigan dated August 24, 1962, on the letterhead of
Jemison Investment Co., Inc. and signed by Mr. Jemison, set forth a conditional offer to
purchase the “assets of the Plantation Patterns Division.” This letter stated:
“We would organize a new corporation to be known as Plantation Patterns
Corporation (it is understood that you would agree to change the name of the
existing corporation) and we would pay in a total of $155,000 in cash – $150,000
in 6½% subordinated notes – which notes would be subordinated to your notes –
and $5,000 in common stock.”
On September 25, 1962, Mr. Jemison caused New Plantation to be organized ... Upon its
incorporation, New Plantation issued ten shares of common stock with a par value of $100
per share to its incorporators. On the same date that it was incorporated, the incorporators
transferred those ten shares of stock to Mrs. Marie S. Jemison.
On September 26, 1962, New Plantation issued an additional 40 shares of common stock
to Mrs. Jemison for a price of $4,000 cash. Mrs. Jemison paid for this additional 40 shares
and her initial ten shares of stock by her check for $5,000 dated September 26, 1962. The
record does not indicate whether or not the funds for the purchase of the stock came from
12

the separate estate of Mrs. Jemison. The total capital stock of New Plantation, consisting
of the 50 shares of common stock held by Mrs. Jemison, remained at $5,000 through
September 30, 1966.
Mrs. Jemison took no active part in the preliminary negotiations leading up to the
incorporation of New Plantation on September 25, 1962, in any of the events that took
place thereafter, or in the management of New Plantation from the time it was incorporated
to September 30, 1966, inclusive. Mrs. Jemison, her husband and Mr. Thomas Bradford
were the directors of New Plantation. A meeting of the directors and a joint meeting of the
directors and stockholders of New Plantation took place on September 28, 1962. Although
Mrs. Jemison was the sole shareholder of record and a director, she attended neither
meeting. Mr. Jemison was active in the management of New Plantation. Mr. Jemison
testified that he had contacts with large department stores that sold wrought iron furniture.
On September 27, 1962, New Plantation obtained $150,000 from Bradford and Company,
Inc., an unrelated finance and investment company, for which it issued 6½% serial
debentures aggregating $150,000 maturing in $50,000 units on September 1, 1974, 1975,
and 1976. The debentures were subordinated to all other indebtedness of New Plantation
and were not guaranteed as to payment of either principal or interest. Mr. Thomas Bradford
controlled Bradford and Company. The loan by Bradford and Company was made as an
inducement to Mr. Jemison to place Mr. Bradford’s son with New Plantation. Although
this advance was made with little security and no priority as to repayment, the Tax Court
found that it was a bona fide loan.
The ... terms of sale were embodied in an agreement dated September 28, 1962 between
New Plantation and the stockholders of Old Plantation. Pursuant to that agreement, the
stockholders agreed to sell and New Plantation agreed to buy the stock of Old Plantation
… [NP purchased all of the OP stock from the OP shareholders. NP then sold the chair
division to Thomas E. Jernigan and William C. Jernigan. The balance of the purchase price
of OP stock was $709,878.33. NP was to pay this amount thus: $100,000 at the time of
closing and $609,878.33 in ten equal annual installments of $50,000 with a final
installment of $109,878.33. Jemison Investment Company and Mr. Jemison personally
guaranteed the unsecured 5½% serial notes representing the installments. Two of the
$50,000 notes were not subordinated; this enabled the Jernigans to obtain additional capital
to develop their chair business. The remaining notes were subordinated to all but the loan
from Bradford and Co. Jemison Investment Co. received annually a $15,000 guarantee
fee. The small down payment and the need for the debt to be unsecured made the guarantee
necessary.]
During the period from October 1, 1962 to September 30, 1966, New Plantation duly paid
principal and interest as due on the 6½% debentures issued to Bradford and Company and
on the 5½% notes issued to the stockholders of Old Plantation. The payments were made
by New Plantation without recourse to any additional financing.
13

During its four taxable years ended September 30, 1963 through September 30, 1966, New
Plantation accrued $117,652.65 interest expense on the 5½% serial notes issued to the
shareholders of Old Plantation, and $39,000 on the 6½% debentures issued to Bradford
and Company, which amounts it deducted on its tax returns filed for those years as the Tax
Court noted in its findings of fact.
In the notice of deficiency sent to New Plantation for its taxable years ended September
30, 1963 through September 30, 1966, inclusive, the Commissioner disallowed as an
expense the deductions claimed by New Plantation for such interest.9
….
In the notice of deficiency addressed to Mr. and Mrs. Jemison for the calendar year 1963,
the Commissioner determined that the individual taxpayers realized dividends in the
amount of $184,274.23 on account of the following payments by Old Plantation:
Payment of non-interest-bearing note due 3/14/63
Payment of non-interest-bearing note due 6/15/63
Payment of 5½% note due 10/1/63
Payment of interest on 5½% note due 10/1/63
Payment on account of 5½ % note of minority
stockholder on 10/24/63
Total

$50,000.00
$50,000.00
$50,000.00
$33,543.31
$730.92
----------$184,274.23

The Tax Court held that all steps taken by Mr. Jemison and the shareholders of Old
Plantation were parts of a single transaction for the purchase by New Plantation of the
wrought iron furniture business of Old Plantation, and, applying the relevant factors with
respect to debt-equity situations to the facts here, one of which was found to be thin
capitalization, that the guaranteed debt must be treated as an indirect contribution to New
Plantation’s capital by Mr. Jemison. Therefore, it held that New Plantation was not entitled
to deductions claimed under § 163 for interest on the 5½% serial notes in its taxable years
ended September 30, 1963 to September 30, 1966 and that the Jemisons were taxable in
1963 under §§ 301 and 316 with the principal and interest payments on these guaranteed
notes in that year.10 Their deficiency was fixed at $28,403.91.

9 The Commissioner conceded in the Tax Court that New Plantation was entitled to an expense deduction for

the $39,000 interest paid on the 6½% debentures issued to Bradford and Company.
10 The Tax Court allowed the Jemisons a deduction for interest paid the sellers by New Plantation.

14

II. THE ISSUES ON APPEAL
The issues presented for our consideration are these:
1. Whether $100,000 of guaranteed 5½% serial debentures issued by New Plantation to
the sellers of Old Plantation are to be treated as debt for income tax purposes where the
notes were not subordinated and were paid when due by New Plantation without recourse
to other financing?
2. Whether $509,878.33 of guaranteed 5½% notes issued by New Plantation to the sellers
of Old Plantation are to be treated as debt for income tax purposes where the notes were
subordinated to general creditors but were senior to $150,000 of other debentures which
the Tax Court did treat as debt for income tax purposes?
3. Whether Jemison Investment Company, a co-guarantor, rather than John S. Jemison,
Jr., a coguarantor, should be deemed to have made the contribution to the equity capital of
New Plantation in the event that any of the $609,878.33 principal amount of 5½% notes
is deemed to represent a contribution to the equity capital of New Plantation?
III. THE RELEVANT LAW
The criteria for adjudicating debt-equity cases were set forth most clearly by Judge Jones
for this Court in 1963 in Montclair, Inc. v. C.I.R., 5 Cir., 1963, 318 F.2d 38[, 40]. ... [T]he
factors which bear most strongly on the determination of the label to be applied to the
transaction are enunciated:
“(1) the names given to the certificates evidencing the indebtedness; (2) the
presence or absence of a maturity date; (3) the source of the payments; (4) the right
to enforce the payment of principal and interest; (5) participation in management;
(6) a status equal to or inferior to that of regular corporate creditors; (7) the intent
of the parties; (8) ‘thin’ or adequate capitalization; (9) identity of interest between
creditor and stockholder; (10) payment of interest only out of ‘dividend’ money;
(11) the ability of the corporation to obtain loans from outside lending
institutions.”11
... The tests are not “talismans of magical power,” and the most that can be said is that they
are a source of helpful guidance. [citation omitted]. Thus we decide debt-equity issues by
a case by case analysis, applying the Montclair rubrics as best we can to the facts at hand.

11 This delineation was not intended to prevent the consideration of other factors which may be relevant in a

particular case. See Dillin v. United States, 5 Cir. 1970, 433 F.2d 1097 at footnote 3, page 1100.

15

IV. TREATMENT OF THE $100,000 UNSUBORDINATED 5½% DEBENTURES
AND THE $509,878.33 PARTIALLY SUBORDINATED 5½% NOTES
With regard to the $100,000 unsubordinated debentures, the taxpayers urge us to reverse
the Tax Court for the following reasons: (1) There was a reasonable prospect of payment
when due, (2) the notes were not subordinated to any other indebtedness of New
Plantation, (3) the holders, along with general creditors, had first claim on more than
$1,000,000 in assets of New Plantation, (4) the notes matured within two years, (5) the
notes could have been paid by New Plantation’s cash flow, and (6) the notes were paid
when due without recourse to additional financing.
Of these factors, taxpayers point first and foremost to the fact that the debentures were
totally unsubordinated, and thus conferred on the holders the right to participate with
general creditors.
....
Taxpayers also vigorously assert that the assets of the corporation were more than adequate
to support the $100,000 unsubordinated notes because on September 30, 1962, New
Plantation’s assets had a fair market value of $1,261,327.81. Central to this appeal is the
taxpayers’ contention that the Tax Court erroneously concluded that New Plantation was
thinly capitalized.
Additionally, with regard to the $100,000 of unsubordinated 5½% debentures, taxpayers
emphasize that they were to mature within two years, a factor militating strongly against
a conclusion that the money was put “at the risk” of the business. Bolstering this point,
taxpayers state that the cash flow from depreciation in 1963 and 1964, the years of payment
of the $100,000 notes, exceeded the principal payments of $50,000 due on the notes. They
say that in view of the fact that the interest on the notes is deducted in determining net
income, it was not necessary for New Plantation to have net income to pay these notes,
and thus their repayment was not contingent on the profitability of the business.
Finally, the taxpayers criticize the Tax Court for not giving greater weight in assessing the
economic realities of the situation to the fact that the notes were paid on time. Taxpayers
claim that giving this development its proper weight will lead us to the conclusion that the
Tax Court was clearly erroneous in its holding that when the notes were issued there was
no reasonable expectation that New Plantation could pay the notes. In this regard taxpayers
also insist that the Tax Court gave undue emphasis to the overall debt-equity ratio, which
they assert bears slight relevance to the determination of the treatment given
unsubordinated notes. Taxpayers argue that whether a corporation can pay all of its debts
is irrelevant to the question whether it can pay its priority debts.

16

Turning to the remaining $509,878.33 of partially subordinated 5½% serial debentures,
the taxpayers argue five points in support of their proposition that the Tax Court erred: (1)
There was reasonable prospect of payment when due, (2) the notes, though partially
subordinated, were senior to $150,000 of 6½% debentures and $5,000 of common stock,
(3) the assets of New Plantation were sufficient to support the debt, (4) the cash flow was
sufficient to pay the debt, and (5) the notes were paid when due without recourse to
additional financing.
Many of the arguments made by the taxpayers in favor of debt treatment for the $100,000
unsubordinated debentures are equally applicable for the remaining $509,878.33 of
partially subordinated notes, and the taxpayers have urged us to accord them equal vitality
here. New arguments also are raised at this juncture, however. Taxpayers contend that it
is anomalous and inconsistent for the Tax Court to characterize the $509,878.33 partially
subordinated debentures as equity while at the same time characterizing inferior fully
subordinated debentures held by Bradford and Company as debt, arguing that if the fully
subordinated 6½% notes held by Bradford and Company are equity, surely the
$509,878.33 debentures are entitled to the same treatment.
Here the taxpayers protest vigorously against the Tax Court’s determination of the proper
debt-equity ratio to apply in assessing the nature of the transaction. The principal dispute
with the Tax Court revolves about that Court’s valuation of the intangible assets of New
Plantation, with particular emphasis on the personal business skills of Mr. Jemison. The
Tax Court did recognize that intangible assets not carried on the balance sheet might have
a bearing on the ability of the corporation to pay its debts. Murphy Logging Company v.
United States, 9 Cir. 1967, 378 F.2d 222. But the Tax Court held that the relationship of
Mr. Jemison’s business skills to the wellbeing of New Plantation was not demonstrated
with the specificity requisite to alter the picture of the overall debt-paying potential of New
Plantation. ... [T]he taxpayers contend that the record amply demonstrates that Mr.
Jemison was a veritable financial genius, commanding Jemison Investment Company, a
company with control of assets valued at more than $11,000,000 and with annual gross
receipts of over $10,000,000. They point to the record as reflecting that Mr. Jemison was
successfully engaged in a broad variety of business ventures. He was a director of several
successful corporations, a bank, and two insurance companies. More important, however,
taxpayers assert, is Mr. Jemison’s demonstrated close contact with several large
department store chains which provided ideal outlets for New Plantation’s products.
Taxpayer on this account urges that a proper debt-equity ratio should take into account the
financial skills of Mr. Jemison.
Without receding from their strong stand that the 5½% debentures constitute debt, the
taxpayers alternatively argue that if the court should hold that such notes do not constitute
debt, the same equity treatment should be given to the 6½% subordinated debentures held
by Bradford and Company. … If these notes are regarded as equity, taxpayers argue that
the debt-equity ratio of New Plantation would be approximately 4 to 1 ($609,878.33 to
17

$155,000), and not the plus 125 to 1 ratio which the government asserts is the proper debtequity ratio ($759,878.33 to $5,000). This would effectively demolish the Tax Court
finding of thin capitalization.
The Commissioner answers these contentions with the familiar tax law precept: substance
and not form determines proper tax treatment for a transaction, urging that the substance
of this transaction is that a corporation was sold for a price more than $600,000 in excess
of its net worth, with payment promised by a new corporation without significant capital
or other assets, whose only solidarity was the guarantee of the individual taxpayer, Mr.
Jemison. The Commissioner continues that the guarantee was in reality a contribution of
capital and that in substance the payments on the notes were dividends on the Jemison
capital investment taxable to them as income.
More specifically the Commissioner places primary emphasis on the Tax Court’s findings
that the assets of the new corporation vis a vis its debts were insufficient to give New
Plantation viable independence as a corporation. The Tax Court found that the corporate
assets of New Plantation were “wholly inadequate to sustain a debt of $609,878.33.” ...
The Commissioner discounts the fact that New Plantation was in actuality able to pay its
obligations without resort to its guarantors, pointing out that we must view the transaction
on the basis of the economic realities as they existed at New Plantation’s inception, and
not in the light of later developments. As matters stood September 28, 1962, asserts the
Commissioner, the deal had not set up a bona fide corporation reasonably to be expected
to manage to go it alone, and later developments do not alter the nature of the transaction
for tax purposes.
Making further use of the debt vs. equity criteria established by Montclair and later cases,
the Commissioner notes particularly that the sellers took the unusual step of agreeing to
subordinate all but $100,000 of the purchase money notes. The Commissioner asserts that
this action was taken because the sellers looked first and foremost to the guarantee of Mr.
Jemison, an obligation which was primary in nature.
The Commissioner also claims that no third party arm’s-length creditors, because of New
Plantation’s paper thin capitalization, would have loaned the amount of money by which
the corporation became indebted. Establishment of any indebtedness, argues the
respondent, would have required Mr. Jemison’s guarantee, and therefore for tax purposes
the indebtedness should be regarded as that of the Jemisons.
Resolving these two conflicting views of this amorphous transaction is no easy task, but
we are not persuaded that the taxpayers have successfully demonstrated the incorrectness
of the position taken by the Tax Court. Certainly we recognize that this transaction was
initially cast to have all of the outward appearances of a debt transaction, complete with
instruments styled “debentures” which had fixed maturity dates. But these surface

18

considerations do not end our examination. Closer scrutiny establishes that the other
factors which would give the transaction the aura of debt are noticeable by their absence.
Of critical importance in determining whether financial input is debt or equity is whether
or not the money is expended for capital assets. In the instant case the substantial portion
of the $609,878.33 was directed to the purchase of capital assets and to finance initial
operations. In contrast, only $5,000.00 was set up as equity to finance launching of the
corporate venture.
Other equity factors exist. While the sellers were ostensibly to look to the corporation for
payment of the debt, it is apparent from the meager capital position of the company that
Mr. Jemison’s guarantee was regarded as the real undergirding for the deal. Our conclusion
is reinforced by noting that the sellers apparently considered financially acceptable the
agreement to subordinate the great majority of the 5½% debentures to almost all other
corporate indebtedness so long as the debentures were guaranteed by Mr. Jemison. Mr.
Jemison’s guarantee was, of course, an obligation primary in nature.
Further, while Mrs. Jemison was the stockholder of record, and Mr. Jemison on the surface
was only a guarantor, surrounding circumstances clearly demonstrate that Mr. Jemison
completely controlled the shares held by Mrs. Jemison. … Regarding Mr. Jemison as the
“constructive” owner of the stock, we have an identity of interest between the stockholder
and the guarantor – a factor which points strongly toward equity treatment.
The record cannot support a determination by us that the Tax Court’s finding that New
Plantation was thinly capitalized is “clearly erroneous.” [citation omitted]. The balance
sheet of the corporation showed that its quick assets (cash and accounts receivables) of
$317,000 could not cover its current liabilities of approximately $490,000. This ratio is
one of the acid test indicators used by businessmen to determine the health of a business.
After the dissolution of Old Plantation the new corporation had tangible assets, at fair
market value, of approximately $1,064,000 securing debts of approximately $1,078,000.
We regard this as thin capitalization, as did the Tax Court.
The guarantee enabled Mr. Jemison to put a minimum amount of cash into New Plantation
immediately, and to avoid any further cash investment in the corporation unless and until
it should fall on hard times. At the same time he exercised total control over its
management. Adding together the personal guarantee of Mr. Jemison to the guarantee of
Jemison Investment Company, which was wholly owned by him and Mr. Jemison’s
control of New Plantation, we think that the result is that Mr. Jemison’s guarantee simply
amounted to a covert way of putting his money “at the risk of the business.” Stated
differently, the guarantee enabled Mr. Jemison to create borrowing power for the
corporation which normally would have existed only through the presence of more
adequate capitalization of New Plantation.

19

We do not regard as significant the fact that ultimately things progressed smoothly for
New Plantation and that its debts were paid without additional financing. The question is
not whether, looking back in time, the transaction was ultimately successful or not, but
rather whether at its inception there was a reasonable expectation that the business would
succeed on its own. The transaction must be judged on the conditions that existed when
the deal was consummated, and not on conditions as they developed with the passage of
time. [citations omitted]. When New Plantation was incorporated its prospects of business
success were questionable indeed without the Jemison guarantees.
We hold also that the Tax Court was correct in refusing to give value to the intangible
financial skills of Mr. Jemison for purposes of computing the corporation’s debt-equity
ratio. ... In our view courts should be wary in giving weight to such intangible assets as
those attributed to Mr. Jemison. Certainly business acumen or financial wizardry of
stockholders or corporate management could not properly be valued and placed on the
corporate balance sheet under generally accepted principles of accounting, although they
might afford window dressing in a footnote. ... [W]e conclude that intangible assets such
as those claimed for Mr. Jemison have no place in assessing debt-equity ratio unless it can
be shown by convincing evidence that the intangible asset has a direct and primary
relationship to the well-being of the corporation. Additionally it seems clear to us that the
assets sought to be valued must be something more than management skills and normal
business contacts. These are expected of management in the direction of any corporation.
We decide only this case. We do not assert that intangible assets are never a proper
consideration in assessing debt-equity ratio. Nevertheless we agree with the Tax Court that
courts should proceed cautiously in giving value to such intangible assets in the absence
of special circumstances demonstrating a primary relationship to the corporation. That
standard is not met by evidence that Mr. Jemison was a talented business man with useful
contacts among department stores.
Our holding does not require that we find the notes held by Bradford and Company to be
equity interests. While the Bradford and Company notes were subordinated, subordination
is far from the sole criterion for determining whether an interest is debt or equity. It is not
controlling. Aside from this single factor this record is productive of nothing to indicate
that this was not a bona fide loan made by Bradford with the primary motive of inducing
New Plantation to employ young Bradford. We agree with the Tax Court that this was a
legitimate loan.
V. SHOULD THE EQUITY CONTRIBUTION BE DEEMED TO HAVE BEEN MADE
BY JEMISON INVESTMENT COMPANY RATHER THAN BY MR. JEMISON?
The Tax Court found that the equity contribution was to be attributed to Mr. Jemison and
not to Jemison Investment Company. Although acknowledging that Jemison Investment
Company received a fee of $15,000.00 for its guarantee on the notes, the Tax Court
20

reasoned that inasmuch as Mr. Jemison controlled both Jemison Investment and New
Plantation, the fee for the guarantee was either a matter of internal accounting or for
cosmetic effect, and not an indication that the sellers of Old Plantation realistically looked
to Jemison Investment Company for any security. It is uncontested that practically all of
Mr. Jemison’s assets consisted of stock in Jemison Investment Company. It owned the
house he lived in and the automobile he drove, but he owned it in its entirety. Furthermore,
the Tax Court found that the sellers of Old Plantation only investigated the credit of Mr.
Jemison, and that the Messrs. Jernigans as sellers looked at all times to Mr. Jemison’s
guarantee as the real insurance for the notes.
… [T]hrough all of the haze of corporate red tape, the real financial keystone supporting
the entire deal, the person to whom the sellers ultimately looked for their protection in the
event of the failure of New Plantation was Mr. John S. Jemison, Jr.
VI. CONCLUSION
Error is not demonstrated on this record. None of the Tax Court’s Findings and
Conclusions based upon stipulated facts are shown to be “clearly erroneous.” The decision
of the Tax Court as to all matters raised by this appeal is
Affirmed.

Questions and comments:
1. What would have been Mr. Jemison’s reason for having Mrs. Jemison own stock of
New Plantations rather than himself? A dividend is a distribution by a corporation made
“with respect to its stock.” § 301(a). How can a corporation make a distribution “with
respect to its stock” to someone who is not a shareholder? The distribution would be a
payment with respect to what? Remember, Mr. Jemison was an experienced and successful
investment banker.
2. What is a “debenture?” What does it mean for a debt to be subordinate to another?
3. Rather than sell shareholders’ stock and the Jernigans buy back certain assets, why
couldn’t the owners of Old Plantation simply have sold the other assets to New Plantation?
What do you think the tax consequences of a sale of assets would be relative to a sale of
stock?
4. What opportunities arise in the context of buying/selling a corporation to manipulate
debt/equity rules?

21

5. Taxpayers argued (unsuccessfully) that money was not put at the risk of the success of
the business. If taxpayers had persuaded the Tax Court that money was not put at the risk
of the success of the business, how would it have helped taxpayers? Keep in mind that
they wanted a deduction for payment of interest.
6. Evidently Old Plantation was very good at manufacturing wrought iron furniture – at
least it was good enough for the parties to make plans on the assumption that the wrought
iron furniture business would generate sufficient revenue to service all the loans involved.
•Assuming New Plantation paid off the $800,000 of debt obligations, how would the
income that went towards payment of interest be taxed?
•How, i.e., to whom, will that income be taxed after the Fifth Circuit’s decision?
7. The “common law” of debt-equity cases always seems to involve a consideration of
“factors.” The Fifth Circuit offered eleven factors. The court in Fin Hay Realty Co. v.
United States, 398 F.2d 694, 696 (3d Cir. 1968) offered 16 factors, viz.:
(1) the intent of the parties; (2) the identity between creditors and shareholders; (3)
the extent of participation in management by the holder of the instrument; (4) the
ability of the corporation to obtain funds from outside sources; (5) the “thinness”
of the capital structure in relation to debt; (6) the risk involved; (7) the formal
indicia of the arrangement; (8) the relative position of the obligees as to other
creditors regarding the payment of interest and principal; (9) the voting power of
the holder of the instrument; (10) the provision of a fixed rate of interest; (11) a
contingency on the obligation to repay; (12) the source of the interest payments;
(13) the presence or absence of a fixed maturity date; (14) a provision for
redemption by the corporation; (15) a provision for redemption at the option of the
holder; and (16) the timing of the advance with reference to the organization of the
corporation.
Is this list better than the one announced in Montclair, Inc.? Such factors are evidentiary
in nature, and as the court in Plantation Patterns said, there is no universally applicable
test to resolve such issues. Why do you think this is so?
8. Why do you think that Congress (or the Secretary of the Treasury) can’t simply
announce a black letter debt to equity ratio and apply it to all cases?
9. Preview: why would it matter that the guarantee was extended personally by Mr.
Jemison and not by the Jemison Investment Company? Quickly scan § 243.

22

Note on § 385
A congressional effort to deal with the debt-equity problem is § 385, which was enacted
in 1969. Read it.
First, note that Congress seems willing to pass the buck to the Secretary of the Treasury to
handle the matter through rulemaking. § 385(a). The parenthetical indicates that Congress
is willing to have the Treasury treat corporate financing as partly equity and partly debt,
i.e., not all one or all the other. Second, Congress required the Secretary to name factors
to consider in resolving debt-equity questions; Congress offered a nonexclusive list of five
factors to get the ball rolling. § 385(b). Third, the issuer of an interest in a corporation and
all holders of the interest are bound by their choice of characterization, whether debt or
equity – but the IRS is not so bound. § 385(c)(1). The holder of an interest may – subject
to regulations – announce on its tax return that it is taking a position contrary to the choice
that the issuer has made. § 385(c)(2).
•[How would this affect Mr. Jemison’s alternative contention that the Bradford
money was for an equity investment rather than a loan?]
In 1980, Treasury proposed regulations. The regulations contained some objective
standards, but also contained some subjective standards with safe harbors. Commentators
criticized the proposed regulations for, among other things, not taking the approach of
prescribing factors to consider – as the statute seems to require. Debt-equity issues also
arise in the international arena, and the proposed regulations did not address such
transactions.12 In 1983, the IRS withdrew the proposed regulations. See generally Marie
Sapirie, Regulation Redux: The Debt-Equity Regs in 1980 and Today, TAX NOTES 449
(July 25, 2016).
Why do you think that it is so difficult to draft regulations that will “work?” Can you
identify elements that are always (or never) present when someone loans money to
another? If so, it should be a simple matter to codify, at a minimum, these elements as
conclusively indicative of debt rather than equity.
In April 2016, Treasury proposed new § 385 regulations. 81 Fed. Reg. 20912 (2016). In
October 2016, Treasury promulgated final regulations. 81 Fed. Reg. 72,858-01. The rules
had much to say about debt between members of an “expanded group,” a chain of
corporations linked by at least 80% ownership of stock. Those regulations were removed

12 Before December 2017, the United States had one of the highest corporate income tax rates in the world, and

the corporate income tax applies to the worldwide income of U.S. corporations. A U.S. corporation may form a
wholly-owned foreign subsidiary (or be the wholly-owned subsidiary of a foreign firm). The U.S. corporation
may borrow from the foreign corporation to finance its operations in many places. The interest that the U.S. firm
pays reduces that income of the affiliated group that would otherwise be subject to the highest corporate income
tax. This arrangement is one form of “income-stripping.”

23

because their net benefits were substantially ameliorated by the TCJA. 84 Fed. Reg.
59,297, 59,299-300. In the context of the issues raised in cases involving closely-held
corporations, Reg. § 1.385-1(b) provides:
(b) General rule. Except as otherwise provided in the Internal Revenue Code and
the regulations thereunder, including the § 385 regulations, whether an interest in
a corporation is treated for purposes of the Internal Revenue Code as stock or
indebtedness (or as in part stock and in part indebtedness) is determined based on
common law, including the factors prescribed under such common law.
Is it possible that by requiring Treasury to set forth factors to consider, § 385(b), Congress
created an undue constraint on Treasury?

Note on § 163(j)
For corporations and partnerships with average annual gross receipts exceeding
$25,000,000 (§ 448(c)(1)), the Tax Cuts and Jobs Act
The CARES Act, § 2306,
limits the amount of business interest that a taxpayer may
increased the amount of
deduct. 13 The limit is the sum of taxpayer’s business
deductible business interest for
interest income, 30% of taxpayer’s adjusted taxable
2019 and 2020 to 50% of
income,14 and taxpayer’s floor plan financing interest. §
taxpayer’s “adjusted taxable
163(j)(1). Any interest not allowed as a deduction
income.” A taxpayer may also
because of this limit may be carried forward to the
elect to use its 2019 “adjusted
succeeding year. § 163(j)(2). “Business interest” does
taxable income” to make this
not include investment interest. § 163(j)(5). “Business
determination.
interest income” is interest includible in taxpayer’s gross
income and properly allocable to a trade or business. § 163(j)(6). “Floor plan financing
interest” is interest paid to finance the acquisition of motor vehicles held for sale or lease
and secured by such inventory. § 163(j)(9).

13

The interest deduction limits do not apply to taxpayers who –
•engage in a trade or business as an employee, § 163(j)(7)(A);
•perform services and materially participate in a real property trade or business that irrevocably elects
to account for cost recovery using the alternative depreciation system, §§ 163(j)(7)(A)(ii), 163(j)(7)(B),
469(c)(7)(B), 163(j)(10), 168(g)(1)(F);
•perform services in a farming business or cooperative that irrevocably elects to account for cost
recovery using the alternative depreciation system, §§ 163(j)(7)(A)(iii), 163(j)(7)(C), 163(j)(10)(B),
263A(e)(4), 199A(g)(2), 168(g)(1)(G); or
•a public utility subject to rate regulation, § 163(j)(7)(A)(iv).

14

… i.e., taxable income computed without regard to non-business interest income, NOL, § 199A deduction,
depreciation, amortization, or depletion deductions, § 163(j)(8)(A), as well as other adjustments the Secretary of
Treasury may prescribe, § 163(j)(8)(B).

24

These rules apply to all tax-paying entities – not merely corporations. The computation of
the limit is much more straight-forward than under the older rules.

III. Getting Money Out of the Corporation Through Deductible Payments
A corporation may earn substantial sums. This does not help shareholders who may wish
to obtain some of that money without incurring an income tax burden. In a closely held
corporation, the same people often wear different hats. This point may enable shareholders
to obtain some or all of a corporation’s earnings without paying income tax on dividend
income. The corporation may make payments to a shareholder who happens to be an
employee. A shareholder may be the lessor or seller of property to a corporation. The
corporation will make payments to the lessor or seller. The tax consequences of money
moving into or out of the corporation through these various transactions are likely to be
quite different – and less burdensome – than those that follow from the corporation sharing
its after-tax profits with shareholders through dividends. In all cases, the bona fides of the
underlying transaction is the issue on which the case will turn.

A. Employment
Whether a “salary” is in fact a dividend is a question that arises often in the context of the
corporation claiming a deduction for payment of a “reasonable” salary under § 162(a)(1).

Menard, Inc. v. Commissioner, 560 F.3d 620 (CA7 2009)
POSNER, Circuit Judge.
The Internal Revenue Code allows a business to deduct from its taxable income a
“reasonable allowance for salaries or other compensation for personal services actually
rendered,” 26 U.S.C. § 162(a)(1), or, as Reg. § 1.162-7(a) adds, for “payments purely for
services.” Occasionally the Internal Revenue Service challenges the deduction of a
corporate salary on the ground that it’s really a dividend. A dividend, like salary, is taxable
to the recipient, but unlike salary is not deductible from the corporation’s taxable income.
So by treating a dividend as salary, a corporation can reduce its income tax liability without
increasing the income tax of the recipient. At least that was true in 1998, the tax year at
issue in this case. As a result of a change in law in 2003, dividends are now taxed at a lower
maximum rate than salaries – 15%, versus 35% for salary. 26 U.S.C. § 1(h)(11). This makes
the tradeoff more complex; although the corporation avoids tax by treating the dividend as
a salary, which is deductible, the employee pays a higher tax.
But depending on its tax bracket, the corporation may still save more in tax than the
employee pays, and in that event, if the employee owns stock in the corporation, he may,
25

depending on how much of the stock he owns, prefer dividends to be treated as salary.
Menards’ tax bracket in 1998 was, … 35%. Had the new law been in effect then, the
corporation, if unable to deduct the $17.5 million bonus, would have paid $6.1 million in
additional income tax, while Mr. Menard, had he received the bonus as a dividend and thus
paid 15% rather than 35% of it in tax, would have saved only $3.5 million.
Even before the change in the Internal Revenue Code, treating a dividend as salary was less
likely to be attempted in a publicly held corporation, because if the CEO or other officers
or employees receive dividends called salary beyond what they are entitled to by virtue of
owning stock in the corporation, the other shareholders suffer. But in a closely held
corporation, the owners might decide to take their dividends in the form of salary in order
to beat the corporate income tax, and there would be no one to complain – except the
Internal Revenue Service.
The usual case for forbidding the reclassification (for tax purposes) of dividends as salary
is thus that “of a corporation having few shareholders, practically all of whom draw
salaries,” Reg. § 1,162-7(b)(1), especially if the corporation does not pay dividends (as
such) and some of the shareholders do no work for the corporation but merely cash a
“salary” check. A difficult case – which is this case – is thus that of a corporation that pays
a high salary to its CEO who works full time but is also the controlling shareholder. The
Treasury regulation defines a “reasonable” salary as the amount that “would ordinarily be
paid for like services by like enterprises under like circumstances,” § 1.162-7(b)(3), but
that is not an operational standard. No two enterprises are alike and no two chief executive
officers are alike, and anyway the comparison should be between the total compensation
package of the CEOs being compared, and that requires consideration of deferred
compensation, including severance packages, the amount of risk in the executives’
compensation, and perks.
Courts have attempted to operationalize the Treasury’s standard by considering multiple
factors that relate to optimal compensation. E.g., Haffner’s Service Stations, Inc. v.
Commissioner, 326 F.3d 1, 3-4 (1st Cir. 2003); Eberl’s Claim Service, Inc. v.
Commissioner, 249 F.3d 994, 999 (10th Cir. 2001); LabelGraphics, Inc. v.
Commissioner, 221 F.3d 1091, 1095 (9th Cir. 2000); Alpha Medical, Inc. v.
Commissioner, 172 F.3d 942, 946 (6th Cir. 1999); Rutter v. Commissioner, 853 F.2d 1267,
1271 (5th Cir. 1988). (Alpha and Rutter each list nine factors.) We reviewed a number of
these attempts in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999), and
concluded that they were too vague, and too difficult to operationalize, to be of much utility.
Multifactor tests with no weight assigned to any factor are bad enough from the standpoint
of providing an objective basis for a judicial decision, Farmer v. Haas, 990 F.2d 319, 321
(7th Cir. 1993); Prussner v. United States,896 F.2d 218, 224 (7th Cir. 1990) (en
banc); Palmer v. Chicago, 806 F.2d 1316, 1318 (7th Cir. 1986); United States v. Borer, 412
F.3d 987, 992 (8th Cir. 2005); multifactor tests when none of the factors is concrete are
worse, and that is the character of most of the multifactor tests of excessive
compensation. They include such semantic vapors as “the type and extent of the services
rendered,” “the scarcity of qualified employees,” “the qualifications ... of the employee,”

26

his “contributions to the business venture,” and “the peculiar characteristics of the
employer’s business.”
All businesses are different, all CEOs are different, and all compensation packages for
CEOs are different. In Exacto, in an effort to bring a modicum of objectivity to the
determination of whether a corporate owner/employee’s compensation is “reasonable,” we
created the presumption that “when ... the investors in his company are obtaining a far
higher return than they had any reason to expect, [the owner/employee’s] salary is
presumptively reasonable.” But we added that the presumption could be rebutted by
evidence that the company’s success was the result of extraneous factors, such as an
unexpected discovery of oil under the company’s land, or that the company intended to pay
the owner/employee a disguised dividend rather than salary. 196 F.3d at 839. The strongest
ground for rebuttal, which brings us back to the basic purpose of disallowing
“unreasonable” compensation, is that the employee does no work for the corporation; he
is merely a shareholder. See id.; cf. General Roofing & Insulation Co. v.
Commissioner, T.C. Memo 1981-667, 15-17 (1981). Other types of evidence that might
rebut the Exacto presumption include evidence of a conflict of interest, though we’ll see
that such evidence is not always decisive. Also relevant is the relation between the
executive’s compensation that is challenged and the compensation of other executives in
the company; for useful discussions see Rapco, Inc. v. Commissioner, 85 F.3d 950, 954-55
(2d Cir. 1996), and Elliotts, Inc. v. Commissioner,716 F.2d 1241 (9th Cir. 1983).
Comparison with the compensation of executives of other companies can be helpful if –
but it is a big if – the comparison takes into account the details of the compensation package
of each of the compared executives, and not just the bottom-line salary. This qualification
will turn out to be critical in this case. For the Tax Court acknowledged that the presumption
of reasonableness had been established but thought it rebutted by evidence that corporations
in the same business as Menards paid their CEOs substantially less than Menards paid its
CEO.
Menard, Inc. is a Wisconsin firm that under the name “Menards” sells hardware, building
supplies, and related products through retail stores scattered throughout the Midwest. It had
138 stores in 1998 and was the third largest retail home improvement chain in the United
States; only Home Depot and Lowe’s were larger. It was founded by John Menard in 1962,
and, at least through 1998, the tax year at issue in this case, he was the company’s chief
executive. (All the evidence in the record concerns his activities in that year.)
Uncontradicted evidence depicts him as working 12 to 16 hours a day 6 or 7 days a week,
taking only 7 days of vacation a year, working even while spending “personal time” with
his family, involving himself in every detail of his firm’s operations, and fixing everyone’s
compensation. Under his management Menards’ revenues grew from $788 million in 1991
to $3.4 billion in 1998 and the company’s taxable income from $59 million to $315 million.
The company’s rate of return on shareholders’ equity that year was, according to the
Internal Revenue Service’s expert, 18.8% -- higher than that of either Home Depot or
Lowe’s.

27

Menard owns all the voting shares in the company and 56% of the nonvoting shares, the
rest being owned by members of his family, two of whom have senior positions in the
company. Like the other executives of Menards, he is paid a modest base salary but
participates along with them in a profit-sharing plan. In 1998, his salary was $157,500 and
he received a profit-sharing bonus of $3,017,100, and the Tax Court did not suggest that
there was anything amiss with these amounts. But the bulk of his compensation was in the
form of a “5% bonus” that yielded him $17,467,800, as a result of which his total
compensation for the year exceeded $20 million.
The 5% bonus program (5% of the company’s net income before income taxes) was
adopted in 1973 by the company’s board of directors at the suggestion of the company’s
accounting firm, though there is no indication that the firm suggested a number rather than
just advising the board that Mr. Menard should have his own bonus plan because of his
commanding role in the management of the company. The board at the time included a
shareholder who was not a member of Menard’s family and he voted for the plan, which
was still in force in 1998 and so far as we know had not been reexamined in the interim.
That shareholder departed and the board in 1998 consisted of Menard, a younger brother
of his who works for the company, and the company’s treasurer.
There is no suggestion that any of the shareholders were disappointed that the company
obtained a rate of return of “only” 18.8% or that the company’s success in that year or any
year has been due to windfall factors, such as the discovery of oil under the company’s
headquarters. But besides thinking Menard’s compensation excessive, the Tax Court
thought it was intended as a dividend. It thought this because Menard’s entitlement to his
5% bonus was conditioned on his agreeing to reimburse the corporation should the
deduction of the bonus from the corporation’s taxable income be disallowed by the Internal
Revenue Service or its Wisconsin counterpart and because 5% of corporate earnings year
in and year out “looked” more like a dividend than like salary.
These are flimsy grounds. Given the fondness of the IRS and the Tax Court for a “totality
of the circumstances” approach to determining excessive compensation, it was prudent (and
incidentally not in Menard’s personal financial interest) for the company to require him to
reimburse it should the IRS successfully challenge the deduction. Nor does 5% of net
corporate income look at all like a dividend. Dividends generally are specified dollar
amounts – so many dollars per share – rather than a percentage of earnings. E.g., William
L. Megginson, Scott B. Smart & Brian M. Lucey, Introduction to Corporate Finance 436–
37 (2008); Harold Bierman, Jr. & Seymour Smidt, Financial Management for Decision
Making 489 (2003); Angela Schneeman, The Law of Corporations and Other Business
Organizations 320–21 (3d ed.2002); Erich A. Helfert, Financial Analysis Tools and
Techniques: A Guide for Managers 122 (2001); Jae K. Shim & Joel G. Siegel, Financial
Management 285 (2000). When earnings fall, dividends may be cut, but they are cut from
one fixed amount to another rather than made to vary continuously, as a percentage of
earnings would do.
Paying a fixed (though occasionally altered) dividend provides the shareholder with a more
predictable cash flow than if the dividend varied directly with corporate earnings, which
28

fluctuate from year to year. It thus reduces the risk (variance) associated with ownership of
common stock. Moreover, the reason for varying a manager’s compensation with the
company’s profits is to increase his incentive to work intelligently and hard in order to
increase those profits, and that reason has no application to a passive owner. Although tying
compensation to the market value of the company’s stock is criticized by some economists
because of the many factors besides managerial effort and ability that influence the price
of a publicly traded stock, stock in Menards is not publicly traded; probably it is not traded
at all.
The most insignificant factor that the Tax Court thought indicative of a “concealed”
dividend was that Menard’s 5% bonus is paid at the end of each year. Well, it would have
to be paid either at the end of the year, when the earnings for the year are known, or in
installments throughout the year. Bonuses are usually paid in a lump, once a year, often at
Christmas, but that would not be a feasible course for Menards to follow unless it closed
for the following week, because its net income for the year wouldn’t be determinable until
the close of the last day of the year on which the store was open. Bonuses are more likely
to be paid in single payments at or near the end of the year than dividends are; dividends
usually are paid quarterly. William A. Rini, Fundamentals of the Securities Industry 13
(2003).
The court thought it suspicious that the board of directors that approved the 5% bonus in
1998 was controlled by Menard. But it could not be otherwise, since he is the only
shareholder who is entitled to vote for members of the board of directors, as he owns all
the voting shares in the company. The logic of the Tax Court’s position is that a one-man
corporation cannot pay its CEO (if he is that one man) any salary! The Tax Court has flirted
with that strange logic, as we shall see.
A slightly better candidate for suspicion is that the board of directors had not sought outside
advice on what appropriate compensation for Menard would be. But the only point of doing
that would have been to provide some window dressing in the event of a challenge by the
IRS. Menard doubtless has a strong opinion of what he is worth to his company and would
not pay a compensation consultant to disagree.
It might seem that since Menards paid no formal dividend at all, some of Mr. Menard’s
compensation (and perhaps that of other executives as well) must be a dividend. But that is
incorrect, as noted in the Elliotts case that we cited earlier. 716 F.2d at 1244. Many
corporations do not pay dividends but instead retain all their earnings in order to have more
capital. One reason that publicly held corporations – that is, corporations in which
ownership is diffuse, which may enable managers to pursue personal goals at the expense
of shareholder welfare – usually do pay dividends is that it helps to discipline management
by making it more likely to have to go outside the company for money for new ventures,
thus forcing it to convince the capital markets that the ventures are likely to succeed. That
reason for paying dividends has no application to a corporation like Menards in which there
is an almost complete fusion of management and ownership.

29

The main focus of the Tax Court’s decision was not on the issue of “concealed dividend”
(that is, whether the company was acting in good faith in paying $17.5 million as a bonus
rather than as a dividend); it was on whether Menard’s compensation exceeded that of
comparable CEOs in 1998 – that is, whether it was objectively excessive, and hence (in
part) functionally if not intentionally a dividend rather than a bonus.
The CEO of Home Depot was paid that year only $2.8 million, though it is a much larger
company than Menards; and the CEO of Lowe’s, also a larger company, was paid $6.1
million. But salary is just the beginning of a meaningful comparison, because it is only one
element of a compensation package. Of particular importance to this case is the amount of
risk in the compensation structure. Risk in corporate compensation is significant in two
respects. First, most people are risk averse, and the scholarly literature on corporate
compensation suggests that risk aversion is actually an obstacle to efficient corporate
management because managers tend to be more risk averse than shareholders. Shareholders
can diversify the risk of a particular company by owning a diversified portfolio, but a
manager tends to have most of his financial, reputational, and “specific human” capital tied
up in his job. Robert Yalden et al., Business Organizations: Principles, Policies and
Practice 698-99 (2008); Lucian Bebchuk & Jesse Fried, Pay Without Performance: The
Unfulfilled Promise of Executive Compensation 19 (2006); Lance A. Berger & Dorothy R.
Berger, The Compensation Handbook: A State–of–the–Art Guide to Compensation
Strategy and Design 386-87 (4th ed.2000); Frank H. Easterbrook & Daniel R. Fischel, The
Economic Structure of Corporate Law 99-100 (1991). (By “specific human capital”
economists mean the earnings that a worker obtains by virtue of skills, training, or
experience specialized to the specific firm that he is working for.) So the riskier the
compensation structure, other things being equal, the higher the executive’s salary must be
to compensate him for bearing the additional risk.
That is not a critical consideration in this case because, as we said, management and
ownership in Menards are not divorced. But a second significance of risk in a compensation
structure is fully applicable to this case. A risky compensation structure implies that the
executive’s salary is likely to vary substantially from year to year – high when the company
has a good year, low when it has a bad one. Mr. Menard’s average annual income may thus
have been considerably less than $20 million – a possibility the Tax Court ignored. Had
the corporation lost money in 1998, Menard’s total compensation would have been only
$157,500 – less than the salary of a federal judge—even if the loss had not been his fault.
The 5% bonus plan was in effect for a quarter of a century before the IRS pounced; was it
just waiting for Menard to have such a great year that the IRS would have a great-looking
case?
Nor did the Tax Court consider the severance packages, retirement plans, or perks of the
CEOs with whom it compared Menard (although it did take account of their stock options),
even though such extras can make an enormous difference to an executive’s compensation.
E.g., Lucian Arye Bebchuk & Jesse M. Fried, “Stealth Compensation via Retirement
Benefits,” 1 Berkeley Bus. L.J.291 (2004); Phred Dvorak, “Companies Cut Holes in CEOs’
Golden Parachutes – New Disclosure Rules Prompt More Criticism of Guaranteed
Payouts,” Wall St. J., Sept. 15, 2008, p. B4. Just two years after Menard received his
30

questioned $20 million, Robert Nardelli became CEO of Home Depot. In his slightly more
than six years in that post he was paid $124 million in salary, exclusive of stock options;
and when fired in 2007 (he was unpopular, and during his tenure the market capitalization
of Home Depot increased negligibly – only to jump when his firing was announced), he
received a much-criticized severance payment of $210 million (including the value of his
stock options). He went on to become the CEO of Chrysler, where he is being paid $1 a
year, thought by some observers to be generous. We wonder whether the IRS plans to
challenge Menard’s compensation for the years 2001 to 2006, using Nardelli’s
compensation package as a basis for comparison.
The Tax Court ruled that any compensation paid Menard in 1998 in excess of $7.1 million
was excessive. The $7.1 million figure was arrived at by the following steps: (1) Divide
Home Depot’s return on investment (16.1%) by the compensation of Home Depot’s CEO
($2,841,307). (2) Divide Menards’ return on investment (18.8%) by the result of step (1).
(3) Multiply the result of step (2) ($3,317,799) by 2.13, that being the ratio of the
compensation of Lowe’s’ CEO to that of Home Depot’s CEO. In words, the court allowed
Menard to treat as salary slightly more than twice the salary he supposedly would have had
if he had been Home Depot’s CEO and if Home Depot had had as high a return on
investment as Menards did. The judge’s assumption was that rate of return drives CEO
compensation except for random factors assumed to have the same effect on Menard’s
compensation as it did on that of Lowe’s’ CEO; for Lowe’s paid its CEO more than twice
as much as Home Depot paid its CEO even though Lowe’s was a smaller company and its
rate of return was lower.
This was an arbitrary as well as dizzying adjustment. It disregarded differences in the full
compensation packages of the three executives being compared, differences in whatever
challenges faced the companies in 1998, and differences in the responsibilities and
performance of the three CEOs.
We have discussed risk; with regard to responsibilities there is incomplete information
about the compensation paid other senior management of Menards besides Mr. Menard
himself, and no information about the compensation paid the senior managements of Home
Depot or Lowe’s other than those companies’ CEOs. The relevance of such information is
that it might show that Menard was doing work that in other companies is delegated to
staff, or conversely that staff was doing all the work and Menard was, in substance though
not in form, clipping coupons. The former inference is far more likely, given the undisputed
evidence of Menard’s workaholic, micromanaging ways and the fact that Menards’ board
of directors is a tiny dependency of Mr. Menard. He does the work that in publicly held
companies like Home Depot or Lowe’s is done by boards that have more than two directors
besides the CEO. Of course they are larger companies – Home Depot’s revenues were
seven times as great as Menards’ in 1998 – so we would expect them to have more staff.
But we are given no information on how much more staff they had.
We know that besides Menard himself, Menards – already a $3.4 billion company in 1998
– had only three corporate officers. The Tax Court thought it suspicious that they were
modestly compensated – their total compensation in 1998 was only $350,000, and the
31

highest-paid employee in the company after Menard himself – the senior merchandise
manager – received total compensation of only $468,000. The Tax Court did not consider
the possibility, which the evidence supports, that Menard really does do it all himself.
The Tax Court’s opinion strangely remarks that because Mr. Menard owns the company he
has all the incentive he needs to work hard, without the spur of a salary. In other words,
reasonable compensation for Mr. Menard might be zero. How generous of the Tax Court
nevertheless to allow Menards to deduct $7.1 million from its 1998 income for salary for
Menard!
The Fifth Circuit has commented sensibly on the Tax Court’s belief that owners don’t need
or deserve salaries: “the Tax Court questioned whether an incentive bonus tied to company
performance is needed for an employee who is also a shareholder. Apparently, the
argument is that such an employee already has sufficient incentive to make the business
successful because as a shareholder he will receive the profits of the business anyway. This
argument, however, misses the economic realities of the corporate form as taxed under the
internal revenue code. For compensation purposes, the shareholder-employee should be
treated like all other employees. If an incentive bonus would be appropriate for a
nonshareholder-employee, there is no reason why a shareholder-employee should not be
allowed to participate in the same manner. In essence, the shareholder-employee is treated
as two distinct individuals for tax purposes: an independent investor and an
employee.” Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1328 (5th Cir.
1987); see also Elliotts, Inc. v. Commissioner, supra, 716 F.2d at 1248.
The Tenth Circuit, it is true, remarked in Pepsi–Cola Bottling Co. v. Commissioner, 528
F.2d 176, 182 (10th Cir. 1975), that “due to the identity between the predominant
shareholder and the employee in our case we cannot accept the applicability of the
‘incentive compensation’ reasoning. Mrs. Joscelyn did not have a lack of such incentive.
As owner of 248 of 250 shares she would profit from her hard work even without salary
compensation. A bonus contract that might be reasonable if executed with an executive
who is not a controlling shareholder may be viewed as unreasonable if made with a
controlling shareholder, since incentive to the stockholder to call forth his best effort would
not be needed.” We do not agree, but we note that the court based its decision on a
comparison between Mrs. Joscelyn’s compensation and that of executives of other
companies, rather than holding that a controlling shareholder may never receive a bonus.
That would not make good sense. After all, bonuses do not only, or even primarily, reward
motivation; they reward performance.
We conclude that in ruling that Menard’s compensation was excessive in 1998, the Tax
Court committed clear error, and its decision is therefore
REVERSED.

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Questions and comments:
1. What were the risks that Menard assumed as CEO of his hardware company? How do
those risks compare, qualitatively and quantitively, with the risks borne by the chief
executive officers of Home Depot or Lowe’s? In what manner are CEOs compensated for
the risks they bear?
2. In the first three paragraphs of the opinion, the court lays out what is at stake:
characterizing a distribution as payment for service rather than a dividend results in only
one layer of income tax. Moreover, the stakes were higher when dividends were taxed as
ordinary income.
3. Many courts apply a list of factors to such cases that do not necessarily point to one
conclusion. Focusing on an independent investor at the least provides a “lens” through
which to view the factors. Alternatively, the test may do more by providing a presumption
of reasonableness or unreasonableness, thus casting the burden of proof on the one who
would upset the presumption. See Exacto Spring Corp. v. Comm’r, 196 F.3d 833, 839 (7th
Cir. 1999). The Commissioner met this burden in Mulcahy, Pauritsch, Salvador & Co. v.
Commissioner, 680 F.3d 867, 872 (CA7 2012) (successful firm should have more than 0%
return).
4. If a corporation has not paid dividends in the (recent) past, the court in McCandless
Tile Serv. v. United States, 422 F.2d 1336 (Ct. Cl. 1970) assumed that a payment of
compensation was necessarily partly a dividend. As the court noted, such an assumption
(“automatic dividend”) was subject to criticism and not widely adopted.
5. Do you think that a shareholder who performs multiple duties should be entitled to
multiple salaries? Is there any other information you might want to know if this were your
case to decide? Does performance of multiple duties increase the number of hours
available to perform them?
6. The “independent investor” approach itself raises some questions:
•Should the court derive a firm’s rate of return by dividing its net income by its
equity for a specific year? Or should it determine its rate of return by determining
its growth rate, compounded, for the years in which it did not pay a dividend?
•How does a court determine the appropriate benchmark rate of return?
•How does a court measure a firm’s equity?
See generally Anne E. Moran, The Independent Investor Test for Reasonable
Compensation: Lens, Laser, or Labyrinth?, TAX PRACTICE MEMORANDUM (BNA) (Dec.
28, 2016).

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B. Sale of Property
Burr Oaks Corporation v. Commissioner, 365 F.2d 24 (7th Cir. 1966), cert. denied, 385
U.S. 1007 (1967)
KNOCH, Circuit Judge
The petitioners, Burr Oaks Corporation, A. Aaron Elkind and Rosella Elkind, Harold A.
Watkins and Fannie G. Watkins, Maurice Ritz and Esther Leah Ritz, instituted these
proceedings in the Tax Court to contest deficiencies in income taxes determined against
them. ... The cases were consolidated. ... The Tax Court held that the transfer of certain
land by the petitioners A. Aaron Elkind, Harold A. Watkins and Maurice Ritz (hereinafter
called ‘the individual appellants’) to the corporate appellant represented a contribution to
capital and not a sale. Accordingly, the Tax Court determined a deficiency against the
corporate appellant for fiscal years ended September 30, 1958, 1959 and 1960. The Tax
Court found deficiencies for one of the individual appellants, but also found an
overpayment by all three of the individual appellants for 1959. The individual appellants
have taken this appeal because of their concern as to adverse effect on future taxable years.
The three individual appellants acquired a tract of undeveloped land in 1957 for $100,000,
which the appellants state to be less than the then market value.
After discarding plans to develop a regional shopping center or an industrial park, the
individual appellants decided to subdivide the land, improve it and sell lots. The Burr Oaks
Corporation was formed. The individual appellants transferred the land to it, and, in return,
each received a two-year 6% promissory note in the principal amount of $110,000. The
sum of $30,000 still due on the original purchase was entered on the corporation’s books
as ‘Mortgage Payable.’ Another account ‘Land Contract Payable’ in the amount of
$330,000 represented the three notes.
At the trial in the Tax Court, the appellants’ expert witness testified that the property
transferred to the corporation was worth at least $360,000. The Tax Court, however, found
more convincing the testimony of the Commissioner’s expert witness who stated that the
land had a fair market value of only $125,000. On the basis of all the evidence adduced,
the Tax Court found a fair market value of not more than $165,000 at the time of the
transfer.
The wives and brothers of the three appellants transferred a total of $4,500 in cash to the
corporation and received common stock ... They are the only stockholders of record. ...
However, all control of the corporation was relinquished to the three individual appellants,
who dominated its affairs, despite engagement of a manager and an accounting firm.
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….
The Tax Court decided that the three promissory notes did not represent a true
indebtedness. In 1959, these three notes, in the amount of $110,000 each, were surrendered
by payment of $23,000 in cash on each note, and a new one-year promissory note dated
November 1, 1959, in the amount of $87,000 at 6% was given in exchange for each of
these three notes. Later the same year, the corporation paid $8000 to each of three
noteholders and issued new promissory notes in the amount of $79,000. On December 29,
1959, the corporation purported to pay these notes, although at the close of business that
day it had a bank balance of only $5,398.88. Immediately after such purported payment,
the three individual appellant-noteholders each lent the corporation $79,000 in return for
three new one-year promissory notes dated December 31, 1959, in the amount of $79,000
each. The Tax Court construes this transaction as a mere extension of the maturity date.
Cf. Arthur L. Kniffen, 1962, 39 TC 553, 565-566. Additional payments were made to each
of the three individual appellants as follows:
8/31/60
1/31/61
12/31/61

$8,000
$15,000
$10,000

leaving a balance of $46,000 due each at the time of the trial. None of the earnings of the
corporation were distributed to any of the shareholders of record.
Although the appellants all treated the transfer of the land in November, 1957, as a sale,
the three individual appellants reported no gain until 1959 when the corporation ‘paid’ the
promissory notes issued at the transfer. In their returns for 1959, the three reported long
term capital gains of $85,729.06. The Commissioner determined that this was ordinary
income. The Commissioner increased the corporation’s taxable income for 1958 through
1960 on the ground that the corporation claimed too high a basis or cost for the land it sold
during that period.
The Tax Court considered the ‘notes’ to be preferred stock because the three holders
occupied a preferred position compared to the common stockholders, the 6% interest
constituting a prior charge on the earnings of the corporation.
The three individual appellants contend that they transferred the Burr Oaks property, a
capital asset held in excess of six months, to the corporation in return for promissory notes,
valid indebtednesses incurred by the corporation, resulting in gain properly reportable in
1959 when the notes were paid in full. The Tax Court noted that the three individual
appellants were all cash basis taxpayers who should have reported as income the fair
market value of the notes received in exchange for the property sold. Pinellas Ice & Cold
Storage Co. v. Commissioner of Internal Revenue, 1933, 287 U.S. 462, 468.

35

The corporation asserts that it bought the Burr Oaks property at a cost of $360,000 and
that that should be its correct basis.
The Tax Court disregarded the form of the transaction and determined the substance of it
to be not a sale but an equity contribution. Substance, rather than form, is the controlling
factor in determining proper tax treatment. Sherwood Memorial Gardens, Inc., 42 T.C.
211, 1964, on appeal Sherwood Memorial Gardens, Inc. v. Commissioner of Internal
Revenue, 7 Cir., 1965, 350 F.2d 225.
The Tax Court found the transfer lacking the essential characteristics of a sale, but, on the
contrary, possessed of the elements normally found in equity contribution. See Emanuel
N. Kolkey, 1956, 27 T.C. 37, affirmed, Kolkey v. Commissioner of Internal Revenue, 7
Cir., 1958, 254 F.2d 51. In that case, certain criteria were established:
Was the capital and credit structure of the new corporation realistic? What was the
business purpose, if any, of organizing the new corporation? Were the noteholders
the actual promoters and entrepreneurs of the new adventure? Did the noteholders
bear the principal risks of loss attendant upon the adventure? Were payments of
‘principal and interest’ on the notes subordinated to dividends and to the claims of
creditors? Did the noteholders have substantial control over the business
operations; and, if so, was such control reserved to them, as an integral part of the
plan under which the notes were issued? Was the ‘price’ of the properties, for
which the notes were issued disproportionate to the fair market value of such
properties? Did the noteholders, when default of the notes occurred, attempt to
enforce the obligations?
In this case, the corporation was organized with a paid-in capital of only $4500, but shortly
thereafter reflected liability of $360,000 on its books. Although it was anticipated that the
City of Madison, Wisconsin, would pay the major costs of improvement of the tract to be
subdivided, the corporation would have to incur development costs estimated at $100,000
or more. Within two months, the corporation borrowed $15,000 from individual appellant
Aaron Elkind and on February 28, 1958, borrowed another $10,000 from him. Although
the taxpayers assert that a number of lots were ready for sale and that heavy capitalization
was therefore unnecessary, the sales were not so quickly made as to eliminate the need to
borrow. The land was the corporation’s only asset.
When the payment to the transferors is dependent on the success of an untried
undercapitalized business with uncertain prospects, a strong inference arises that the
transfer is an equity contribution.
The three individual appellants, though not shareholders, controlled the corporation’s
affairs. Harold Watkins was president. Aaron Elkind, his wife, Maurice Ritz, his brother
Philip, Harold Watkins and his wife were directors. The manager had been employed by
36

Aaron Elkind in varying capacities for about 15 years. His activity was supervised by
Maurice Ritz’s accounting firm.
After hearing the testimony of the shareholders, Maurice Ritz’s brothers, Mrs. Elkind and
Mrs. Watkins, the Tax Court was convinced that they knew and understood little of the
corporation’s business and were subject to the control of the three individual appellants.
Two of the latter agreed that the corporation was formed to allow them to receive a part of
the development profits. The large ‘sales price’ extended the time during which the three
individual appellants participated as ‘creditors’ and the amounts they could withdraw as
principal if the corporation were successful.
….
The Tax Court found the payments to the three individual appellants ... should be treated
as dividends.
After close scrutiny of the entire record, we conclude that the decisions of the Tax Court
are correct and must be affirmed.
Affirmed.

Questions and comments:
1. Why do you think that the parties’ valuations of the property were different by a
multiple of almost 3, i.e., $125,000 and $360,000? What were the taxpayers trying to do?
2. The corporation did pay the three notes down from $110,000 to $46,000. Where did
that money come from? Where is it now? How many times was it taxed and to whom?
3. The Tax Court found a deficiency for the corporation but an overpayment for the
individuals.
4. A contribution to capital, as we shall see in chapter 2, is not a taxable event under §
351 if persons who transfer property to a corporation are in control of the corporation
immediately after its formation. They have a basis in their stock equal to the basis that they
had in the property that they transferred. The corporation has a basis in the property it
receives equal to the basis that the property had when the shareholders transferred it.
•How would the application of these rules have wreaked havoc with the taxpayers’
plans?
5. It is unlikely that a shareholder’s sale of property to a closely-held corporation shortly
after its purchase should reflect a trebling of the property’s value. The proximity in time
37

between the shareholder’s purchase and sale of the property should be a relevant
consideration in addition to the ones mentioned by the court.
6. A shareholder may lease property to a closely-held corporation. The same valuation
problems will arise. The parties may treat the rental value of the property as more than it
really is.
7. Distributions of “constructive dividends” or “disguised dividends” are considered in
chapter 3, part III, infra.

C. Loans to Shareholders
Characterizing advances from corporations to shareholders as loans (rather than dividends)
is one way to get money out of a corporation and into the hands of a shareholder without
either corporation or shareholder paying any income tax on the transfer. Whether a transfer
of money from one party to another is a loan is a question raised in many contexts, e.g.,
security deposits, embezzled money. The intent of the parties at the time the arrangement
is established is what matters. The debtor must intend to repay, and that intent must exist
at the time she borrows the funds. The creditor must intend to enforce the obligation.
Section 7872 will impute a market rate of interest – either as interest or as reflective of the
discounted value of a repayment obligation – into below-market corporation/shareholder
loans of $10,000 or more. Before § 7872 becomes relevant, there must be a loan.

Bergersen v. Commissioner, 109 F.3d 56 (1st Cir. 1997)
BOUDIN, Circuit Judge
This appeal involves a tax dispute posing two questions: whether certain payments to the
taxpayers by a controlled company were constructive dividends (rather than loans) and
whether the taxpayers were residents of Illinois (rather than Puerto Rico) in 1986 and 1987.
The Tax Court answered yes to both questions, resulting in adverse consequences for the
taxpayers, who now appeal. We affirm the Tax Court.
... The taxpayers are Earl and Evelyn Bergersen, a long-married couple who resided for
many years in Illinois. Earl Bergersen practiced as an orthodontist in Winnetka, Illinois,
starting in 1959. In addition to practice and part-time teaching, Earl Bergersen invented
and patented new orthodontic products, which enjoyed a good deal of success.
In the early 1970s, the Bergersens incorporated Ortho-Tain, Inc., under Delaware law, to
manufacture and sell products based upon Earl Bergersen’s inventions. At all times
38

pertinent, the couple were the only members of the Ortho-Tain board of directors. During
the tax years at issue in this case (1985-1987), the Bergersens also held all of the class A
voting shares in the company (56 each), with five class B voting shares held by each of
their three children. Each of the children also held between 100 and 300 shares of class C
nonvoting stock. Santos Ortiz, manager of the company’s Puerto Rico plant, held 200
shares of class D nonvoting stock, and Thomas Sedwick, the tool and die maker at the
plant, held 190 shares of class E nonvoting stock.
Initially based in Winnetka, the plant was moved to Puerto Rico in 1976. The Bergersens
hoped to move to Puerto Rico eventually; residents of Puerto Rico are exempt from U.S.
income tax on income derived from Puerto Rico sources. 26 U.S.C. § 933. After the plant
moved, Ortho-Tain elected to be treated as a possessions corporation, exempting it from
U.S. income tax on Puerto Rico source income. Id. § 936.15 The company also received a
15-year industrial tax exemption from Puerto Rico, which also permitted Puerto Rico
residents to receive company dividends free of income tax. [citation omitted].
During the late 1970s, Ortiz and Sedwick ran the Puerto Rico plant while the Bergersens
handled the company’s finances from Illinois. Ortho-Tain’s sales grew from $600,000 in
1977 to $1.2 million in 1987. During these years, the taxpayers received no salary from
the company, and no dividends were declared on their stock until 1987. During most of
the period, modest dividends (ranging from $5,000 to around $22,000) were paid annually
to Ortiz and to Sedwick.
In this same period, Ortho-Tain’s accumulated undistributed earnings grew from just under
$350,000 in 1977 to just over $5 million in 1986. The company’s possession status freed
it from the U.S. accumulated earnings tax. 26 U.S.C. § 936(g). Meanwhile, starting in
1982, Earl Bergersen borrowed substantial amounts from the company, totaling almost
$3,700,000 by 1987. The loans were evidenced by unsecured demand notes and carried
interest rates of 8.5 to 10 percent; the taxpayers regularly paid this interest to the company
and deducted the interest payments on their U.S. income tax returns for the years 1982
through 1986.
Apart from one loan repayment of about $400,000 in 1984, the loans were carried on
Ortho-Tain’s books until March 1987, when Ortho-Tain issued dividends of about
$2,800,000 to the taxpayers, which they treated as exempt from U.S. income tax under §
933 and immediately paid back to the company to reduce their outstanding loans. The
remaining loan balance was repaid after further dividends of just over $2,000,000 to
taxpayers in 1988. As one might guess, it is the position of the Internal Revenue Service
that the loans were constructive dividends subject to U.S. income tax when made.

15

[Section 936 was repealed in 2018.]

39

The other issue in dispute concerns the timing of the Bergersens’ move to Puerto Rico.
Looking toward this move, they purchased land in Puerto Rico in 1981 and, over the next
several years, planned an elaborate house. Construction began in 1984 but, because of
delays, the house was not finished as expected by late 1985. In the meantime, starting in
1984, Earl Bergersen turned over much of his orthodontics practice to another dentist and
spent only a few days a month with established patients.
In July 1985, the Bergersens sold their Winnetka house and in September 1985 agreed to
buy a town house in Glenview, Illinois. In April 1986, they joined a Glenview social club.
They also sublet an apartment in Puerto Rico from their employee Sedwick from
November 1985 through October 1986. When the sale closed on the Winnetka house in
November 1985, the Bergersens dispersed their belongings to various places in Illinois
and Puerto Rico.
By summer 1986, the Bergersens’ new Puerto Rico house had one bedroom finished,
which they used on occasion, and they installed a housekeeper couple in the house. More
of their furnishings were shipped there in August 1986. At about the same time, the
Bergersens shipped a car to Puerto Rico, registered it, and activated a country club
membership there. They obtained an occupancy permit for the new house in January 1987,
but construction continued until August 1987.
During 1986 and 1987, the Bergersens traveled a good deal for both business and pleasure,
dividing their time between Puerto Rico and the United States mainland. They spent 108
days in Puerto Rico in 1986 and 93 there in 1987. They spent 107 days in the Glenview
town house in 1986 and 138 days there in 1987. Thus, in 1986, they spent 150 days in
places other than Illinois and Puerto Rico; in 1987, the figure was 134 days. Earl Bergersen
spent no more than a few weeks each year seeing patients in Winnetka.
In February 1987, the Bergersens replaced Illinois drivers’ licenses that they had lost. In
August 1987, the new Puerto Rico house was completed, and the government admits that
the taxpayers used it as their principal residence thereafter. Earl Bergersen wound up his
Winnetka practice in late 1987. In 1988, the Bergersens acquired Puerto Rico voting cards
and, in 1989, Puerto Rico drivers’ licenses.
The present case began after the Internal Revenue Service reviewed the taxpayers’ income
tax returns for 1985 through 1987. In due course, the IRS ruled that the loans made to the
Bergersens in these years were not bona fide loans but constructive dividends; the result
was to include the amounts received as part of the taxpayers’ reportable income and to
disallow deductions taken by them for interest payments on the loans.
The IRS also concluded that the Bergersens in 1986 and 1987 were not bona fide residents
of Puerto Rico for the entire year, as they claimed, but were residents of Illinois for all of
1986 and part of 1987. It is common ground that § 933 excludes Puerto Rico source income
40

from U.S. income tax only where the taxpayer is a resident of Puerto Rico for the entire
year in question. Vazquez v. Commissioner, 66 T.C.M. (CCH) 406, 407, 1993 WL 315404
(1993); Reg. § 1.9331(a). Accordingly, the IRS determination meant that the moneys the
Bergersens received from Ortho-Tain in those years were not excludable from U.S. income
tax under § 933.
The Bergersens petitioned the Tax Court to redetermine ... 26 U.S.C. § 6213. The case was
tried before the Tax Court in April 1994. In August 1995, the Tax Court ... held that the
loans were constructive dividends and that the Bergersens were not residents of Puerto
Rico for the entire year either in 1986 or 1987. This appeal followed.
The Loan or Dividend Issue. The loan or dividend issue, which is not uncommon in tax
cases involving controlled companies, usually poses the question whether the owner is
trying to smuggle earnings out of the company without paying personal income tax. A
dividend or salary paid to an owner is taxable as income; a loan, being only a temporary
transfer, is not. But if a “loan” by the company to an owner is not intended to be repaid,
then allowing that label to control would effectively deprive the government of its tax bite
on dividends and salaries.
The conventional test is to ask whether, at the time of the withdrawal in question, the
parties actually intended repayment. Crowley v. Commissioner, 962 F.2d 1077, 1079 (1st
Cir. 1992). Explaining that “intent” is difficult to discern, courts regularly resort to
objective criteria, asking whether the transaction bears the traditional hallmarks of a loan
or of a dividend. Id. In any event, purporting to be looking at intent, appeals courts
generally describe such intent as a fact, id. at 1080, and subject the fact-finder’s
determination to clear error review, see id.; see also Commissioner v. Duberstein, 363 U.S.
278, 290-91 (1960).
Here, the government invokes this deferential standard of review. It argues that the finding
of constructive dividends cannot be clearly erroneous in light of the various indicia
mentioned by the Tax Court as suggesting dividend status; that the loans had no collateral
and no fixed repayment schedule; that no limits were set on the amounts to be borrowed;
that the proceeds were used by the Bergersens for personal purposes; and that Ortho-Tain
accumulated huge earnings but paid the Bergersens no dividends during the years of the
loans until 1987.
The Bergersens, on the other hand, say that the Tax Court made an error of law by stressing
that the Bergersens were trying to “avoid taxes” by delaying dividends until they moved
to Puerto Rico; Congress, the Bergersens point out, chose in § 936(g) to allow possessions
companies to accumulate earnings in Puerto Rico and to distribute the amounts free of
U.S. income tax to those who have moved there. And the Bergersens dispute the
government’s portrayal and weighing of the objective factors.

41

Like white asparagus or a blood orange, this first issue is not ordinary fare but an odd
variation, caused by the interplay of ordinary factors with Puerto Rico tax status. The
Bergersens may well have intended to repay the loans after they moved to Puerto Rico.
After all, at that point they could do so by declaring a dividend to themselves free of U.S.
(and Puerto Rico) income tax; and after using the dividends to repay the loans, they
remained free to use the repaid funds for a new dividend, again without U.S. (or local) tax
consequences.
The situation is thus very different from the ordinary loan-or-dividend case, where
repayment of the loan to the company would effectively preclude a tax-free distribution.
Here, the Bergersens could reasonably have intended to repay the money and reap the
benefits of a tax-free distribution. Nor would there have been anything wrong if the
Bergersens, knowing that they were moving eventually to Puerto Rico, had accumulated
earnings in the company but refrained from withdrawing them until after the move.
The question here, then, is whether the Bergersens could pay out moneys to themselves
before moving to Puerto Rico and avoid U.S. income taxes by designating the payments
as loans. We think that this ought to depend upon whether, in overall character and context,
the payments were more like loans or more like dividends. After all, “intent to repay” is
merely a functional test that is usually suitable; but the purpose of the tax law is to tax
transactions, not rubrics or labels. [citation omitted].
Here, the payments had some of the traditional indicia of loans (notes existed, interest was
paid). In other respects, formalities were absent (no fixed repayment date, no collateral,
no credit limit). But regardless of formalities, the nominal loans, paid by a controlled
company that was accumulating large earnings but paying its main owners no dividends,
effectively gave the Bergersens permanent tax-free control over the moneys.
If after their move, the Bergersens had decided not to repay but to cancel the loans as a
form of dividend, there would have been no tax due on this dividend. If instead – as
actually happened – they declared cash dividends and repaid the loans, the effect was to
redeposit the money in their own corporate vehicle, available for redistribution to them at
any time, again with no tax consequences. As the Tax Court observed, the repayment was
effectively a “meaningless exchange of checks.” Indeed, even the earlier interest payments
could be recovered by the Bergersens without tax effects.
Thus, at the very outset of the loans, the Bergersens knew that there was no effective
corporate constraint to induce repayment, nor (given the intended move to Puerto Rico)
any meaningful tax consequences from a permanent failure to repay. An effective
permanent transfer of corporate funds to an owner is the hallmark of a dividend or a salary,

42

and not a loan. There is nothing wrong with an owner making such a transfer. But when
made to a U.S. mainland resident, the transfer is subject to U.S. income tax.16
Looking through form to substance, see Commissioner v. Court Holding Co., 324 U.S.
331, 333 (1945), we reach the same result as the Tax Court and therefore need not concern
ourselves on this issue with the proper standard of review (since even de novo review
would lead to affirmance). The claim that the Tax Court made a mistake of law in
construing § 933 without giving sufficient consideration to § 936(g) is a red herring.
Congress’ policy permitted the company to accumulate earnings in Puerto Rico free of
tax; it did not authorize tax-free dividends to Illinois residents.
The Residence Issue. We turn now to a more conventional issue, namely, whether the
Bergersens were residents of Illinois during 1986 and at least part of 1987, as the Tax
Court ruled, or whether they were residents of Puerto Rico for either or both years in their
entirety. ...
….
... Clearly the Bergersens did intend eventually to base themselves and remain permanently
in Puerto Rico; that is why they embarked on construction of a very expensive house in
1984, before the tax years in dispute. The question for us, as we see it, is when the
Bergersens had effectively moved their base to Puerto Rico and established their residence
there.
As the Tax Court candidly said, the Bergersens’ conduct amounts to a move to Puerto Rico
carried out over a period of time. ...
….
We agree with the Tax Court that for 1986 and at least part of 1987, the Bergersens were
residents of Illinois and not yet of Puerto Rico. ...
….
... [T]he Bergersens were perfectly free to consider tax advantages in moving their
residence to Puerto Rico, and here we think that tax motives provide little help in

Nor does it matter that the Bergersens might have achieved their ends through a different device, say, by
borrowing the money from a bank – a real loan requiring repayment – and repaying it with a tax-free dividend
declared after the move to Puerto Rico. The taxpayers are stuck with the transaction they chose to employ. See
Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 148-49 (1974).
16

43

determining when this move occurred. (A tax motive does, however, help explain why the
payments were structured as loans.)
….
Because the Bergersens were not bona fide residents of Puerto Rico either in 1986 or for
the full year in 1987, they were not entitled to avoid U.S. income tax on Puerto Rico source
income in those years. 26 U.S.C. § 933. As the “loans” were constructive dividends, they
were taxable income to the Bergersens when made, and the Bergersens were not entitled
to deduct the interest payments to the company. [citation omitted].
Affirmed.

Questions and comments:
1. Most cases involving loans that are really dividends involve shareholders who treat
their wholly-owned corporations as their alter egos. This one involved an effort to
minimize income tax by matching tax exempt income with tax-free money (loan). The
taxpayers (or their tax counsel) were clever – just not clever enough.
2. As in other contexts, intent to repay at the time the loan is made is necessary to make
the transaction a loan. In distinguishing loans from dividends, the corporation must intend
to enforce the repayment obligation.
3. Section 7872 does not apply to de minimis (less than $10,000) loans from corporation
to shareholder so long as tax avoidance is not one of the principal purposes of the interest
arrangement. If Ortho-Tain’s loans to the Bergersens had not provided for the payment of
interest, do you think that the Bergersens could have “passed” this test of § 7872?
4. Not surprisingly, courts will consider various factors when determining whether an
advance is a loan or a dividend. In Miller v. Comm’r, 41 T.C.M. (CCH) ¶ 139, T.C. Memo.
1980-445 (1980), the court articulated the balancing of factors that led it to conclude that
the corporation had extended a loan to the shareholder/debtor. Paraphrasing the court’s
discussion of the indicia of dividends or loan, the following considerations are relevant.
Militating in favor of treating the advances as loans –
(1) the shareholder/debtor executes a demand note;
(2) the shareholder/debtor actually repays part or all of the loan;
(3) the corporation treats the loans as receivables, both on its books and when
dealing with third parties for whom this matters;
(4) the shareholder/debtor owns sufficient assets to repay the loans.
44

Militating in favor of treating the advance as dividends –
(1) the demand note does not provide for the payment of interest;
(2) the shareholders/debtors does not make interest payments on the loan;
(3) the shareholder/debtor does not give security for the loan;
(4) the shareholder exercises control over the corporation – perhaps because the
debtor is the sole shareholder;
(5) there is no documented limitation on the amount of transfers to
shareholder/debtors;
(6) the corporation paid dividends or wages to the shareholder/debtor.
We can add to these lists:
•A history of not paying dividends tends to show that advances are dividends.
•A set maturity date tends to show that advances are loans.

45

Chapter 2: Forming the Corporation and Adding to Its Capital
Read IRC §§ 351, 357, 358, 362, 368(c), 1032, 1223.
Formation of a corporation involves forming an entity separate and apart from the
shareholders who form and own it. This occurs under state law. Subject to certain
conditions, the Code does not inhibit the formation of corporations by taxing the
transactions (i.e., exchanges) that must occur. The corporation issues shares. Shareholders
may exchange property and/or services with the corporation for shares. (Shareholders may
receive shares and property if the corporation has already acquired property).
The Exchange: In most contexts, exchanges are recognition events. However, § 351(a)
provides that shareholders do not recognize taxable income when they enter into
transactions with corporations and certain conditions prevail, namely that the transferor or
group of transferors –
1. transfer property (including money) to the corporation,
2. solely in exchange for stock, and
3. immediately after the exchange, the transferor or group of transferors control the
corporation.
•“Control” is ownership of 80% of the total voting power of all classes of
stock entitled to vote and of each and every other class of stock. § 368(c).
Section 1032(a) provides that a corporation recognizes no gain or loss when it exchanges
its own stock for money or property, irrespective of whether the exchange qualifies for
nonrecognition treatment of the shareholder(s).
•Example 1: Quincy and Rebecca formed the Plover Corporation. Quincy
transferred Blackacre, ab = $100, fmv = $250, to the corporation in exchange for
25 shares of Plover Corporation voting common stock. Rebecca transferred
Whiteacre, ab = $175, fmv = $250, to the corporation in exchange for 25 shares of
Plover Corporation voting common stock. This is all the Plover Corporation stock
outstanding. The fmv of each share of voting common stock is $10. While Quincy
realized $150 of gain on the exchange, and Rebecca realized $75 of gain on the
exchange, neither recognizes gain. The Plover Corporation, which now owns
Blackacre and Whiteacre, recognizes no gain or loss on the exchange.
Implicit in these rules is the determination that Congress concluded that mere changes in
the form in which taxpayers do business should not be an occasion for assessing an income
tax. Investors in property who transfer that property to a corporation that they control retain
an investment substantially the same as the investment that they surrendered. The
continuity of shareholders’ investment is manifested by their “control.” “Control” is
ownership of “at least” 80% of the total voting power of all classes of stock entitled to vote
and “at least” 80% of the total number of shares of all the corporation’s other class(es) of
stock. § 368(c). The IRS has construed “control” to be 80% of the total voting power of
46

all classes of stock entitled to vote, no matter how voting power is distributed among
classes of stock, and 80% of each and every class of a corporation’s non-voting stock. Rev.
Rul. 59-259, 1959-2 C.B. 115. Ownership of even non-voting shares is necessary because
“[o]wnership of large numbers of non-voting shares in a multi-class stock structure would
not necessarily assure, in itself, the continuation of substantial proprietary interest in
modified corporate forms as contemplated by the statute.” Id. But consider this example:
•Example 2: In Example 1, at the same time Q and R transferred property to the
corporation, Samuel transferred $500 cash to the Plover Corporation in exchange
for 50 shares of Plover Corporation’s Class B nonvoting common stock. Neither
Quincy, Rebecca, nor Samuel recognize gain (or loss) on the exchanges. All are
transferors of property, and together, transferors of property own 80% or more of
shareholders’ total voting power and 80% or more of each and every class of Plover
Corporation’s nonvoting stock. None of the exchanges of property or money is a
recognition event to shareholders or to the corporation.
The reach of § 351 extends to more than formation of the corporation. Any time the
conditions of § 351(a) prevail, the exchange is a non-recognition event because such
conditions indicate a sufficient continuity of interest in the corporation.
•Example 3: Same as Example 1. Three years after formation of Plover
Corporation, the total value of Plover Corporation’s outstanding stock has
increased to $800. Quincy and Rebecca both transfer $80 to the Plover
Corporation, and Seth transfers Greenacre, ab = $210, fmv = $320, to the Plover
Corporation. Quincy and Rebecca both receive 5 more shares of voting common
stock, and Seth receives 20 shares. The total value of Plover’s voting common
stock is now $1280, and the corporation has 80 shares outstanding. Even though
the second transfer did not involve 80% of the total voting power of the
corporation, the exchange qualifies for § 351 treatment, because transferors of
property do own 80% of the total voting power of the corporation. Both Quincy
and Rebecca may count the shares they already own at the time of the second
transfer in making this determination. Hence, on the second exchanges, transferors
of property own 100% of the voting shares of Plover Corporation. 100% > 80%.
•Example 3A: Same as Example 3, except that three years after formation of the
Plover Corporation only Quincy and Seth make the property transfers described.
Now there are 75 shares outstanding. Transferors of property (i.e., Quincy and
Seth) own 50 of them. 50 < (80% of 75). The second exchange does not receive
non-recognition treatment, and Seth must pay income tax on $110 of gain.
Timing of Recognition: The Code does not forever leave untaxed gain realized on a § 351
exchange, but merely defers its recognition. Deferral occurs through the mechanisms of
basis transfer and basis substitution. The transferor of property to the corporation takes a
basis in his stock equal to the basis he had in the property transferred. § 358(a) (with
adjustments for any gain or loss that falls outside nonrecognition provisions of § 351(a)).
47

He “substitutes” the basis he had in the property that he transferred for whatever basis he
would have had in the stock. Moreover, the shareholder’s holding period in his stock
carries over from the holding period he had in the property that he transferred. § 1223(1).
This preserves the character of the gain, whether long-term or short-term. The transferee
corporation takes the transferor’s basis in the property it receives from the shareholder, §
362(a)(1), i.e., the corporation takes a “transferred” basis in the property that it receives.
The corporation also takes the transferring shareholder’s holding period, i.e., tacks the
shareholder’s holding period to its own. § 1223(2).
The shareholder and the corporation will recognize gain on the subsequent disposition of
what they received in the § 351 exchange. If a transferring shareholder transfers Blackacre
whose fmv is greater than its basis to a corporation in a § 351(a) transaction and receives
stock, the corporation will recognize taxable gain when it sells Blackacre. The transferring
shareholder will recognize gain when he sells the stock, assuming its fmv is the same as
the fmv of Blackacre. Notice that these basis substitution/transfer rules cause two
taxpayers – the transferring shareholder and the transferee corporation – both to recognize
gain whose origin is the single piece of property that the shareholder transferred to the
corporation. That is the consequence of creating a taxpayer, i.e., the corporation, or
transferring property to it in an exchange in which no gain or loss is recognized.
•Example 4: Same facts as Example 1. Assume also that Quincy purchased
Blackacre 27 months ago. Rebecca purchased Whiteacre 7 months ago. Quincy will
have an adjusted basis in his stock of $100. If he were to sell the stock for $250, i.e.,
its fmv had not changed, he would recognize $150 of taxable LTCG – precisely the
amount of gain he did not have to recognize on the initial exchange. If Rebecca sold
her stock one month after the initial exchange for $250, she would recognize $75 of
taxable STCG, precisely the amount of gain she did not have to recognize on the
initial exchange. If she had waited 5 months and 1 day after the initial exchange to
sell her stock, her recognized gain would have been LTCG.
•If Plover Corporation sells Blackacre for $250, i.e., its fmv had not changed, it
must recognize $150 of taxable capital gain – assuming Blackacre is a capital asset,
the same amount of gain Quincy recognized upon sale of his stock.

Problem:
A, B, and C form the Flom Corporation. A transfers Blackacre to Flom Corporation in
exchange for 100 shares of Flom voting common stock. A purchased Blackacre four years
ago for $15,000. At the time of transfer, Blackacre’s fmv was $20,000. B transfers $20,000
in cash in exchange for 100 shares of Flom voting common stock. C transfers inventory
that he purchased six years ago for $17,000 in exchange for 100 shares of Flom common
stock. At the time of transfer, the fmv of the inventory was $20,000. A, B, and C are the
only shareholders of Flom Corporation, and the 300 shares of voting common stock are
the only shares of Flom stock outstanding. Answer the following questions and cite the
relevant statute.
48

•How much gain or loss did A, B, and C realize on their respective exchanges with
Flom Corporation?
•How much gain or loss must A, B, and C recognize on their respective exchanges
with Flom Corporation?
•A, B, and C no longer own Blackacre, cash, or inventory. Rather they each own
100 shares of voting common stock of Flom Corporation. What is each
shareholder’s basis in his shares of Flom Corporation?
•Upon the transfers of cash or property, what is the holding period of A, B, and C
for their Flom Corporation stock?
•How much gain or loss must Flom Corporation recognize on its exchanges with
the three shareholders? What is the holding period of Flom Corporation for
Blackacre, the cash, and the inventory?
Transfers to an Investment Company:
Section 351(e)(1) provides that
nonrecognition treatment does not
extend to transfers to an “investment
company.” Investors who held highly
appreciated assets could at one time
transfer them to a newly-formed
corporation to which other similarly
situated investors would also transfer
their highly-appreciated securities.
The stock which such investors
received would be backed by a more
diversified portfolio than what any
one of them individually had owned.
Reg. § 1.351-1(c) provides that a
transfer is to an “investment
company” if the direct or indirect
result is a diversification of the
shareholders’ interests and the
transferee is either a regulated
investment company, a real estate
investment trust, or a corporation
more than 80% of whose assets
(excluding cash and nonconvertible
debt) are assets held for investment.

Shareholder Transfers of Loss Property(ies):
This scheme should logically allow for the
recognition of losses at both the shareholder and
corporate levels. For many years, it did. Congress
amended § 362 in the American Jobs Creation
Act of 2004. Pub. L. No. 108-357, § 836, 118
Stat. 1594, 1595.

•Section 362(e)(2)(A) provides that if the
properties that a shareholder transfers to the
corporation have aggregate bases greater than the
properties’ aggregate fmv, then the corporation
must reduce its bases in the loss properties in
proportion to their built-in losses so that the
aggregate bases of the transferred properties are
not greater than the aggregate fmv of the
properties. The reduction(s) is (are) made
property-by-property in proportion to the
transferring shareholder’s built-in losses in the
property(ies) that he exchanges. § 362(e)(2)(B).
The shareholder and corporation may together
agree to reverse this pattern, i.e., the shareholder
reduces the basis of his stock and the corporation
takes carryover bases in the property(ies) that it
receives. § 362(e)(2)(C).
•Example 5: Uriah and Victor form the Plover Corporation. Uriah transfers to the
corporation Blackacre, ab = $100, fmv = $250, to Plover Corporation in exchange
for voting common stock. Victor transfers the following properties to the Plover
Corporation: Whiteacre, ab = $50, fmv = $60; Greenacre, ab = $75, fmv = $45;
Redacre, ab = $100, fmv = $60; and Brownacre, ab = $25, fmv = $15. What is
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Uriah’s and Victor’s basis in their stock? Determine Plover Corporation’s basis in
each of the properties that it received.
•Uriah transferred one property, and it has built-in gain. Plover
Corporation’s basis in Blackacre is $100.
•Uriah has a $100 basis in his stock. Victor has a $250 basis in his stock,
which is more than the fmv of the properties that he transferred.
•Victor transferred several properties.
•First: Determine the aggregate bases and aggregate fmv of the
properties. Aggregate bases = $50 + $75 + $100 + $25 = $250.
Aggregate fmv of the properties = $60 + $45 + $60 + $15 = $180.
•Second: Determine the amount by which aggregated adjusted
bases exceeds aggregate fmv. Aggregate bases exceed aggregate
fmv by $70, so Plover Corporation must reduce the bases of the
individual properties that it received from Victor by a total of $70
in proportion to the built-in losses in the properties.
•Third: Identify only the properties with built-in losses, i.e.,
Greenacre ($30 of built-in loss), Redacre ($40 of built-in loss), and
Brownacre ($10 of built-in loss). Their total built-in loss is $80.
•Fourth: Determine what portion of the total built-in loss is
attributable to each loss property: 3/8 of the total built-in loss is
attributable to Greenacre. 4/8 of the total built-in loss is attributable
to Redacre. 1/8 of the total built-in loss is attributable to Brownacre.
So:
•Fifth: Reduce Plover Corporation’s basis in Greenacre by 3/8 of
$70, i.e., $26.25, to $48.75. Reduce Plover Corporation’s basis in
Redacre by 4/8 of $70, i.e., $35, to $65. Reduce Plover
Corporation’s basis in Brownacre by 1/8 of $70 ($8.75) to $16.25.
•Plover Corporation’s basis in Whiteacre is $50.

Problem:
John and Kaylee form the Larrimore Corporation. They are the corporation’s only
shareholders. John transfers $10,000 cash to the corporation and receives 1000 shares, fmv
= $10/share. Kaylee transfers to the corporation Blueacre (ab = $1000, fmv = $2000),
Blackacre (ab = $5000, fmv = $2000), Yellowacre (ab = $5000, fmv = $3000), Pinkacre (ab
= $2000, fmv = $1000), and Orangeacre (ab = $3000, fmv = $2000). What are John’s and
Kaylee’s bases in their stock? Determine Larrimore Corporation’s basis in Blueacre,
Blackacre, Yellowacre, Pinkacre, and Orangeacre. Assume that the parties did not make the
election under § 362(e)(2)(c).
•Same facts, except that the parties did make the election under § 362(e)(2)(c).

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I. Transfer of Property to the Corporation
To come within the non-recognition rule of § 351, transferors must transfer “property.”
Services are not property and so are outside of § 351's non-recognition provisions. Often,
a taxpayer “labors” (i.e., renders services) to produce something and then transfers that
“something” to the corporation. While courts may be generous in characterizing different
“somethings” as property, taxpayers should be careful about whether they are creating
something for the corporation in exchange for compensation or for themselves.

James v. Commissioner, 53 T.C. 63 (1969)
SIMPSON, Judge
The respondent determined deficiencies in income tax and additions to tax for the year
1963 ...
The issue for decision is whether the transaction by which Mr. James and Mr. Talbot
acquired stock in a corporation was taxable or whether such transaction was tax free under
§ 351 of the ... Code of 1954. [footnote omitted]. The answer to the question thus posed
with respect to each person depends on the transfer of property or as compensation for
services.
FINDINGS OF FACT
….
The petitioners William A. James and Beryl N. James are husband and wife, and the
petitioners C.N. Talbot and Lula E. Talbot are husband and wife. All the petitioners resided
in Myrtle Beach, S.C. ...
For many years, Mr. James was a building, real estate promoter, and developer with offices
in Myrtle Beach, S.C. ... During 1963, the James Construction Co. was licensed by the
State of South Carolina to engage in the business of general contracting.
On January 12, 1963, Mr. and Mrs. Talbot entered into an agreement with Mr. James for
the promotion and construction of a rental apartment project, consisting of not less than
50 apartments, the project to conform to Federal Housing Administration (FHA) standards.
The agreement provided that on completion of the project the parties would form a
corporation to take title to the project. The voting stock in such corporation was to be
distributed one-half to the Talbots and one-half to Mr. James, and nonvoting stock was to
be issued to the parties “as the equity of each party in the corporation shall be,” with the
proviso that Mr. James should have the right to purchase up to 50 percent of such stock
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over a period of years. The Talbots agreed to transfer to the corporation the land on which
the apartment project was to be built, such land to be the only asset contributed by the
Talbots to the venture. Mr. James agreed “to promote the project * * * and * * * (to) be
responsible for the planning, architectural work, construction, landscaping, legal fees, and
loan processing of the entire project.” The agreement gave him until January 1, 1964, to
promote the project and to obtain the necessary FHA commitment and financing, with an
option to terminate the agreement if the project became unfeasible or impossible.
After the execution of the January 12 agreement, Mr. James began negotiations to fulfill
his part of the contract. He made arrangements with an attorney and an architectural firm
to perform the work necessary to meet FHA requirements – development of legal
documents, preparation of architectural plans, and the like; and he obtained from United
Mortgagee Service Corp. (United Mortgagee), a lender, its agreement to finance the
project and a commitment by FHA to insure the financing. Mr. James personally met with
the FHA only twice – once in connection with the amount of the commitment and again
at the final closing of the loan, after construction of the project was completed in the late
summer of 1964. Most of the arrangements necessary to the securing of the loan and the
FHA commitment were handled by the attorney, the architectural firm, and United
Mortgagee. The attorney’s and architect’s fees were not paid by Mr. James but were paid
out of the proceeds of the construction loan by the corporation subsequently established.
On August 8, 1963, the FHA issued to United Mortgagee a commitment for the insurance
of advances in the amount of $850,700 to Chicora Apartments, Inc., for the apartment
project sponsored by Mr. James and the Talbots. On August 27, 1963, United Mortgagee
sent Mr. James a draft of a proposed agreement to make a first mortgage loan of $850,700
on the Chicora Apartment project in accordance with Mr. James’ application for such loan.
[footnote omitted] The proposed agreement also provided that United Mortgagee would
advance to Mr. James personally the amount for FHA-required working capital and other
specified sums, such advances to be secured by specified portions of the construction loan
or mortgage proceeds. Although the record does not reveal whether this proposed
agreement was ever executed, the subsequent activities of the parties indicate that some
such agreement was consummated. On August 29, 1963, Mr. James executed a promissory
note payable to United Mortgagee in the amount of $1,149.03, the amount of the “FHA
Commitment Fee.” Mr. James signed this note, which was secured by the mortgage
proceeds, individually, and as president of Chicora Apartments, Inc., although the
corporation had not been created at that time.
On November 5, 1963, Chicora Apartments, Inc. (Chicora), was granted, upon application
of Messrs. Talbot and James, a corporate charter, stating its authorized capital stock to
consist of 20 no-par common shares. On the same date, the land on which the apartment
project was to be constructed was conveyed to Chicora by Mrs. Talbot in consideration
for 10 shares of stock. Nine of these shares were issued to Mrs. Talbot, and one share was
issued to Mr. Talbot. Chicora’s board of directors determined that on the date of this
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conveyance the value of the real property so transferred was $44,000. Also on November
5, 1963, 10 shares of stock were issued to Mr. James. The minutes of a meeting of
Chicora’s board of directors held on that date state that those 10 shares were issued to Mr.
James in consideration of his “transfer” to the corporation of the “following described
property”:
1. FHA Commitment ... whereby the FHA agrees to insure a mortgage loan in the
amount of $850,700.00, [on the Talbots’ land] ..., provided 66 apartment units are
constructed thereon in accordance with plans and specifications as prepared by
Lyles, Bissett, Carlisle & Wolff, Architects-Engineers, of Columbia, South
Carolina.
2. Commitment from United Mortgagee Servicing Corp., agreeing to make a
mortgage loan on said property in the amount of $850,700.00 and also commitment
from said mortgagee to make an interim construction loan in an identical amount.
….
Thus, as a result of these transactions, Chicora had outstanding all 20 of its authorized
shares of stock.
On November 6, 1963, the FHA issued to Chicora its commitment ... in the amount of
$850,700. Under FHA regulations, this commitment could not be issued to an individual,
but was required to be issued to a corporation. ...
The apartment project was built by W.A. James Construction Co. Construction was begun
in late 1963 or early 1964, and the buildings were completed and occupancy begun on or
about July 28, 1964.
The usual procedures were followed with regard to the FHA commitment fee and the FHA
working capital. Mr. James acquired the funds for the commitment fee by the note
executed by him on August 29, 1963. On November 19, 1963, Mr. James executed two
notes in favor of United Mortgagee; the first was for $17,015, the amount of the required
working capital, and the second was for $2,126.75. Mr. James received these amounts
from United Mortgagee in accordance with FHA requirements. Both notes were to be paid
out of the ‘contractor’s cash fee’ and were secured by the mortgage proceeds, and each
bore the notation of consent of Chicora and W.A. James Construction Co. to the
assignment of the contractor’s fee. The funds so advanced to Chicora in the credit of Mr.
James, including the commitment fee, were to be, and were, repaid out of the initial
advances under the FHA guarantees to Chicora. The commitment fee and the working
capital requirement, accordingly, were paid out of the construction loan advance to the
corporation.

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Both Mr. and Mrs. James and Mr. and Mrs. Talbot deemed their receipt of Chicora
common stock to be in return for a transfer of property to a controlled corporation under §
351. Accordingly, neither family reported any income from such receipt on their respective
income tax returns for 1963. In his statutory notice of deficiency, the respondent
determined that Mr. James received such stock, with a value of $22,000, for services
rendered and not in exchange for property, and thus received taxable income in that
amount. He further determined that the Talbot’s transfer of property to Chicora did not
meet the requirements of § 351, with the result that they should have recognized a longterm capital gain of $14,675 – the difference between $7,325, the basis of the land
transferred, and $22,000, the value of the stock received.
OPINION
The first, and critical, issue for our determination is whether Mr. James received his
Chicora stock in exchange for the transfer of property or as compensation for services. The
petitioners argue that he received such stock in consideration of his transfer to Chicora of
the FHA and United Mortgagee commitments and that such commitments constituted
“property” within the meaning of § 351. [footnote omitted]. ... Mr. James was not expected
to render future services to the corporation in exchange for the issuance of stock to him.
... Thus, the sole question on this issue is whether Mr. James’ personal services ... resulted
in the development of a property right which was transferred to Chicora, within the
meaning of § 351.
….
According to the petitioners’ argument, Mr. James, as a result of the services performed
by him, acquired certain contract rights which constituted property and which he
transferred to Chicora. The fact that such rights resulted from the performance of personal
services does not, in their view, disqualify them from being treated as property for
purposes of § 351. ...
It is altogether clear that for purposes of § 351, not every right is to be treated as property.
... [W]hatever may be considered as property for purposes of local law, the performance
of services, or the agreement to perform services, is not to be treated as a transfer of
property for purposes of § 351. Thus, if in this case we have merely an agreement to
perform services in exchange for stock of the corporation to be created, the performance
of such services does not constitute the transfer of property within the meaning of § 351.
Although patents and secret processes – the product of services – are treated as property
for purposes of § 351, we have carefully analyzed the arrangement in this case and have
concluded that Mr. James did not transfer any property essentially like a patent or secret
process; he merely performed services for Chicora. In January of 1963, he entered into an
agreement to perform services for the corporation to be created. He was to secure the
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necessary legal and architectural work and to arrange for the financing of the project, and
these were the services performed by him. Although he secured the services of the lawyer
and the architect, they were paid for by the corporation. He put in motion the wheels that
led to the FHA commitment, but it was not a commitment to him – it was a commitment
to United Mortgagee to insure a loan to Chicora, a project sponsored by Mr. James. It was
stipulated that under the FHA regulations, a commitment would not be issued to an
individual, but only to a corporation. Throughout these arrangements, it was contemplated
that a corporation would be created and that the commitment would run to the corporation.
The petitioners rely heavily on the claim that Mr. James had a right to the commitment,
that such right constituted property, and that such right was transferred to the corporation
in return for his stock. However, the commitment was not his to transfer; he never acquired
ownership of the commitment – he could not and did not undertake to acquire such
ownership. The evidence as to the commitment by United Mortgagee to make a loan for
the construction of the project is somewhat incomplete, but since all the parties knew that
a corporation was to be formed and that the FHA commitment would be made to that
corporation, it seems clear that there was no commitment to loan to Mr. James the funds
necessary for the construction of the project. Thus, throughout these arrangements, Mr.
James never undertook to acquire anything for himself; he was, in accordance with his
agreement with the Talbots, making the preliminary arrangements for the construction of
the apartment project. The enterprise would be operated, once the initial steps were
completed, by a corporation, Chicora, and everything that was done by him was done on
behalf of the contemplated corporation. In these circumstances, it seems clear that Mr.
James received his share of the stock in the corporation in return for the services performed
by him and that he did not transfer any property, within the meaning of § 351, to the
corporation. [citations omitted].
The facts of this case are substantially similar to those in U.S. v. Frazell, 335 F.2d 487
(C.A. 5, 1964), rehearing denied, 339 F.2d 885 (C.A. 5, 1964), certiorari denied 380 U.S.
961 (1964). In that case, the taxpayer, a geologist, investigated certain oil and gas
properties to be acquired by a joint venture, and he was to receive an interest in the joint
venture. However, before any transfer was made to him, a corporation was formed to take
over the assets of the joint venture, and part of the stock was transferred to the taxpayer. It
was not clear whether the taxpayer acquired an interest in the joint venture which was then
exchanged for his share of the stock or whether he acquired the stock directly in exchange
for the services performed by him. The court found that, in either event, the taxpayer
received compensation for his services. If he received the stock in return for the services
performed by him, such stock was taxable as compensation; and he did not transfer any
property to the corporation within the meaning of § 351. See also Mailloux v.
Commissioner, 320 F.2d 60 (C.A. 5, 1963), affirming on this issue a Memorandum
Opinion of this Court.
The next question is whether the Talbots are taxable on the gain realized from the exchange
of their land for Chicora stock. Section 351(a) applies only if immediately after the transfer
55

those who transferred property in exchange for stock owned at least 80 percent of
Chicora’s stock. § 368(c). Since ... James is not to be treated as a transferor of property,
he cannot be included among those in control for purposes of this test. Fahs v. Florida
Machine & Foundry Co., 168 F.2d 957 (C.A. 5, 1948); Mojonnier & Sons, Inc., 12 T.C.
837 (1949); BITTKER & EUSTICE, [FEDERAL INCOME TAXATION OF CORPORATIONS AND
SHAREHOLDERS 70 (2d ed. 1966).] The transferors of property, the Talbots, did not have
the required 80-percent control of Chicora immediately after the transfer, and therefore,
their gain must be recognized. ...
….
Decisions will be entered for the respondent.

Questions and comments:
1. What should James have done differently to bring his case within § 351?
•Compare United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984) (letter from life
insurance company to taxpayer committing to taxpayer personally for 60 days to
loan money at a favorable interest rate and to lease property on favorable terms;
letter is property for purpose of § 721).
2. Suppose Mr. James had contributed $100 cash and services valued at $21,900. This
would make him, quite literally, a transferor of “property.” Read Reg. § 1.351-1(a)(1)(ii).
What does it mean for property to be of “relatively small value?”
•In Rev. Proc. 77-37, 1977-2 C.B. 568, the IRS announced the following:
§ 3.07. When a person transfers property to a corporation in exchange for
stock ... of such corporation and the primary purpose of the transfer is to
qualify under § 351 ... the 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 [Reg. §] 1.351-1(a)(1)(ii),
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 ... already owned (or to
be received for services) by such person.
If the value of the stock Mr. James received was $22,000, how much cash should
he contribute before you would feel safe advising the Talbots that they will not be
taxed on the built-in gain in the property they contributed?
3. As the court noted, patents or secret processes that taxpayers created with their labor
constitute property. In fact, courts have held that “whatever may be transferred” constitutes
property. See, e.g., In the Matter of Chrome Plate, Inc., 614 F.2d 990, 995 (5th Cir. 1980).

56

•Cases such as James turn on whether taxpayer has undertaken an obligation to
perform services for the corporation or owns something without regard to the
corporation’s rights.
In Rev. Rul. 64-56, 1964-1 C.B. 133, the IRS announced:
Once it is established that “property” has been transferred, the transfer will be taxfree under § 351 even though services were used to produce the property. Such is
generally the case where the transferor developed the property primarily for use in
its own manufacturing business. However, where the information transferred has
been developed specially for the transferee, the stock received in exchange for it
may be treated as payment for services rendered.
4. The corporation that benefits from services provided to it in exchange for stock should
be able to deduct (or capitalize) the fair market value of the stock it issued for those
services. § 83(h).
5. Section 351(d)(2) provides that “stock issued for ... indebtedness of the transferee
corporation which is not evidenced by a security ... shall not be considered as issued for
property.” This allows the creditor to claim a bad debt deduction if the amount of the debt
exceeds the value of the stock received. Of course, by excluding such transactions from
the reach of §351(a), if the value of the stock exceeds taxpayer’s basis in the debt, taxpayer
must recognize taxable gain on the exchange to the extent of the excess.

II. Control “Immediately After the Exchange”
“Control” is ownership of 80% of the total voting power of all classes of stock entitled to
vote and of each and every other class of stock. Reg. § 1.351-1(a)(1) provides in part:
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.

Intermountain Lumber Co. v. Comm’r, 65 T.C. 1025 (1976)
WILES, Judge
Respondent determined deficiencies in petitioners’ income taxes ...

57

... The only issue for decision is whether a certain corporate formation was nontaxable
under § 351(a). [footnote omitted] This depends solely upon whether the primary
incorporator had “control” of the requisite percentage of stock immediately after the
exchange within the meaning of § 368(c).
FINDINGS OF FACT
Petitioners are the Intermountain Co., previously known as Intermountain Lumber Co.,
and its affiliates (hereinafter collectively referred to as Intermountain or petitioner). ...
….
From 1948 until March of 1964, Mr. Dee Shook (hereinafter Shook) individually owned
a sawmill at Conner, Mont. During that time Mr. Milo Wilson (hereinafter Wilson) had
logs processed there into rough lumber for a fee. Shook owned the remaining logs
processed at the sawmill, which constituted about half of all the logs processed there.
From 1954 until March of 1964, rough lumber from the sawmill was processed into
finished lumber at a separate finishing plant which Shook and Wilson owned as equal
shareholders.
In March of 1964, fire damaged the sawmill. Shook and Wilson wanted to replace it with
a larger one so that the finishing plant could operate at full capacity. Shook was financially
unable, however, to do so. He accordingly induced Wilson to personally coguarantee a
$200,000 loan to provide financing. In return, Wilson insisted upon an equal voice in
rebuilding the sawmill and upon an opportunity to become an equal shareholder with
Shook in the new sawmill.
On May 28, 1964, Shook, Wilson, and two other individuals, all acting as incorporators,
executed articles of incorporation for S & W Sawmill, Inc. (hereinafter S & W). The
corporate name, S & W, was derived from the names Shook and Wilson.
Minutes of the first stockholders meeting on July 7, 1964, stated in part that “Mr. Shook
informed the meeting that a separate agreement was being prepared between he [sic] and
Mr. Wilson providing for the sale of one-half of his stock to Mr. Wilson.” Also on that
date, 1 share was issued to each of the other two incorporators.
Shook executed a bill of sale for his sawmill equipment and deeded his sawmill site to S
& W on July 15 and 16, 1964, respectively. In exchange, Shook received 364 S & W
shares on July 15, 1964. Shook and Wilson also received 1 share each as incorporators.
The 364 shares and the 4 incorporation shares constituted all outstanding capital stock of
S & W on July 15, 1964.

58

Also on that date, minutes of a special meeting stated in part that “The President, Dee
Shook, announced that he and Milo E. Wilson had entered into an agreement whereby Mr.
Wilson was to purchase 182 shares of Mr. Shook’s stock.” That agreement, dated July 15,
1964, and entitled “Agreement for Sale and Purchase of Stock” (hereinafter agreement for
sale) provided in part as follows:
it is the intention of all the incorporators that Shook and Wilson are to be the
owners of the majority of the stock of said corporation;
AND WHEREAS, it is the desire and plan of both parties hereto that a sufficient
number of shares of stock be sold by Shook to Wilson so that eventually the stock
ownership would be equal;
AND WHEREAS, the purchase of said shares of stock by Wilson from Shook is
to be financed by a series of payments;
IT IS THEREFORE AGREED, That for and in consideration of the covenants to
be performed and the payments to be made as hereinafter set forth, the sale and
purchase of said stock is to be as follows:
1. Dee Shook is to sell to Milo E. Wilson 182 shares of stock in S & W SAWMILL,
INC. for the agreed price of $500.00 per share.
2. Wilson is to pay Shook for said stock as follows:
….
In addition to interest $6,000.00 on the principal is due November 1, 1969.
In addition to interest, $15,000.00 on the principal is due annually,
beginning Nov. 1, 1970, and continuing until the entire purchase price is
paid. The payments may be made in advance at any time and in any amount.
3. As each principal payment is made the proportionate number of shares of stock
are to be transferred on the corporate records and delivered to Wilson.
4. ....
5. For the period of one year from the date hereof Wilson is to have the full power
to vote all of the stock herein agreed to be sold to him by Shook. Thereafter the
voting rights of the stock is (sic) to be determined by the stock ownership records
of the corporation.

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On July 15, 1964, Shook also executed … documents … related to share ownership
between Shook and Wilson. One, entitled “S & W Sawmill, Inc. Stockholders” Restrictive
Agreement,’ provided in part as follows:
….
IT IS THE INTENTION AND PURPOSE of the incorporators that the majority of
the ownership of the corporation is to be held by Dee Shook and Milo E. Wilson
on an equal share basis when Milo E. Wilson completes the purchase of the stock
certificates which are the subject of said purchase agreement.
The other, entitled “Option To Buy Stock Forming Part Of Stockholders’ Restrictive
Agreement,” provided in part that “the ownership of shares in S & W Sawmill, Inc., as the
same now stands, to-wit: Dee Shook 365 shares, Milo E. Wilson 1 shares (sic) * * * shall
continue.”
In connection with the agreement for sale, Shook deposited stock certificates representing
182 shares with an escrow agent on July 17, 1964.
….
Wilson made all payments in 1965 and 1966 …
On July 1, 1967, before principal payments were required by the agreement for sale,
petitioner [Intermountain] purchased all outstanding S & W stock. In anticipation of this
purchase, a letter to petitioner dated May 3, 1967, and signed by Shook and Wilson stated
as follows:
To have it in the record, Milo E. Wilson owes Dee Shook $91,000 for 182 shares
of S & W Sawmill Inc. stock in escrow at Citizens State Bank Hamilton Montana.
On the purchase contract, Intermountain Lumber Co. would pay Dee Shook
$91,000.00 more over the 14 yrs. than Milo E. Wilson.
OPINION
Section 351 provides, in part, that no gain shall be recognized if property is transferred to
a corporation by one or more persons solely in exchange for stock or securities in such
corporation and immediately after the exchange such person or persons are in control of
the corporation. [footnote omitted] “Control” is defined for this purpose in § 368(c) as
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. [footnote omitted]

60

In this case, respondent is in the unusual posture of arguing that a transfer to a corporation
in return for stock was nontaxable under § 351, and Intermountain is in the equally unusual
posture of arguing that the transfer was taxable because § 351 was inapplicable. The
explanation is simply that Intermountain purchased all stock of the corporation, S & W,
from its incorporators, and that Intermountain and S & W have filed consolidated income
tax returns for years in issue. Accordingly, if § 351 was applicable to the incorporators
when S & W was formed, S & W and Intermountain must depreciate the assets of S & W
on their consolidated returns on the incorporators’ basis. § 362(a). [footnote omitted] If §
351 was inapplicable, and the transfer of assets to S & W was accordingly to be treated as
a sale, S & W and Intermountain could base depreciation on those returns on the fair
market value of those assets at the time of incorporation, which was higher than the
incorporators’ cost and which would accordingly provide larger depreciation deductions.
§§ 167(g), 1011, and 1012. [footnote omitted]
Petitioner thus maintains that the transfer to S & W of all of S & W’s property at the time
of incorporation by the primary incorporator, one Dee Shook, was a taxable sale. It asserts
that § 351 was inapplicable because an agreement for sale required Shook, as part of the
incorporation transaction, to sell almost half of the S & W shares outstanding to one Milo
Wilson over a period of time, thereby depriving Shook of the requisite percentage of stock
necessary for “control” of S & W immediately after the exchange.
Respondent, on the other hand, maintains that the agreement between Shook and Wilson
did not deprive Shook of ownership of the shares immediately after the exchange, as the
stock purchase agreement merely gave Wilson an option to purchase the shares. Shook
accordingly was in “control” of the corporation and the exchange was thus nontaxable
under § 351.
Respondent has abandoned on brief his contention that Wilson was a transferor of property
and therefore a person to also be counted for purposes of control under § 351. Respondent
is correct in doing so, since Wilson did not transfer any property to S & W upon its initial
formation in July of 1964. Wilson’s agreement to transfer cash for corporate stock in
March of 1965 cannot be considered part of the same transaction.
Since Wilson was not a transferor of property and therefore cannot be counted for control
under § 351, [citation omitted], we must determine if Shook alone owned the requisite
percentage of shares for control. This determination depends upon whether, under all facts
and circumstances surrounding the agreement for sale of 182 shares between Shook and
Wilson, ownership of those shares was in Shook or Wilson.
A determination of “ownership,” as that term is used in § 368(c) and for purposes of control
under § 351, depends upon the obligations and freedom of action of the transferee with
respect to the stock when he acquired it from the corporation. Such traditional ownership
attributes as legal title, voting rights, and possession of stock certificates are not
61

conclusive. If the transferee, as part of the transaction by which the shares were acquired,
has irrevocably foregone or relinquished at that time the legal right to determine whether
to keep the shares, ownership in such shares is lacking for purposes of § 351. By contrast,
if there are no restrictions upon freedom of action at the time he acquired the shares, it is
immaterial how soon thereafter the transferee elects to dispose of his stock or whether such
disposition is in accord with a preconceived plan not amounting to a binding obligation.
Stephens, Inc. v. U.S., 464 F.2d 53, 66-67 (8th Cir. 1972), cert. denied, 409 U.S. 1118
(1973); Barker v. U.S., 200 F.2d 223, 229 (9th Cir. 1952); S. Klein on the Square, Inc., 14
T.C. 786, 789-790 (1950), aff’d, 188 F.2d 127, 129 (2d Cir. 1951), cert. denied, 342 U.S.
824 (1951); American Bantam Car Co., 11 T.C. 397, 404-408 (1948), aff’d per curiam,
177 F.2d 513 (3d Cir. 1949), cert. denied, 339 U.S. 920 (1950); Wilgard Realty Co., 43
B.T.A. 557, 561 (1941), aff’d, 127 F.2d 514, 516 (2d Cir. 1942), cert. denied, 317 U.S.
655 (1942); Schumacher Wall Board Corp., 33 B.T.A. 1211, 1214 (1936), aff’d, 93 F.2d
79, 81 (9th Cir. 1937); Wilbur F. Burns, 30 B.T.A. 163, 171-72 (1934), aff’d sub nom.
Bassick v. Comm’r, 85 F.2d 8, 10 (2d Cir. 1936), cert. denied, 299 U.S. 592 (1936);
Federal Grain Corp., 18 B.T.A. 242, 248-49 (1929).
After considering the entire record, we have concluded that Shook and Wilson intended to
consummate a sale of the S & W stock, that they never doubted that the sale would be
completed, that the sale was an integral part of the incorporation transaction, and that they
considered themselves to be coowners of S & W upon execution of the stock purchase
agreement in 1964. These conclusions are supported by minutes of the first stockholders
meeting on July 7, 1964, at which Shook characterized the agreement for sale as a “sale”;
minutes of a special meeting on July 15, 1964, at which Shook stated Wilson was to
‘purchase’ half of Shook’s stock; the “Agreement for Sale and Purchase of Stock” itself,
dated July 15, 1964, which is drawn as an installment sale and which provides for payment
of interest on unpaid principal; Wilson’s deduction of interest expenses in connection with
the agreement for sale, which would be inconsistent with an option; the S & W loan
agreement, in which Shook and Wilson held themselves out as the “principal stockholders”
of S & W and in which S & W covenanted to equally insure Shook and Wilson for
$100,000; the March 1965 stock purchase agreement with S & W, which indicated that
Shook and Wilson “are to remain equal” shareholders in S & W; the letter of May 1967
from Shook and Wilson to Intermountain, which indicated that Wilson owed Shook the
principal balance due on the shares as an unpaid obligation; and all surrounding facts and
circumstances leading to corporate formation and execution of the above documents.
Inconsistent and self-serving testimony of Shook and Wilson regarding their intent and
understanding of the documents in evidence is unpersuasive in view of the record as a
whole to alter interpretation of the transaction as a sale of stock by Shook to Wilson.
We accordingly cannot accept respondent’s contention that the substance varied from the
form of this transaction, which was, of course, labeled a “sale.” ...
….
62

We thus believe that Shook, as part of the same transaction by which the shares were
acquired (indeed, the agreement for sale was executed before the sawmill was deeded to
S & W), had relinquished when he acquired those shares the legal right to determine
whether to keep them. Shook was under an obligation, upon receipt of the shares, to
transfer the stock as he received Wilson’s principal payments. Cf. S. Klein on the Square,
Inc., 14 T.C. 786, 790 (1950), aff’d, 188 F.2d 127 (2d Cir. 1951), cert. denied, 342 U.S.
824 (1951). We note also that the agreement for sale gave Wilson the right to prepay
principal and receive all 182 shares at any time in advance. Shook therefore did not own,
within the meaning of § 368(c), the requisite percentage of stock immediately after the
exchange to control the corporation as required for nontaxable treatment under § 351.
We note also that the basic premise of § 351 is to avoid recognition of gain or loss resulting
from transfer of property to a corporation which works a change of form only. See BITTKER
& EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS, ¶ 3.01,
p. 3-4 (3d ed. 1971). Accordingly, if the transferor sells his stock as part of the same
transaction, the transaction is taxable because there has been more than a mere change in
form. See, e. g., Wilbur F. Burns, 30 B.T.A. 163 (1934), aff’d. sub nom. Bassick v.
Comm’r, 85 F.2d 8 (2d Cir. 1936), cert. denied, 299 U.S. 592 (1936). In this case, the
transferor agreed to sell and did sell 50 percent of the stock to be received, placed the
certificates in the possession of an escrow agent, and granted a binding proxy to the
purchaser to vote the stock being sold. Far more than a mere change in form was effected.
We accordingly hold for petitioner. Because of concessions of other issues, Decisions will
be entered under Rule 155.

Questions and comments:
1. The parties were obviously advised by tax counsel.
2. The parties took positions opposite from what taxpayers and the Commissioner usually
argue. While § 351(a) provides for nonrecognition in certain circumstances, you should
surmise from this case that there is nothing optional or elective about the application of §
351(a).
3. Why should the Commissioner so easily have conceded that Wilson was not part of the
transferor group?
4. Reg. § 1.351-1(a)(1) concerning “immediately after the exchange” is to the effect that
such immediacy turns on the prior definition of rights rather than simultaneity of the
exchanges. This seems to invite application of the “step transaction doctrine.” Under the
“step transaction doctrine,” a court (or the IRS) may integrate more than one transaction
63

into one single transaction. In Intermountain Lumber, the parties were careful to spell out
their rights and obligations over the course of several years, and the court treated all of the
transactions undertaken in fulfillment of the parties’ promises as a single transaction.
There are three tests that courts may apply in determining whether the “step transaction”
is applicable:
•End result: When the parties intend the end result of more than one transaction
from the beginning, courts may apply the “step transaction doctrine.”
•Mutual interdependence: when steps are so interdependent that none would have
been undertaken without the others, courts may apply the “step transaction
doctrine.” Indeed, each step would be pointless without the others.
•Binding commitment: when parties enter a binding commitment to take certain
steps after other steps, courts may apply the “step transaction doctrine.”

Problems:
1. Corporation X transferred property to a newly organized corporation, Newco, in
exchange for all of Newco’s stock (a single class of voting common stock). Pursuant to a
prearranged binding agreement between X and corporation Y, X sold 40 percent of its
Newco stock for its fair market value to Y, and Y purchased securities (other than stock)
for cash from Newco. Newco would not have been formed if Y had not agreed to purchase
securities for cash from Newco and part of the Newco stock from X.
•Does nonrecognition treatment apply under § 351(a)? See Rev. Rul. 79-70. 19791 C.B. 144.
2. Corporation Z and a group of investors, pursuant to a binding agreement between them,
transferred property to a newly organized corporation, Newco, in exchange for all of
Newco’s stock (a single class of voting common stock). Z and the investors received 80
percent and 20 percent, respectively, of Newco’s stock. Pursuant to the agreement Z sold
an amount of its Newco stock for its fair market value to the investors to bring its
ownership down to 49 percent. Newco would not have been formed if the investors had
not agreed to transfer property to it and their agreement to do so was conditioned on the
sale by Z to them of part of Z’s Newco stock.
•Does nonrecognition treatment apply under § 351(a)? See Rev. Rul. 79-194, 19792 C.B. 145 (Situation 1).
3. X, a domestic corporation, operates a branch in a foreign country. The foreign country
enacted a nationalization law that required that the business that X’s branch was engaged
in be incorporated in the foreign country and that its citizens be the majority owners of
such corporation. A governmental agency in the foreign country directed X to transfer all
of the assets of its branch to a newly formed foreign country corporation that is, or will be,
at least 51% owned by its citizens. Accordingly, X and a group of investors, who were
64

citizens of the foreign country, pursuant to a binding agreement between them, transferred
property to Newco, a corporation newly organized in the foreign country, in exchange for
all of Newco’s stock (a single class of voting common stock). X and the investors received
99% and one percent, respectively, of Newco’s stock. Pursuant to the agreement, X sold
an amount of its Newco stock for its fair market value to the investors to bring its
ownership down to 49%; the investors would pay X in a series of yearly installments.
Newco would not have been formed if the investors had not agreed to transfer property to
it and their agreement to do so was conditioned on the sale by X to them of part of X’s
Newco stock. Further, the investors transferred property to Newco in order to become
cotransferors with X, and they purchased X’s Newco stock in lieu of the assets of X’s
branch because of the foreign governmental agency’s directive. ... The fair market value
of each asset transferred is in excess of its basis.
•Does nonrecognition treatment apply under § 351(a)? See Rev. Rul. 79-194, 19792 C.B. 145 (Situation 2); cf. Reg. § 1.351-1(a)(1)(ii) (discussed in Estate of
Kamborian v. Commissioner, infra).

III. The Transferor Group
Section 351(a) is applicable even when transferors do not acquire control of the
corporation through an exchange. This is consistent with the rationale that nonrecognition
treatment is accorded to transactions where the transferors do not substantially alter their
interests in the business. Moreover, a transferor-shareholder’s pre-existing share
ownership counts in the 80% determinations. Some taxpayers may try to take advantage
of this to qualify transactions that otherwise violate the spirit of § 351. Read Reg. §
1.3511(a)(1).

Kamborian v. Commissioner, 56 T.C. 847 (1971), aff’d, 469 F.2d 219 (1st Cir. 1972)
The Commissioner determined deficiencies in petitioners’ income tax ...
….
The cases relate to petitioners’ transfer of certain securities to International Shoe Machine
Corp. in exchange for its common stock. ‘Specifically in question is whether gain realized
by petitioners as a result of that transaction qualifies for nonrecognition under § 351, I.R.C.
1954 ...
FINDINGS OF FACT
….
65

International Shoe Machine Corp. (International) was incorporated in Massachusetts in
1938 and at the time of the trial herein was engaged in the business of manufacturing and
leasing shoe machinery and the sale of related supplies. On April 1, 1964, International’s
articles of organization were amended to provide for a 20 for 1 split of its common stock
into two classes of common stock: Class A, $1 par, voting stock, and class B, $1 par,
nonvoting stock. ...
On September 1, 1965, prior to the transaction here in question, International’s capital
stock was held as follows:
Shares of International
Name

Class A common

Class B common

Jacob Kamborian Revocable Trust
Jacob Kamborian, Jr.
Lisbeth (Kamborian) Godley
Michael Becka
Elizabeth Kamborian Trust
Others

20,324
4,220
3,620
60
5,000
3,916

182,916
37,980
32,580
540
45,000
35,244

37,140

334,260

Total:

Jacob S. Kamborian (Jacob) founded International and served as its president at all times
relevant herein. Jacob S. Kamborian, Jr., and Lisbeth Kamborian Godley are the children
of Jacob and his wife, Elizabeth. Michael Becka (Becka) is not related to the members of
the Kamborian family. At the time of the trial herein he had been employed by
International or an affiliate since at least 1943 and had served as International’s executive
vice president and general manager since approximately 1960. As such he was responsible
for the operations of all of International’s departments and reported directly to Jacob, the
president of the corporation.
Jacob established the Jacob S. Kamborian Revocable Trust on April 13, 1965 [to] …
“provide for the maintenance and comfort of the SETTLOR during his life, and after his
death for the benefit of his children and their issue …”
….
The Elizabeth Kamborian Trust (Elizabeth’s trust) was established by Jacob in 1949. At
about that time Jacob and Elizabeth experienced domestic difficulties; they separated for
a time; and the trust was established on their reconciliation in order to provide financial
security for Mrs. Kamborian. The initial trust corpus consisted of 2,500 shares of
International stock. ...
66

….
... As of September 1, 1965, the only assets of the trust were 5,000 shares of International’s
class A common stock and 45,000 shares of its class B common stock.
As of September 1, 1965, International’s board of directors consisted of Jacob, Jacob, Jr.,
Albert Kamborian (Jacob’s brother), Becka, Paul Hirsch II, Harold V. Daniels, and Roy
S. Flewelling. Campex Research & Trading Corp. (Campex), a Swiss corporation with its
principal place of business in Zug, Switzerland, was a patent holding and licensing
company. It held primarily foreign shoe machine patents (i.e., patents not issued by the
United States) and granted and administered licenses under them in a number of European
countries and in Mexico. On September 1, 1965, and prior to the transaction here in
question, the outstanding stock of Campex was held as follows:
Name
Jacob Kamborian Revocable Trust
Jacob Kamborian, Jr.
Lisbeth (Kamborian) Godley
Michael Becka

Shares of Campex
39
4
4
3

On September 1, 1965, the board of directors of International authorized Jacob to enter
into an agreement under which (a) the owners of all of the issued and outstanding shares
of Campex would exchange their stock for common stock of International and (b) certain
stockholders of International would purchase for cash additional shares of International’s
common stock. ...
As part of the transaction it was contemplated that the Elizabeth Kamborian Trust would
purchase additional shares of theretofore unissued International stock for about $5,000, so
that the former owners of the Campex stock and the Elizabeth Kamborian Trust, when
considered collectively and treated as transferors under § 351(a), I.R.C. 1954, would own
at least 80 percent of International’s stock immediately after the transaction in an attempt
to comply with the requirements of § 368(c), I.R.C. 1954. If the Elizabeth Kamborian
Trust were not taken into account, the International stock held by the former owners of
Campex immediately after the transaction amounted to 77.3 percent of each class of
outstanding stock of International – an amount that was insufficient to satisfy the
requirements of § 368(c).
….
International acquired Campex stock as part of its program of preparing for a public issue
of its stock. On the advice of underwriters and other specialists, it was thought that
ownership of foreign patents would enable International to display worldwide activities
67

which would be of value in establishing the price of the public issue. If the contemplated
public offering had been made, it would also have been necessary to remove existing
restrictions on the sale of International’s stock. ...
As vice president and general manager of International, Becka participated from the
beginning in the planning of the acquisition of the Campex stock. Moreover, during 1964
and 1965, Jacob was seriously ill for an extended period of time, underwent a number of
operations, and was hospitalized for a number of months. For approximately 9 months he
was on his back and for a year thereafter he was very limited in what he could do. During
this period Becka was in charge of International’s affairs, and it was at about this time that
International acquired the Campex stock. During the course of planning for the transaction,
International received legal advice with regard to qualifying the acquisition as a tax-free
exchange, and the variations of tax free exchange of stocks were discussed at some length.
As trustee of Elizabeth’s trust, Becka borrowed approximately $5,000 at an interest rate of
6 percent in order to finance the trust’s purchase of the total of 418 shares of International
stock on September 1, 1965. The corpus of the trust consisted exclusively of International
stock, and Becka anticipated that the loan would be repaid out of dividends paid on the
stock. In deciding to acquire additional International stock, Becka also anticipated that
International would make a public offering which might enhance the value of the stock.
... In his discussions with Elizabeth, Becka explained that because the $5,000 loan would
have to be repaid out of dividends paid on the International stock held by the trust, her
income from the trust would be diminished until the loan was repaid. Elizabeth told Becka
to go ahead with the transaction.
….
On their respective Federal income tax returns for 1965, petitioners reported no gain or
loss stemming from the exchange of their Campex stock for International stock. In his
deficiency notices to petitioners, the Commissioner determined that they realized longterm
capital gains ...
….
OPINION
RAUM, Judge
Exchange of Campex stock for International stock. – Petitioners contend that the gain they
realized on their transfer of Campex stock to International in return for International’s
common stock qualifies for nonrecognition under § 351(a). [footnote omitted]. That
section provides for nonrecognition of gain or loss on the transfer of property to a
corporation in exchange for the corporation’s stock or securities – if immediately after the
68

exchange the transferor or transferors are in control of the corporation. Section 351(a)
makes reference to § 368(c) for the definition of control;
§ 368. DEFINITIONS RELATING TO CORPORATE REORGANIZATIONS.
(c) CONTROL. – For purposes of part I (other than § 304), part II, and this part,
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.
Immediately after the exchange here in issue the stock of International was held as follows:
Shares of—
Class A (voting
Class B (non-voting Percent of
common)
common)
total of each
class
Jacob S. Kamborian Revocable Trust
22,108
198,971
56.01
Jacob S. Kamborian, Jr.
4,403
39,627
11.16
Lisbeth (Kamborian) Godley
3,803
34,227
9.64
Michael Becka
197
1,775
0.50
Elizabeth Kamborian Trust
5,042
45,376
12.77
Others
3,916
35,244
9.92
Total

39,469

355,220

Petitioners contend that the transferors of property for purposes of § 351(a) were the five
named stockholders listed above and that their percentage stockholdings after the transfer
satisfy the 80 percent control requirement imposed by §§ 351(a) and 368(c).
The Commissioner’s position is that only the first four stockholders listed above – i.e., the
former owners of Campex – may be considered as transferors of property here, that the
fifth (the Elizabeth Kamborian Trust) may not be taken into account in this connection,
and that since there would thus be a failure to satisfy the control requirement, all gain
realized on the exchange must be recognized. In particular, he urges that International
stock issued to the Elizabeth Kamborian Trust in return for $5,016 does not qualify as
stock issued for property within the meaning of § 351(a) and that consequently the persons
making qualified transfers of property to International in return for its stock held only 77.3
percent of its stock after the exchange. The Commissioner relies on regulations § 1.3511(a)(1)(ii) [provides in part]:
§ 1.351-1 Transfer to corporation controlled by transferor.
….
69

(ii) Stock or securities issued for property which is of relatively small value in
comparison to the value of the stock and securities already owned (or to be received
for services) by the person who transferred such property, shall not be treated as
having been issued in return for property if the primary purpose of the transfer is
to qualify under this section the exchanges of property by other persons
transferring property. ….
The Commissioner contends that since the Elizabeth Kamborian Trust purchased only 42
shares of class A common and 376 shares of class B common, the securities issued were
of relatively small value in relation to the 5,000 shares of class A common and 45,000
shares of class B common which it already held and that the primary purpose of the transfer
was to qualify the exchange of Campex stock by the other stockholders for nonrecognition
treatment under § 351(a).
Petitioners attack the Commissioner’s position on a variety of grounds. They urge (a) that
regulations § 1.351-1(a)(1)(ii) is invalid; (b) that even if valued [sic valid] it is inapplicable
to the transaction in issue; and (c) that even if the regulation is valid and applicable, the
Commissioner’s determination of the fair market value of the International stock received
by petitioners is erroneous.
(a) Validity of the regulation — Initially we note the well-settled principle that Treasury
regulations must be sustained unless unreasonable and plainly inconsistent with the
revenue statues [sic statutes] and that they constitute contemporaneous constructions by
those charged with administration of these statutes which should not be overruled except
for weighty reasons. Commissioner v. South Texas Lumber Co., 333 U.S. 496, 501; see
also Bingler v. Johnson, 394 U.S. 741, 749-750; Colgate Co. v. United States, 320 U.S.
422, 426; Fawcus Machine Co. v. United States, 282 U.S. 375, 378; Brewster v. Gage, 280
U.S. 327, 336; Textile Mills Corp. v. Commissioner, 314 U.S. 326, 336-339; Boske v.
Comingore, 177 U.S. 459, 470; Regal, Inc., 53 T.C. 261, 263-264, aff’d per curiam 435
F.2d 922 (C.A. 2); William F. Sanford, 50 T.C. 823, 832, aff’d 412 F.2d 201 (C.A. 2), cert.
denied, 396 U.S. 841; cf. United States v. Correll, 389 U.S. 299, 307.
….
Petitioners … contend that the regulation’s reference to “property which is relatively small
value in comparison to the value of stock or securities already owned” and its reliance
upon the taxpayer’s motive find support nowhere in the language of § 351 and that the
regulation is for that reason invalid as beyond the scope of the statute. … [W]e must
disagree. By disqualifying certain token exchanges, the regulation is reasonably designed
to exclude from the scope of § 351 transactions which comply with its requirements in
form but not in substance. Far from being unreasonable or inconsistent with the statute,
the regulation promotes its purpose by helping to ensure substantial compliance with the
70

control requirement before the nonrecognition provisions become operative. In this light
the absence of direct support for the regulation in the language of the statute is of minimal
significance. [footnote omitted]. Cf. Fabian Tebon, Jr., 55 T.C. 410, 412-416. We
conclude that the regulation is valid.
(b) Applicability of the regulation. – Petitioners contend that even if it is valid, the
regulation is inapplicable to the transaction here in issue. They argue first that even if
Elizabeth’s trust had not purchased shares of International stock, the control requirement
would have been satisfied, that therefore the purchase was not necessary to meet the
control requirement, and that consequently the regulation is by its own terms inapplicable.
Petitioners reach this conclusion by asserting that the shares held by Becka and Lisbeth
Godley as trustees of Elizabeth’s trust should be attributed to them as individuals [footnote
omitted] and added to the shares they held personally in nonfiduciary capacities. On the
basis of this premise, petitioners conclude that the 80-percent control requirement would
have been satisfied even if Elizabeth’s trust had not participated in the September 1, 1965,
transaction. [footnote omitted]. Petitioners’ argument is ingenious but unacceptable, for it
falters on petitioners’ premise that the trust’s shares may be attributed to the individual
trustees. While legal title to the shares may have been in the names of the trustees, they
had no beneficial interest in such shares. The distinction is not one of form but of plain
economic reality. [footnote omitted] In these circumstances we think the trustees’ interests
in the trust’s shares were far too remote to justify attributing the shares to them for
purposes of § 351. [footnote omitted].
Petitioners also contend that the primary purpose for the trust’s acquisition of
International’s stock was not to qualify the other stockholders’ exchanges under § 351 and
that for this reason the regulation is inapplicable. We note at the outset that the regulation
does not make it entirely clear whose purpose is to be taken into account. However, both
parties have assumed that the purpose of the transferor of property is critical. The language
of the regulation (which appears to distinguish between a “transfer” of property and the
issuance of stock) supports their assumption, and we shall therefore proceed on this basis.
Although Elizabeth’s trust was technically the transferor herein, the parties have also
assumed that Becka’s purpose is critical in this respect – apparently on the ground that as
the managing trustee he was primarily responsible for the decision to make the purchase
of International stock. We shall proceed on the basis of this assumption as well.
The question of Becka’s primary purpose is one of fact, cf. Malat v. Riddell, 383 U.S. 569,
and after a review of all the evidence we conclude that his primary purpose was to qualify
the other stockholders’ exchanges under § 351. We note in particular that at about the time
of the transaction, Jacob was ill and Becka was in charge of International’s affairs, that in
planning the acquisition Becka participated in lengthy discussions with regard to planning
the transaction as a tax-free exchange, and that both the vote of International’s board of
directors and the agreement of September 1, 1965, treated the purchase by Elizabeth’s trust
and the exchange of Campex stock by the other stockholders as component parts of an
71

integrated transaction avowedly designed to meet the 80-percent-control requirement and
thereby qualify for nonrecognition treatment under § 351.
At the trial herein, Becka testified that if the trust had not participated in the transaction,
the issue of International stock to the other major stockholders would have diluted the
trust’s percentage interest in International and that he authorized the purchase of
International stock in order to minimize such dilution. In particular he testified that the
total percentage stock interest held by the trust and the two Kamborian children exceeded
33⅓ percent and that preservation of that interest protected Mrs. Kamborian against the
making of certain corporate decisions (requiring a two-thirds majority) without her
consent. [footnote omitted]. We do not give his testimony very much weight, however.
The record does not establish whether or why the children were regarded as allies of Mrs.
Kamborian rather than as allies of her husband. Moreover, the trust’s participation in the
transaction left them with an aggregate stock interest of 33.57 percent— only 0.08 of 1
percent more than they would have held if the trust had not purchased any additional
shares.
Becka also testified that he authorized the purchase of the stock because it was a “good
investment.” While he may well have taken this into account in making his decision, the
record leaves us convinced that the purchase was made primarily to qualify the exchanges
by the other stockholders (one of whom was Becka himself) [footnote omitted] under §
351. We conclude that § 1.351-1(a)(1) (ii) is applicable.
….
Decisions will be entered under Rule 50.

Questions and comments:
1. The court provides a rationale for Reg. § 1.351-1(a)(1)(a)(ii). What is it?
2. What is “relatively small value” in this context? In Rev. Proc. 77-37, 1977-2 C.B. 568,
the IRS stated:
§ 3.07. When a person transfers property to a corporation in exchange for stock ...
of such corporation and the primary purpose of the transfer is to qualify under §
351 ... the 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 [Reg. §] 1.351-1(a)(1)(ii), 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 ... already owned (or to be received for services) by such person.

72

If the revenue procedure had already been promulgated, and the parties in Kamborian had
tried to fall within its terms, how much stock would the trust have had to purchase?
Remember, the trust already owned 13% of the outstanding shares of International Shoe
Machine Corp.
3. One who renders only services in exchange for stock cannot be a part of the transferor
group for purposes of § 351(a).

Do the CALI exercise:
Corporate Taxation: Formation: Formation of C Corporations: Advanced Issues.

IV. Boot and Derivative Issues
If a transferor/shareholder/taxpayer receives something aside from or in addition to stock
– i.e., something to “boot” – then the transferor has not exchanged property “solely” for
stock. Because “control” is defined in terms of 80% (i.e., less than 100%) ownership of
different stock interests in the corporation, it is possible for transferors of property to have
“control” of the corporation after the transfer(s) of property and for one or more of the
transferors to receive boot. The amount of boot in a § 351 transaction is the amount of
money plus the fair market value of other property received. The boot portion of the
exchange occurs outside of § 351(a) and will be subject to only one level of tax. Section
351(b)(1) provides that the shareholder must pay tax on the gain from the exchange or the
boot received, whichever is less. Taxpayer may not recognize loss. § 351(b)(2).

A. Transfer of Multiple Properties
Rev. Rul. 68-55, 1968-1 C.B. 140
Advice has been requested as to the correct method of determining the amount and
character of the gain to be recognized by Corporation X under § 351(b) ... under the
circumstances described below.
Corporation Y was organized by X and A, an individual who owned no stock in X. A
transferred 20x dollars to Y in exchange for stock of Y having a fair market value of 20x
dollars and X transferred to Y three separate assets and received in exchange stock of Y
having a fair market value of 100x dollars plus cash of 10x dollars. In accordance with the
facts set forth in the table below if X had sold at fair market value each of the three assets
it transferred to Y, the result would have been as follows:
73

Asset 1

Asset 2

Asset 3

Character of Asset

§ 1245 property
Capital asset held more Capital asset held
than [1 year]
not more than [1 year]

fair market value

$22x

$33x

$55x

adjusted basis

$40x

$20x

$25x

Gain (loss)

($18x)

$13x

$30x

Character of gain or loss

LTCL

STCG

Ordinary income

The facts in the instant case disclose that with respect to the § 1245 property the
depreciation subject to recapture exceeds the amount of gain that would be recognized on
a sale at fair market value. Therefore, all of such gain would be treated as ordinary income
under § 1245(a)(1) of the Code.
Under § 351(a) ..., no gain or loss is recognized if property is transferred to a corporation
solely in exchange for its stock and immediately after the exchange the transferor is in
control of the corporation. If § 351(a) ... would apply to an exchange but for the fact that
there is received, in addition to the property permitted to be received without recognition
of gain, other property or money, then under § 351(b) ... gain (if any) to the recipient will
be recognized, but in an amount not in excess of the sum of such money and the fair market
value of such other property received, and no loss to the recipient will be recognized.
The first question presented is how to determine the amount of gain to be recognized under
§ 351(b) ... The general rule is that each asset transferred must be considered to have been
separately exchanged. See the authorities cited in Revenue Ruling 67-192, C.B. 1967-2,
140, and in Revenue Ruling 68-23, which hold that there is no netting of gains and losses
for purposes of applying §§ 367 and 356(c) ... Thus, for purposes of making computations
under § 351(b) ..., it is not proper to total the bases of the various assets transferred and to
subtract this total from the fair market value of the total consideration received in the
exchange. Moreover, any treatment other than an asset-by-asset approach would have the
effect of allowing losses that are specifically disallowed by § 351(b)(2) ...
The second question presented is how, for purposes of making computations under §
351(b) ..., to allocate the cash and stock received to the amount realized as to each asset
transferred in the exchange. The asset-by-asset approach for computing the amount of gain
realized in the exchange requires that for this purpose the fair market value of each
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category of consideration received must be separately allocated to the transferred assets in
proportion to the relative fair market values of the transferred assets. See Reg. §
1.12454(c)(1) ... which, for the same reasons, requires that for purposes of computing the
amount of gain to which § 1245 ... applies each category of consideration received must
be allocated to the properties transferred in proportion to their relative fair market values.
Accordingly, the amount and character of the gain recognized in the exchange should be
computed as follows:

fair market value of asset
transferred

Total

Asset 1

Asset 2

Asset 3

$110x

$22x

$33x

$55x

20%

30%

50%

$100x

$20x

$30x

$50x

10x

2x

3x

5x

$110x

$22x

$33x

$55x

$40x

$20x

$25x

($18x)

$13x

$30x

percent of total fair market
value
fair market value of Y stock
received in exchange
cash received in exchange
amount realized
adjusted basis

gain (loss) realized

Under § 351(b)(2) ... the loss of 18x dollars realized on the exchange of Asset Number I
is not recognized. Such loss may not be used to offset the gains realized on the exchanges
of the other assets. Under § 351(b)(1) ..., the gain of 13x dollars realized on the exchange
of Asset Number II will be recognized as short-term capital gain in the amount of 3x
dollars, the amount of cash received. Under §§ 351(b)(1) and 1245(b)(3) ..., the gain of
30x dollars realized on the exchange of Asset Number III will be recognized as ordinary
income in the amount of 5x dollars, the amount of cash received.

75

Questions and comments:
1. Prop. Reg. § 1.351-2(b) presents an example analogous to Rev. Rul. 68-55.
2. How does the approach of Rev. Rul. 68-55 prevent the changing of character of gain or
loss on the § 351 exchange? How does it prevent the immediate recognition of losses?
3. Note that the aggregate basis of the assets that Corporation X transferred to Corporation
Y was less than their aggregate fmv. Thus, no § 362(e)(2) problem would have been present
even if it had been in the Code in 1968.
4. For the shareholder, the basis rules on the receipt of boot are stated in §§ 358(a) and
(d). The basic mechanics are first, taxpayer-transferor reduces the basis of the stock that
he received by the fmv of the boot received, and second, increases it by the amount of gain
recognized and subject to income tax. § 358(a). The basis of any boot other than money
received is its fmv. § 358(a)(2).
•For purposes of determining basis: Assumption of a taxpayer’s liability by another
party to the exchange counts as money received by the taxpayer on the exchange.
§ 358(d)(1).
•Note: assumption of liabilities is treated differently when determining the amount
of taxable gain on the exchange. See § 357, discussed infra.
5. For the corporation, the basis rules when the shareholder/transferor receives boot are
stated in § 362(a). The basis of the property that the corporation acquires is the same as it
was in the hands of the transferor, increased by the amount of gain that transferor
recognized.
6. Notice: to the extent boot is recognized and taxed to the transferor, the boot transaction
occurs outside of the § 351 exchange, i.e., as if two taxpayers exchanged properties with
each other in a taxable exchange. Thus, with respect to boot that is recognized and taxed,
there will be no duplication of taxable gain for both the shareholder and the corporation.
7. Section 358(b)(1) provides that when a shareholder transfers multiple properties to the
corporation, the basis of the shares that the shareholder receives is to be determined under
rules that the Secretary of the Treasury prescribes. In a revenue ruling, the IRS has held
that a transferor of properties of different character and holding periods who receives more
than one class of stock may not designate which property was exchanged for which shares
of stock. Rev. Rul. 85-164, 1985-2 C.B. 117. Instead, every share of every class that the
transferor receives has both a split character and a split holding period, proportional to the
fmv of the different classes of stock that the transferor receives.
With some modification, the facts of that revenue ruling were the following: a sole
proprietor transferred –
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•accounts receivable, ab = $0, fmv = $60,
•depreciable machinery held more than one year (and so § 1231 property), ab = $5,
fmv = $10, and
•land & building held more than one year (and so § 1231 property), ab = $25, fmv
= $30.
The property was exchanged with the corporation for all the corporation’s class A voting
common stock (fmv = $60) and all of the corporation’s class B nonvoting common stock
(fmv = $40).
•Taxpayer may not designate which property is exchanged for which stock, e.g.,
accounts receivable for class A voting common stock and § 1231 property for class
B nonvoting common stock.
•“[T]he aggregate basis of property transferred [by the shareholder] is allocated
among the stock ... received in proportion to the fair market values of each class
[of stock that shareholder received].”
•The total adjusted basis of the assets that taxpayer transferred was $30.
•The total fmv of the class A voting common stock was 60% of the total value of
all stock issued in the exchange for taxpayer’s property.
•60% of the basis of what taxpayer transferred was $18. Taxpayer’s basis
in its class A voting common shares is $18.
•The total fmv of the class B nonvoting common stock was 40% of the total value
of all stock issued in the exchange for taxpayer’s property.
•40% of the basis of what taxpayer transferred was $12. Taxpayer’s basis
in its nonvoting common stock is $12.
•The holding period of the stock received is determined by the fmv of the assets
exchanged for the stock. 40% of the value of what the shareholder transferred was
for § 1231 (LTCG) property. 60% of the value of what shareholder transferred was
for property with a zero holding period.
•The “amount realized” on any disposition of class A voting common stock or class
B nonvoting stock must be allocated in the same manner as the allocation of
holding period. After allocating basis in the same manner, we can conclude that –
•60% of any gain to be recognized on sale of voting common stock will be
short-term gain.
•60% of any gain to be recognized on sale of nonvoting common stock will
be short-term gain.
•40% of any gain to be recognized on sale of voting common stock will be
long-term gain.
•40% of any gain to be recognized on sale of nonvoting common stock will
be long-term gain.
•Suppose that shareholder sells ⅓ of her class A voting shares for $20 before she
has held them for more than one year. What is the amount and character of the gain
she must recognize?

77

•Shareholder’s total basis in all her class A voting shares is $18. ⅓ of that
amount is $6. Upon sale for $20, shareholder must recognize $14 of
income.
•60% of that amount is $8.40, and it is short-term gain.
•40% of that amount is $5.60, and it is long-term gain.
8. How do the rule(s) of Rev. Rul. 85-164 prevent a shareholder from changing the
character of gain or loss?

Problem:
Stephen and Peter formed Alpha Corporation. Stephen transferred to Alpha Corporation
$10,000 cash in exchange for 100 shares of common voting stock of Alpha Corporation.
Peter transferred to Alpha Corporation Blackacre, ab = $7000, fmv = $12,000 in exchange
for 100 shares of voting common stock of Alpha Corporation plus $2000 cash. Assume
that § 351 applies.
A. Irrespective of whether subject to federal income tax, what was Peter’s realized
gain/loss on the exchange?
B. On how much income must Peter pay income tax? What is Peter’s basis in his Alpha
Corporation voting common stock? What is Alpha Corporation’s basis in Blackacre?
C. What if Peter’s basis in Blackacre had been $11,000?
D. Now suppose that Stephen exchanged $8000 plus a 2011 Toyota Corolla (ab = $750,
fmv = $2000) for 100 shares of voting common stock. Peter transferred Blackacre, ab =
$7000, fmv = $12,000 in exchange for 100 shares of voting common stock of Alpha
Corporation plus the 2011 Toyota Corolla.
1. Irrespective of whether subject to federal income tax, how much was Stephen’s
gain/loss on the exchange? How much is subject to federal income tax? What is
Alpha Corporation’s basis in the 2011 Toyota Corolla?
2. On how much income must Peter pay income tax? What is Peter’s basis in his
stock and in the 2011 Toyota Corolla? How much income of Alpha is subject to
federal income tax? See IRC § 311(b). What is Alpha’s Corporation basis in
Blackacre?

78

B. Assumption of Liabilities
Note: All gain (income) is subject to income
tax exactly once. Money remaining after
being subject to income tax and invested
is the measure of a taxpayer’s after-tax
investment and the taxpayer’s basis in the
investment. But taxpayers cannot create
basis out of thin air in an exchange without
paying income tax on (at least some)
realized gain. Sections 351/358 permit
a taxpayer not to recognize (all) realized
gain. However, untaxed realized gain
will presumptively be subject to income
tax on some day in the future. So long as
we hold an investment, we defer
recognition of its inherent built-in gain.
We can trade basis for not taxing boot.
That is why we first reduce basis by the
amount of boot received. When taxpayer
pays income tax on realized gain,
taxpayer adds to his basis the amount of
gain on which he paid income tax. That is
why we increase basis by the amount of
income on which taxpayer paid income
tax.
From the foregoing, we can state the
following:
AR = (original basis of
investment) + (gain taxed now) + (built-in
gain to be taxed later).
•In problems B and C, put your
answers into this formula. If the
result does not hold true, then your
answers were wrong.
From the corporation’s side, increasing
basis by the amount on which the
transferor/shareholder pays income tax
assures that such gain is subject to income
tax only once and at the shareholder level.

The assumption of one’s liabilities by another
in an exchange transaction is treated as the
receipt of money and therefore included in
one’s “amount realized” on the exchange
unless there is a statutory exception. See
Commissioner v. Tufts, 461 U.S. 300, 308-10
(1983). In the context of § 351, treating a
corporation’s assumption of (perhaps)
substantial liabilities as the receipt of cash (i.e.,
taxable boot) could severely dampen
enthusiasm for incorporating. After all, most
real estate is subject to liabilities. In United
States v. Hendler, 303 U.S. 564, 565 (1938),
the Supreme Court nevertheless affirmed the
notion that another’s assumption of one’s
liabilities is equivalent to receiving cash – even
if the effect of such a holding is to dampen
enthusiasm for nonrecognition transfers:
The transaction, however, under which the
Borden Company assumed and paid the debt
and obligation of the Hendler Company is to be
regarded in substance as though the
$534,297.40 had been paid directly to the
Hendler Company. The Hendler Company was
the beneficiary of the discharge of its
indebtedness. Its gain was as real and
substantial as if the money had been paid it and
then paid over by it to its creditors.
Congress responded by enacting what is now §
357.

Problem:
How does § 357 treat the corporation’s
assumption of the shareholder’s liabilities?
Taken together, what is the rule of § 357(c), §
358(a)(1), and § 358(d)? How might a taxpayer
take advantage or even abuse these rules?

79

Drybrough v. Commissioner, 376 F.2d 350 (6th Cir. 1967)
O’SULLIVAN, Circuit Judge
This matter is before us on the petition of taxpayers, F.W. Drybrough and the executor of
the estate of his deceased wife, Citizens Fidelity Bank & Trust Company, to review a
decision of the Tax Court of the United States ... The issues before us are (1) the tax effect
of the assumption of liabilities in connection with transfers by Drybrough to controlled
corporations, and (2) the deductibility of interest paid on certain mortgage indebtedness.
...
Commencing in the twenties and continuing to the time of the events here involved,
Drybrough had been a successful investor in downtown Louisville real estate and, with his
wife, also operated a successful mercantile collection agency. To implement acquisition
of various holdings, he borrowed heavily from banks and insurance companies. Thus in
1940, 1945 and 1946, years of relevance here, Drybrough borrowed, on the security of his
real estate holdings, the sums of $200,000.00, $200,000.00 and $500,000.00, respectively,
from the National Life and Accident Insurance Company (National Life). These
borrowings were generally used to pay off or consolidate balances of existing mortgages
or to acquire additional parcels of real estate.
On April 3, 1953, Drybrough borrowed $700,000.00 from National Life, secured by a
mortgage on several parcels of real estate. Of such monies, $357,185.16 was used to pay
off his 1946 loan from National Life and some other debts and expenses. The balance,
$342,814.84, was deposited in Drybrough’s commercial Account with the Liberty
National Bank & Trust Co. of Louisville. In May, following, Drybrough withdrew from
this account $203,602.00 and transferred such sum to an account styled “Public Garage,
M.S. Drybrough, owner,” allegedly as partial payment of principal and the accrued interest
due upon a note of $260,000.00 which he had, on January 1, 1952, given to his wife to
evidence an indebtedness to her. Although the Public Garage account into which this sum
was deposited was in Marion’s name, Drybrough had power to draw checks on it. It may
be assumed that it was he who subsequently proceeded to buy, in Marion’s name, $200,000
of tax exempt securities, paying for them out of the Public Garage account funds.
In 1957 Drybrough still owed $600,000 on the 1953 loan from National Life. At that time
he desired to incorporate certain of his real estate holdings and have the resulting
companies take over the payment of the 1953 mortgage balance. ...
... Accordingly, ... he transferred to four newly organized corporations, ... four parcels of
real estate subject to the 1953 mortgage; each of the corporations agreed to pay an assigned
share of that mortgage. Drybrough received all of the issued shares of stock of the
respective corporations, and shortly thereafter made a gift of 40% of such shares to his
son, F.W. Drybrough, Jr.
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On March 15, 1957, Drybrough borrowed the sum of $150,000 from the Liberty Bank of
Louisville, mortgaging a property known as 620 South Fifth Street. This property was once
a part of the security for the 1953 loan, but had been released therefrom in 1956. Relevant
to this property, Drybrough had, in 1956, included in a letter to National Life the
observation that, “620 South Fifth and the Mexican Village property are both clear and I
am eager to mortgage them to the limit before combining these two properties in a
corporation.” The proceeds of this $150,000 loan were deposited in Drybrough’s
commercial account at the Liberty Bank. Drybrough testified that he had an original
intention to use this money to acquire some additional property, but the specific proceeds
were not so employed; they were disbursed by Drybrough primarily to purchase tax
exempt securities. He did, however, use other of his funds to purchase two parcels of
property costing over $150,000. After putting the $150,000 mortgage on the 620 South
Fifth Street property, he conveyed, by gift, an undivided 40% interest in the fee thereof to
his son. Thereafter on June 28, 1957, the father and son transferred this property to a new
corporation, 620 South Fifth Street, Inc., in exchange for 60% and 40%, respectively, of
that company’s issued shares. The corporation took title to the property subject to the
$150,000 mortgage and assumed and agreed to pay its then balance of $149,000.
A total of five corporations were thus created in 1957, four of them assuming the balance
unpaid on the 1953 mortgage, and the fifth assuming the 1957 mortgage. ...
On their joint tax return for 1957, Drybrough and Marion reported $223,806.12 as long
term capital gain arising from the transfers of the properties to, and the assumption of
liability by, the newly created controlled corporations. That sum represented the total
amount by which the mortgage debt assumed by the transferee corporations exceeded
Drybrough’s basis in the respective assets transferred; such amount would be taxable
under § 357(c)(1), and the taxpayer’s return assumed that the gain on the transfers was not
otherwise taxable by virtue of the provisions of 357(a) ... The Commissioner, however,
assessed a deficiency, claiming that § 357(b) [footnote omitted] controlled, on his assertion
that Drybrough had failed to prove that his principal purpose in arranging these
transactions was not that of tax avoidance and was not for a bona fide business purpose
and, therefore, the assumption of the liabilities should be treated as money received on the
exchange. A deficiency of $170,306.89 was assessed for the year 1957.
The Commissioner also disallowed Drybrough’s deduction of the interest paid on
$200,000.00 of the $700,000.00 borrowed in 1953, on the claim that this sum was used to
purchase tax exempt securities. Section 265(2) [now § 265(a)(2)] forbids such deduction.
[footnote omitted]. A deficiency arising from the disallowance of these interest deductions
was accordingly assessed.
The Tax Court sustained the Commissioner’s determinations in the above respects. We
reverse the Tax Court’s holding that the assumption of a total of $600,000.00 of the 1953
81

borrowing by the four corporations organized on June 1, 1957, was taxable in full. We
affirm its holding as to the assumption of the $149,000 mortgage by 620 South Fifth Street,
Inc. (the 1957 borrowing); and we affirm the disallowance of the interest paid on $200,000
of the 1957 mortgage of $700,000.
1) 1957 corporate assumptions of 1953 mortgage debt.
Until the Supreme Court’s 1938 decision in U.S. v. Hendler, 303 U.S. 564 (1938),
taxpayers and the Treasury Department had assumed that no taxable event occurred when
a taxpayer transferred encumbered assets to a controlled corporation which assumed the
obligations of the encumbrance. Such an assumption was not considered as “other property
or money” as those terms were used in [§ 351] ... The simplest form of such a tax free
exchange was the changing of a business enterprise from a proprietorship to the corporate
form. Even though the assets transferred had acquired a market value in excess of their
cost, or base, and consequently the stock shares received by the transferor were worth the
enhanced value of the transferred assets, still no taxable gain was then realized. Such gain,
however, did not escape taxation because upon subsequent sale or other transfer, the stock
shares carried the same basis as the original assets that had been transferred. The Hendler
decision, however, held that the amount of such an assumed obligation was equivalent to
“other property or money” and required that the gain be immediately recognized by the
transferor. Continued application of this rule forebode serious consequences to the federal
treasury as well as to taxpayers, and Congress was quick to provide amelioration by
enactment of the predecessor to 357. [citation omitted]. Section [357] was adopted as the
needed remedy, providing that in an otherwise tax-free exchange if “as part of the
consideration another party (the transferee) to the exchange assumes a liability of the
taxpayer (the transferor) or acquires from the taxpayer property subject to a liability, such
assumption or acquisition shall not be considered as ‘other property or money’ received
by the taxpayer * * *.”
To guard against abuse of the privilege granted, Congress attached an exception which
now as part of 357 provides in subsection (b) ... that if in making the exchange, the
principal purpose of the taxpayer with respect to the assumption or acquisition was a
purpose to avoid federal income tax “on the exchange,” or if not such purpose, was not a
bona fide business purpose, then the assumption or acquisition should in the total amount
thereof be considered “as money received by the taxpayer on the exchange.” This section
also provides that in determining the principal purpose of the taxpayer there should be
taken “into consideration the nature of the liability and the circumstances in the light of
which the arrangement for the assumption or acquisition was made.” Notwithstanding this
broad contextual area to be considered, we emphasize that the purpose to avoid income
tax is precisely narrowed to a purpose “with respect to the assumption” and to a purpose
to avoid income tax “on the exchange.”

82

We read this language as excluding from identification as a purpose to avoid tax on the
exchange, the original and unrelated motivation for borrowing the money which created
the assumed obligation. In this case, Drybrough in 1953 borrowed $700,000; substantially
one-half of this sum was used to pay off existing mortgage indebtedness and expenses
connected with the borrowing, and the other half was deposited in Drybrough’s bank
account. Of this latter amount, Drybrough used $203,602 to pay accrued interest and
principal on a note allegedly owing to his wife; he also paid some $90,493.00 to his
collection agency and $5,000 to his wife to reimburse advances which had admittedly been
made to him to purchase further real estate. We may accept the Tax Court’s unclear
assertion that the note to Drybrough’s wife was a sham, and that of the money allegedly
paid thereon, $200,000 had been in truth borrowed and used to purchase tax exempt
securities. We cannot find or infer, however, that the purposes thus served revealed as a
matter of fact or law a purpose to avoid income tax “on the exchange” made four years
later when in 1957 Drybrough’s business as an investor in real estate was converted from
a proprietorship to corporate enterprises. Assuming an intent by Drybrough to save or
avoid income tax by the 1953 purchase of tax exempt securities, such purpose cannot be
said to be a part of “the principal purpose of the taxpayer (Drybrough) with respect to the
assumption” of the balance of the 1953 loan by the corporations which came into existence
in 1957.
It is clear that the Tax Court was of the view that under the facts of this case a purpose to
avoid income tax “on the exchange” could be found by inquiry into the reasons for, and
the use of the proceeds of, the 1953 borrowing. Its opinion extensively details facts
relevant to this subject and ... observes: “We believe that it is relevant to the 1957
assumption of Drybrough’s liabilities by the newly formed corporations to consider the
nature of the liability assumed.” [citation omitted].
Under the statute’s language, it was proper to consider “the nature of the liability assumed”
but under the facts of this case we do not consider that the use that Drybrough made of the
1953 borrowing was of controlling importance here. With some intervening language, the
above quoted excerpt was followed by emphasis on the fact that by having the corporations
assume the debt owed by him, he reduced his exposure to personal liability. “Thus,
although Drybrough stood as security for the corporate indebtedness, he would not, as a
practical matter, have been called upon to satisfy the liabilities, except in the most unusual
circumstances.” [citation omitted].
Such is true, but is no more than the result in all tax free exchanges where a wholly owned
corporation is successor to the assets and liabilities of a proprietorship.
With reference to the inquiry into the use made by Drybrough of the proceeds of the 1953
borrowing, the language of the Ninth Circuit in Easson v. C.I.R., 294 F.2d 653, 659 (CA
9 1961) is pertinent:

83

The test suggested by the Commissioner looks to the origin of the encumbrance
and to the use of the proceeds derived from it. Section [357], however, says nothing
about the origin of the encumbrance. It says only that if a corporation “acquires
from the taxpayer property subject to a liability such * * * acquisition shall not be
considered as” boot, unless the taxpayer’s principal purpose regarding the
acquisition is tax avoidance or not a bona fide business purpose. Nor is there
anything in the section which deals with the reasons for the encumbrance, or the
manner in which the mortgage proceeds are used.
There was evidence also that part of the motivation for incorporating was to allow the long
term retirement of Drybrough’s debt out of the corporate earnings; such earnings, when
applied to the 1953 loan, would likely be taxed at a lower rate than they would be in
Drybrough’s own tax bracket. Drybrough’s expectation, however, that income tax would
be saved by the lower rate that would apply to the corporate earnings as contrasted with
his own income tax exposure was not, in our view, a purpose to avoid “Federal income tax
on the exchange.” We read such to be the holding of the Tax Court’s own decision in
W.H.B. Simpson v. Comm’r, 43 T.C. 900 (1965) announced some months after the decision
before us. In Simpson, the Tax Court said,
We do not believe it (357(b)) was intended to require recognition of gain on bona
fide transactions designed to rearrange one’s business affairs in such a manner as
to minimize taxes in the future, consistent with existing provisions of the law. 43
T.C. at 916.
... [I]n using the term “liability” in §§ 351 and 357, Congress was concerned with
the assumption by the transferee of an existing liability of the transferor, not with
the manner in which it might subsequently be discharged. It is clear that as the
corporation paid off the liabilities the value of petitioner’s stock in Collins-Crain
would be increased and petitioner’s gain would be recognized upon disposition of
that stock. But under the law the gain on that stock will be deferred until it is
disposed of, and under § 351 recognition of the gain resulting from the appreciation
in value of the securities transferred will also be postponed until the Collins-Crain
stock is disposed of. We find no permanent escape from taxation of any of this
gain. We do not believe the fact alone that the income which will be used to pay
off the liabilities to which the securities were subjected will be taxed at a lower rate
falls within the tax-avoidance purpose contemplated in § 357(b). 43 T.C. at 917.
In Simpson, supra, the Tax Court held the exchange there made to be tax free and in
seeking to distinguish Simpson from its earlier decision of the Drybrough case which we
now review, said: “Unlike in the Drybrough case, and in W.H. Weaver, 32 T.C. 411 (1959)
aff’d sub nom. Bryan v. Comm’r, 281 F.2d 238 (CA4 1960), petitioner did not incur the
liabilities to which the transferred securities were subject immediately prior to the transfer
and solely in anticipation thereof.” 43 T.C. at 917.
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But in the case before us the 1953 mortgage liability of Drybrough had not been incurred
“immediately prior to the transfer” and was not incurred “solely in anticipation” of the
forming of the corporations in 1957.
While the Tax Court did not with desirable clarity give separate treatment to the tax
avoidance purpose as distinguished from the need of Drybrough to prove also that his 1957
incorporations had “a bona fide business purpose,” we read its decision as a finding that
Drybrough did not have “a bona fide business purpose” for the 1957 incorporations. This
was error. Drybrough testified that included in his motivation for not paying off the
$600,000 mortgage before incorporating was his desire to keep as liquid as possible to be
able to make further investments; to put the involved real estate investments in a more
manageable condition for estate planning; and generally to obtain the advantages that
attend operating in the corporate form. The Tax Court’s suggestion that Drybrough by
liquidating other assets could have obtained sufficient cash to pay off the $600,000 so that
the corporate assets would be debt free is not impressive. Such conduct, would be unwise
and certainly not good practice. For many years Drybrough was engaged in the business
of buying and holding downtown Louisville real estate, and operating those holdings in
various enterprises such as parking lots. The conversion of these businesses into corporate
form was clearly to serve a bona fide business purpose. What was done here was
substantially the “garden variety” of tax free exchange – the shift of a proprietorship to a
wholly owned corporation which assumed the debts of the proprietorship.
... We are of the view ... that the Tax Court’s use of impermissible tests in assessing
Drybrough’s purposes amounted to an error of law subject to our review, and we reverse
its determination that the assumption in question is controlled by 357(b) of the 1954
Internal Revenue Code.
2) Corporate assumption of the 1957 $150,000.00 mortgage.
We sustain the Tax Court’s holding that the assumption by 620 South Fifth Street, Inc., on
June 28, 1957, of the $150,000 mortgage which had been placed on the assets transferred
to that corporation on March 15, 1957, had not been proven by Drybrough to be otherwise
than for a principal purpose “to avoid income tax on the exchange.” In late 1956
Drybrough had, with reference to the 620 South Fifth Street property, written to National
Life “620 South Fifth and Mexican Village property are both clear and I am eager to
mortgage them to the limit before combining these two properties in a corporation.” This
was a clear expression that the creation of the debt was directly in anticipation of, and
connected in purpose with, having the corporation assume the debt, thus releasing to
Drybrough $150,000 of the value of this asset without a present realization of taxable gain
on the exchange. The borrowed money was used to purchase tax-exempt securities; it was
not used to carry on the purposes of the business enterprise of 620 South Fifth Street, Inc.,
nor in furtherance of Drybrough’s general real estate investments, justifying also a finding
85

that the assumption could not be accommodated under the “bona fide business purpose”
requirement of 357(b)(1)(B). We think it was a fair inference too that Drybrough’s conduct
was equivalent to a pro tanto liquidation of the involved asset, and that his purpose “with
respect to the assumption” disclosed a plan to avoid realization of gain on this liquidation
by selling the mortgaged asset to his controlled corporation. It was permissible for the Tax
Court to find in this transaction “a purpose to avoid Federal income tax on the exchange,”
357(b)(1)(A).
We find no fault with the legal standard employed to reach the above conclusions; and
cannot hold as clearly erroneous the factual findings involved.
3) Disallowance of interest deduction on $200,000.00.
Out of the proceeds of the 1953 borrowing of $700,000 Drybrough put $203,602.00 into
the Public Garage account, allegedly as payment on indebtedness to his wife, and then
used $200,000 of that payment to purchase tax exempt bonds in the name of his wife
Marion. Applying [§ 265(a)(2)], the Commissioner disallowed the deduction taken for
interest paid on the $700,000 mortgage to the extent of $200,000.00. The Tax Court found
support for the Commissioner on two grounds: first, that Drybrough’s claim that he owed
his wife the $203,602.00 put into her account was a sham; and second, that even if the
$200,000 used to purchase the tax exempt securities was Marion Drybrough’s money, the
1953 borrowing of $700,000 was, to the extent of $200,000, “indebtedness incurred or
continued to purchase or carry obligations * * * the interest on which is wholly exempt
from the taxes imposed by this title,” and therefore under [265(a)(2)], the interest thereon
was not deductible.
[The court upheld these determinations.]
Accordingly, we reverse the Tax Court’s decision to the extent that it finds that the
assumption of the balance of the 1953 loan by the four corporations organized on June 1,
1957, should ‘be considered as money received by the taxpayer (Drybrough) on the
exchange,’ 357(b) IRC 1954; in all other respects, relevant to this petition for review, the
Tax Court’s decision is affirmed.

Questions and comments:
1. Why would taxpayer be “eager to mortgage [his personally owned properties] to the
limit before combining these two properties in a corporation?”
2. What is a bailout? Did taxpayer Drybrough successfully execute one or more bailouts?

86

3. Notice: In 1957, taxpayers paid income tax on $223,806.12 of capital gain. The
liabilities that the corporations assumed exceeded their bases in the properties. Taxpayers’
gained access to loan proceeds by paying only the capital gains rate of tax rather than the
ordinary income rate of tax.
4. How important is the timing of encumbering property with a loan liability and later
transferring it to the corporation? The court quoted from W.H.B. Simpson v. Comm’r, 43
T.C. 900 (1965). What did the court say about the timing of these events in Simpson?
5. The penalty for running afoul of § 357(b) is severe. If prior to incorporating, Drybrough
borrowed $1M, gave a mortgage on property that he owned, transferred the property
subject to the mortgage to a newly formed corporation, and used $1000 to pay off a
personal credit card bill, all of the liability that the corporation assumed would be boot –
not merely $1000.

Do the CALI exercise:
Corporate Taxation: Formation: Formation of C Corporations: The Effect of Liabilities.

C. Non-Qualified Preferred Stock
Until 1989, a § 351(a) nonrecognition transfer required that the transferor receive from the
corporation “stock or securities.” This permitted tax-free incorporation even though
transferors who received securities that were not stock (e.g., bonds) might essentially be
creditors of the corporation rather than owners of equity interests. From the view of the
corporation, the issuance of debt securities could make the transaction more like the
purchase of the transferor’s assets than the issuance of an ownership interest in exchange
for the transferor’s property. In the Omnibus Budget Reconciliation Act of 1989 17
(OBRA), Congress deleted the phrase “or securities” from § 351(a) so that exchanges
qualified for § 351 treatment only if the transferor of property received stock in return.
Prior to enactment of OBRA, exchanges could qualify for § 351 non-recognition treatment
when shareholders received “preferred stock,” i.e., stock whose rights to dividends the
corporation must satisfy before it satisfies the rights to dividends accorded owners of its
common stock. The rights of preferred shareholders to dividends could be limited to a
specified amount, no matter how profitable the corporation was.18 The holder of preferred

17 Pub. L. No. 101-239, § 7203(a), 103 Stat. 2333, 2334.
18 For purposes of § 351, preferred stock is not only “limited and preferred,” but also “does not participate in

corporate growth to any significant extent.” § 351(g)(3)(A). To avoid the label of “preferred stock,” the

87

stock also might have no right to share in the benefits of the corporation’s growth. These
features of preferred stock are also characteristic of a creditor’s interest. Nevertheless,
payments to holders of preferred stock are dividends in that the corporation must have
earnings and profits from which to pay dividends. (See chapter 3, infra.) The rights of
holders of preferred stock are inferior to those of creditors – whose right to payment does
not depend on the corporation being profitable. The fact that payment of dividends to
preferred shareholders must occur before payment of dividends to common shareholders
places the holder of preferred stock between creditors and shareholders who hold common
stock – whether voting or nonvoting.
The characteristics of preferred stock are partly those of debt instruments and partly those
of equity instruments. In the Taxpayer Relief Act of 1997, 19 Congress created
“nonqualified preferred stock,” which is preferred stock that has one of four characteristics
of debt:
1. the holder of the stock may require the issuer or a related person to redeem or
purchase the stock within 20 years of its issuance if no contingency makes the
likelihood of such redemption or repurchase remote; OR
2. the issuer of the stock or a related person is required to redeem or purchase the
stock within 20 years of its issuance if no contingency makes the likelihood of such
redemption or repurchase remote; OR
3. the issuer of the stock or a related person has the right to redeem or purchase
the stock if on the issue date, it is more likely than not that the right will be
exercised and no contingency makes the likelihood of such redemption or
repurchase within 20 years remote; OR
4. the dividend rate varies at least in part directly or indirectly with reference to
some index.
§ 351(g)(2)(A and B).20

likelihood of participating in earnings and corporate growth to a significant extent must be “real and
meaningful.” Id.
19 Pub. L. No. 105-34, § 1014, 111 Stat. 919.
20 There are exceptions if a right may be exercised “only upon” the death, disability, or mental incompetency of

the holder of the stock. § 351(g)(2)(C)(i)(I). This exception does not apply if any class of stock of the corporation
is readily traded on an established securities market. § 351(g)(2)(C)(ii)(I). In the case of a transfer in exchange
for services, there is an exception if the right may be exercised “only upon” the holder’s separation from service.
§ 351(g)(2)(C)(i)(II).

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If as part of a § 351 exchange, a transferor receives non-qualified preferred stock, the
transferor must treat it as boot. § 351(g)(1). However, the non-qualified preferred stock is
a class of stock of which transferors of property must own 80% for the exchange to qualify
for § 351 nonrecognition treatment. S. REP. NO. 105-174 at 178 (“the nonqualified
preferred stock continues to be treated as stock received by a transferor for purposes of
qualification of a transaction under section 351(a), unless and until regulations may
provide otherwise”).
Limitations on Reporting Boot Income on the
Installment Method:
•The taxpayer/shareholder may elect not to
Do the CALI exercise:
have the installment method apply.
§
Corporate
Taxation:
Formation: 453(d)(1).
Formation of C Corporations: Basic •The taxpayer/shareholder may not use the
Issues.
installment method in a sale of depreciable
property to a “related person” unless
taxpayer can establish to the satisfaction of
the Secretary that tax avoidance was not one
D. Boot and the Installment Method
of the “principal purposes” of the transfer, §
453(g)(1 and 2). A “related person” in this
Review IRC § 453.
context includes a corporation of which the
A shareholder/transferor may receive an shareholder/transferor owns directly or
installment obligation of the corporation indirectly more than 50% of the value of the
corporation’s outstanding stock. §§ 1239(b)(1);
as part of a § 351 exchange. A regulation
1239(c)(1)(A). The constructive ownership rules
proposed in 1984 21 allows taxpayer to
of § 267(c)(1, 2, 4, and 5) apply.
report income from the receipt of boot on
•Taxpayer/shareholder may not use the
the installment method. Prop. Reg. § installment method to the extent that any of
1.4531(f)(3)(ii) (first sentence). The the gain would be depreciation recapture. §
proposed regulation assigns basis both to 453(i)(1).
the stock (gain on which is not taxable) •Taxpayer/shareholder may not use the
that the shareholder/transferor received in installment method in a dealer disposition or in
the exchange and to the installment the transfer of inventory of personal property.
obligation (gain on which is taxable).
§ 453(b)(2).
The basis of the stock is tentatively the lesser of
•the basis that the shareholder/transferor had in the property transferred plus cash
transferred to the corporation
or
•the stock’s fmv plus transferred liabilities to the extent not subject to tax under §
357(c)(1).

21 Installment Obligations Received in Certain Nonrecognition Exchanges, 49 Fed. Reg. 18866 (proposed May 3, 1984).

89

If the first of these is the lesser, shareholder transferor’s basis in his stock is the basis of
the property plus any cash transferred minus liabilities assumed by the corporation. If the
second of these is the lesser, shareholder/transferor’s basis in his stock is the fmv of the
stock received less liabilities assumed by the corporation.
The basis of the installment obligation is the “excess basis” – i.e., amount by which the
second of these amounts is greater than the first. The “selling price” and “contract price”
are determined without regard to the liabilities that the corporation assumes (other than
those subject to tax under § 357(c)(1)).22 Prop. Reg. § 1.453-1(f)(3)(ii) (fourth sentence).
Any other boot that the shareholder/transferor receives is added to the contract and selling
price for purposes of § 453 calculations and treated as a payment in the year of the
exchange. Prop. Reg. § 1.453-1(f)(3)(ii) (second sentence).
The shareholder/transferor’s determination of his basis in the stock he receives is made as
if the installment method did not apply. Prop. Reg. § 1.453-1(f)(3)(ii) (sixth sentence). The
corporation applies the rule of § 362(a) by taking a transferred basis in the property that
shareholder transferred, increasing it by any amount the shareholder recognizes on the
exchange, and increasing it as and when shareholder pays tax on installment note payments
that he receives as boot. Prop. Reg. § 1.453-1(f)(3)(ii) (eighth sentence).
•Example 6: Nestor and Ophelia form the Plover Corporation. Nestor contributes
$10,000 to Plover Corporation in exchange for 1000 shares of voting common
stock, fmv = $10/share. Ophelia contributes Blackacre, ab = $14,000, fmv =
$18,000 in exchange for 1000 shares of voting common stock of Plover
Corporation and an 8-year note for $8000, to be paid in 8 annual installments of
$1000 plus adequate interest on the declining balance. Nestor takes a $10,000 basis
in his shares. The note that Ophelia received is boot. In assigning basis to her stock
and the installment note, the effect of Prop. Reg. § 1.453-1(f)(3)(ii) is to transfer
her basis in Blackacre plus cash that she transfers to the corporation to her stock to
the extent of the stock’s fmv. That is $10,000. The “excess basis” is $4000, and
that is Ophelia’s basis in the note. The contract price and the selling price is $8000.
50% of each payment will be taxable income. The corporation will take a $14,000
basis in Blackacre and increase it by the amount of income as and when Ophelia
recognizes it. Eventually, Plover Corporation’s basis in Blackacre will be $18,000.
•Notice: Ophelia paid tax on boot or gain, whichever is less. The boot was
$8000. Her gain on the exchange was $4000. She pays tax (eventually) on
$4000. Her basis in the note after all payments have been made is $8000,
the fmv of the note. See § 351(a)(2).

22

The terminology of the installment method is defined in Reg. § 15A.453-1(b)(1).

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•Example 6A: Same facts except that Ophelia’s basis in Blackacre is $8000. She
will transfer all her basis in Blackacre (plus the cash she transferred to the
corporation, i.e., $0) to the stock since it is less than the stock’s fmv. Her basis in
the note will be $0, so all of every installment payment will be taxable income.
Plover Corporation’s basis in Blackacre will be $8000, and Plover Corporation
may increase the basis as and when Ophelia recognizes income from the
installment note. Eventually, Plover Corporation’s basis in Blackacre will be
$16,000.
•Notice: Ophelia paid tax on boot or gain, whichever is less. The boot was
$8000. Her gain on the exchange was $10,000. She pays tax (eventually)
on $8000. Her basis in the note after all payments have been made is $8000,
the fmv of the note. See § 351(a)(2). Her basis in the stock of $8000 leaves
her with $2000 of built-in gain.
•Example 6B: Same facts except that Ophelia’s basis in Blackacre is $6000 and
Blackacre is encumbered by a $5000 mortgage. Plover Corporation exchanges
1000 shares of voting common stock, assumes the $5000 mortgage, and gives
Ophelia a note for $3000, payable in 8 annual installments of $375 plus adequate
interest. The fmv of the stock that Ophelia received plus the liability that Plover
Corporation assumed ($10,000 + $5000) is more than her basis in Blackacre
($6000) plus cash transferred ($0), so all the basis is assigned to her stock. Section
358(a)(1)(A) and § 358(d)(1) require that she reduce her basis in her stock by the
liability assumed, i.e., by $5000. Ophelia’s basis in her stock is $1000. Her basis
in the note is $0 so all the payments she receives will be taxed. Plover Corporation
has a $6000 basis in Blackacre that will increase as and when Ophelia recognizes
payments on the note. Eventually, Plover Corporation’s basis in Blackacre will be
$9000.
•Notice: Ophelia paid tax on boot or gain, whichever is less. The boot was
$3000. Her gain on the exchange was $12,000. She pays tax (eventually)
on $3000. Her basis in the note after all payments have been made is $3000,
the fmv of the note. See § 351(a)(2). Her basis in the stock of $1000 leaves
her with $9000 of built-in gain.

Problems:
1. Quincy, Rebecca, and Seth form the Plover Corporation. Quincy transfers $10,000 to the
Plover Corporation and receives 1000 shares of voting common stock. Rebecca transfers
Blackacre (adjusted basis = $7000, fair market value = $10,000) to the Plover Corporation
and receives 1000 shares of voting common stock. Seth transfers Whiteacre (adjusted basis
= $6000, fair market value = $10,000) to the Plover Corporation and receives 1000 shares
of non-convertible, non-voting preferred stock with a dividend rate equal to the prime rate
plus two percentage points. What are the gains realized, the gains recognized, and adjusted
bases of the stock received by Quincy, Rebecca, and Seth?
91

2. Same as #1 except that Seth transfers $5000 cash and performs services in exchange for
1000 shares of the preferred stock described in #1.
3. Bolf and Colomba form the Dink Corporation. Bolf transfers $50,000 cash and receives
500 shares of voting common stock, the only stock of Dink Corporation outstanding.
Colomba transfers Blackacre (adjusted basis = $40,000, fair market value = $70,000) to the
Dink Corporation in exchange for 500 shares of voting common stock plus $20,000, to be
paid in five annual installments plus interest on the declining balance. What are the tax
consequences to Colomba of his exchange and to Dink Corporation?
4. Same as #3 except that Colomba’s basis in Blackacre was $55,000.
5. Same as #3 except that Blackacre is subject to a $5000 liability at the time of the transfer
to Dink Corporation. Dink Corporation assumes the liability and gives Colomba its
installment obligation of $15,000.

V. Including Transferor Shareholder’s Promissory Note in Transferor’s Stock
Basis
Suppose that a transferor of property – perhaps the only shareholder of a corporation –
contemplates transferring property(-ies) that is (are) subject to more liabilities than his
adjusted bases in the properties in exchange for stock. The exchange will qualify for § 351
nonrecognition treatment. However, shareholder knows that he will owe income tax on
the excess of liabilities that the corporation assumes over his aggregate bases under §
357(c)(1)? Can the transferor escape this “trap” by writing his own promissory note to the
corporation? If the corporation is very closely held – again, suppose that the transferor is
the only shareholder – is there something disingenuous about escaping tax on income
simply by making a promise that no one will enforce?

Peracchi v. Commissioner, 143 F.3d 487 (9th Cir. 1998)
KOZINSKI, Circuit Judge
We must unscramble a Rubik’s Cube of corporate tax law to determine the basis of a note
contributed by a taxpayer to his wholly-owned corporation.
The Transaction
The taxpayer, Donald Peracchi [footnote omitted], needed to contribute additional capital
to his closely-held corporation (NAC) to comply with Nevada’s minimum premium-to92

asset ratio for insurance companies. Peracchi contributed two parcels of real estate. The
parcels were encumbered with liabilities which together exceeded Peracchi’s total basis in
the properties by more than half a million dollars. As we discuss in detail below, under §
357(c), contributing property with liabilities in excess of basis can trigger immediate
recognition of gain in the amount of the excess. In an effort to avoid this, Peracchi also
executed a promissory note, promising to pay NAC $1,060,000 over a term of ten years at
11% interest. Peracchi maintains that the note has a basis equal to its face amount, thereby
making his total basis in the property contributed greater than the total liabilities. If this is
so, he will have extracted himself from the quicksand of § 357(c) and owe no immediate
tax on the transfer of property to NAC. The IRS, though, maintains that (1) the note is not
genuine indebtedness and should be treated as an unenforceable gift; and (2) even if the
note is genuine, it does not increase Peracchi’s basis in the property contributed.
The parties are not splitting hairs: Peracchi claims the basis of the note is $1,060,000, its
face value, while the IRS argues that the note has a basis of zero. If Peracchi is right, he
pays no immediate tax on the half a million dollars by which the debts on the land he
contributed exceed his basis in the land; if the IRS is right, the note becomes irrelevant for
tax purposes and Peracchi must recognize an immediate gain on the half million. The fact
that the IRS and Peracchi are so far apart suggests they are looking at the transaction
through different colored lenses. To figure out whether Peracchi’s lens is rose-tinted or
clear, it is useful to take a guided tour of §§ 351 and 357 and the tax law principles
undergirding them.
Into the Lobster Pot: Section 35123
The Code tries to make organizing a corporation pain-free from a tax point of view. A
capital contribution is, in tax lingo, a “nonrecognition” event: A shareholder can generally
contribute capital without recognizing gain on the exchange.24 It’s merely a change in the
form of ownership, like moving a billfold from one pocket to another. See I.R.C. § 351.

23 “Decisions to embrace the corporate form of organization should be carefully considered, since a corporation

is like a lobster pot: easy to enter, difficult to live in, and painful to get out of.” BORIS I. BITTKER & JAMES S.
EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS ¶ 2.01[3]
(6th ed. 1997) (footnotes omitted) (hereinafter BITTKER & EUSTICE).
24 The income tax often operates as a tax on transactions. Regardless of when a taxpayer realizes accretions to his

economic wealth, income is usually recognized when a measuring event occurs, such as receipt of a paycheck or
the “sale or exchange” of property. But the Code exempts certain sales and exchanges from recognition, such as
when a sale is involuntary, or merely a change in the form of ownership, or otherwise warrants nonrecognition.
See generally BORIS I. BITTKER & LAWRENCE LOKKEN, FEDERAL TAXATION OF INCOME,
ESTATES AND GIFTS ¶ 44.1.1 (2d ed. 1990) (“The Code contains numerous nonrecognition provisions
covering a wide range of transactions that have little in common except that they have elicited a legislative
judgment that the taxpayer’s realized gain or loss should not be taxed or deducted when the exchange or other
event occurs.”). Congress has not deemed the organization of a corporation an appropriate event for recognition
of income.

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[footnote omitted]. So long as the shareholders contributing the property remain in control
[footnote omitted] of the corporation after the exchange, § 351 applies: It doesn’t matter
if the capital contribution occurs at the creation of the corporation or if – as here – the
company is already up and running. The baseline is that Peracchi may contribute property
to NAC without recognizing gain on the exchange.
Gain Deferral: Section 358(a)
Peracchi contributed capital to NAC in the form of real property and a promissory note.
Corporations may be funded with any kind of asset, such as equipment, real estate,
intellectual property, contracts, leaseholds, securities or letters of credit. The tax
consequences can get a little complicated because a shareholder’s basis in the property
contributed often differs from its fair market value. The general rule is that an asset’s basis
is equal to its “cost.” See I.R.C. § 1012. But when a shareholder like Peracchi contributes
property to a corporation in a nonrecognition transaction, a cost basis does not preserve
the unrecognized gain. Rather than take a basis equal to the fair market value of the
property exchanged, the shareholder must substitute the basis of that property for what
would otherwise be the cost basis of the stock. [footnote omitted]. This preserves the gain
for recognition at a later day: The gain is built into the shareholder’s new basis in the stock,
and he will recognize income when he disposes of the stock.
The fact that gain is deferred rather than extinguished doesn’t diminish the importance of
questions relating to basis and the timing of recognition. In tax, as in comedy, timing
matters. Most taxpayers would much prefer to pay tax on contributed property years later
– when they sell their stock – rather than when they contribute the property.25 Thus what
Peracchi is seeking here is gain deferral: He wants the gain to be recognized only when he
disposes of some or all of his stock.
Continuity of Investment: Boot and Section 351(b)
Continuity of investment is the cornerstone of nonrecognition under § 351. Nonrecognition
assumes that a capital contribution amounts to nothing more than a nominal change in the
form of ownership; in substance the shareholder’s investment in the property continues.
But a capital contribution can sometimes allow a shareholder to partially terminate his
investment in an asset or group of assets. For example, when a shareholder receives cash
or other property in addition to stock, receipt of that property reflects a partial termination
of investment in the business. The shareholder may invest that money in a wholly unrelated

25

Of course, should the taxpayers be lucky enough to die before disposing of the stock, their heirs would take
a stepped-up basis in the stock equal to its fair market value as of the date of death. See I.R.C. § 1014.

94

business, or spend it just like any other form of personal income. To the extent a § 351
transaction resembles an ordinary sale, the nonrecognition rationale falls apart.
Thus the central exception to nonrecognition for § 351 transactions comes into play when
the taxpayer receives “boot” – money or property other than stock in the corporation – in
exchange for the property contributed. See I.R.C. § 351(b). Boot is recognized as taxable
income because it represents a partial cashing out. It’s as if the taxpayer contributed part
of the property to the corporation in exchange for stock, and sold part of the property for
cash. Only the part exchanged for stock represents a continuation of investment; the part
sold for cash is properly recognized as yielding income, just as if the taxpayer had sold the
property to a third party.
Peracchi did not receive boot in return for the property he contributed. But that doesn’t
end the inquiry: We must consider whether Peracchi has cashed out in some other way
which would warrant treating part of the transaction as taxable boot.
Assumption of Liabilities: Section 357(a)
The property Peracchi contributed to NAC was encumbered by liabilities. Contribution of
leveraged property makes things trickier from a tax perspective. When a shareholder
contributes property encumbered by debt, the corporation usually assumes the debt. And
the Code normally treats discharging a liability the same as receiving money: The taxpayer
improves his economic position by the same amount either way. See I.R.C. § 61(a)(12)
[now § 61(a)(11)]. NAC’s assumption of the liabilities attached to Peracchi’s property
therefore could theoretically be viewed as the receipt of money, which would be taxable
boot. See U.S. v. Hendler, 303 U.S. 564 (1938).
The Code takes a different tack. Requiring shareholders like Peracchi to recognize gain
any time a corporation assumes a liability in connection with a capital contribution would
greatly diminish the nonrecognition benefit § 351 is meant to confer. Section 357(a) thus
takes a lenient view of the assumption of liability: A shareholder engaging in a § 351
transaction does not have to treat the assumption of liability as boot, even if the corporation
assumes his obligation to pay. See I.R.C. § 357(a).
This nonrecognition does not mean that the potential gain disappears. Once again, the basis
provisions kick in to reflect the transfer of gain from the shareholder to the corporation:
The shareholder’s substitute basis in the stock received is decreased by the amount of the
liability assumed by the corporation. See I.R.C. § 358(d), (a). The adjustment preserves
the gain for recognition when the shareholder sells his stock in the company, since his
taxable gain will be the difference between the (new lower) basis and the sale price of the
stock.

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Sasquatch and The Negative Basis Problem: Section 357(c)
Highly leveraged property presents a peculiar problem in the § 351 context. Suppose a
shareholder organizes a corporation and contributes as its only asset a building with a basis
of $50, a fair market value of $100, and mortgage debt of $90. Section 351 says that the
shareholder does not recognize any gain on the transaction. Under § 358, the shareholder
takes a substitute basis of $50 in the stock, then adjusts it downward under § 357 by $90
to reflect the assumption of liability. This leaves him with a basis of minus $40. A negative
basis properly preserves the gain built into the property: If the shareholder turns around
and sells the stock the next day for $10 (the difference between the fair market value and
the debt), he would face $50 in gain, the same amount as if he sold the property without
first encasing it in a corporate shell.26
But skeptics say that negative basis, like Bigfoot, doesn’t exist. Compare Easson v.
Commissioner, 33 T.C. 963, 970 (1960) (there’s no such thing as a negative basis) with
Easson v. Commissioner, 294 F.2d 653, 657-58 (9th Cir. 1961) (yes, Virginia, there is a
negative basis). Basis normally operates as a cost recovery system: Depreciation
deductions reduce basis, and when basis hits zero, the property cannot be depreciated
farther. At a more basic level, it seems incongruous to attribute a negative value to a figure
that normally represents one’s investment in an asset. Some commentators nevertheless
argue that when basis operates merely to measure potential gain (as it does here), allowing
negative basis may be perfectly appropriate and consistent with the tax policy underlying
nonrecognition transactions. See, e.g., J. Clifton Fleming, Jr., The Highly Avoidable
Section 357(c): A Case Study in Traps for the Unwary and Some Positive Thoughts About
Negative Basis, 16 J. CORP. L. 1, 27-30 (1990). Whatever the merits of this debate, it seems
that § 357(c) was enacted to eliminate the possibility of negative basis. See George Cooper,
Negative Basis, 75 HARV. L. REV. 1352, 1360 (1962).
Section 357(c) prevents negative basis by forcing a shareholder to recognize gain to the
extent liabilities exceed basis. [footnote omitted]. Thus, if a shareholder contributes a
building with a basis of $50 and liabilities of $90, he does not receive stock with a basis
of minus $40. Instead, he takes a basis of zero and must recognize a $40 gain.
Peracchi sought to contribute two parcels of real property to NAC in a § 351 transaction.
Standing alone the contribution would have run afoul of § 357(c): The property he wanted

26 If the taxpayer sells the property outright, his amount realized includes the full amount of the mortgage debt,

see Crane v. Commissioner, 331 U.S. 1 (1947), and the result is as follows: Amount realized ($10 cash + $90
debt) − $50 Basis = $50 gain.

96

to contribute had liabilities in excess of basis, and Peracchi would have had to recognize
gain to the extent of the excess, or $566,807.27
The Grift: Boosting Basis with a Promissory Note
Peracchi tried to dig himself out of this tax hole by contributing a personal note with a face
amount of $1,060,000 along with the real property. Peracchi maintains that the note has a
basis in his hands equal to its face value. If he’s right, we must add the basis of the note to
the basis of the real property. Taken together, the aggregate basis in the property
contributed would exceed the aggregate liabilities ...
Under Peracchi’s theory, then, the aggregate liabilities no longer exceed the aggregate
basis, and § 357(c) no longer triggers any gain. The government argues, however, that the
note has a zero basis. If so, the note would not affect the tax consequences of the
transaction, and Peracchi’s $566,807 in gain would be taxable immediately. [footnote
omitted].
Are Promises Truly Free?
Which brings us (phew!) to the issue before us: Does Peracchi’s note have a basis in
Peracchi’s hands for purposes of § 357(c)?28 The language of the Code gives us little to
work with. The logical place to start is with the definition of basis. Section 1012 provides
that “[t]he basis of property shall be the cost of such property....” But “cost” is nowhere
defined. What does it cost Peracchi to write the note and contribute it to his corporation?
The IRS argues tersely that the “taxpayers in the instant case incurred no cost in issuing
their own note to NAC, so their basis in the note was zero.” See Alderman v.
Commissioner, 55 T.C. 662, 665 (1971); Rev. Rul. 68-629, 1968-2 C.B. 154, 155. 29
27 Peracchi remained personally liable on the debts encumbering the property transferred to NAC. NAC took

the property subject to the debts, however, which is enough to trigger gain under the plain language of § 357(c).
See Owen v. Commissioner, 881 F.2d 832, 835-36 (9th Cir. 1989).
....
28 Peracchi owned all the voting stock of NAC both before and after the exchange, so the control requirement

of § 351 is satisfied. Peracchi received no boot (such as cash or securities) which would qualify as “money or
other property” and trigger recognition under 351(b) alone. Peracchi did not receive any stock in return for the
property contributed, so it could be argued that the exchange was not “solely in exchange for stock” as required
by § 351. Courts have consistently recognized, however, that issuing stock in this situation would be a
meaningless gesture: Because Peracchi is the sole shareholder of NAC, issuing additional stock would not affect
his economic position relative to other shareholders. See, e.g., Jackson v. Commissioner, 708 F.2d 1402, 1405
(9th Cir. 1983).
29 We would face a different case had the Treasury promulgated a regulation interpreting § 357(c). A revenue

ruling is entitled to some deference as the stated litigating position of the agency which enforces the tax code,
but not nearly as much as a regulation. Ruling 68-629 offers no rationale, let alone a reasonable one, for its
holding that it costs a taxpayer nothing to write a promissory note, and thus deserves little weight.

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Building on this premise, the IRS makes Peracchi out to be a grifter: He holds an
unenforceable promise to pay himself money, since the corporation will not collect on it
unless he says so.
It’s true that all Peracchi did was make out a promise to pay on a piece of paper, mark it
in the corporate minutes and enter it on the corporate books. It is also true that nothing will
cause the corporation to enforce the note against Peracchi so long as Peracchi remains in
control. But the IRS ignores the possibility that NAC may go bankrupt, an event that would
suddenly make the note highly significant. Peracchi and NAC are separated by the
corporate form, and this gossamer curtain makes a difference in the shell game of C Corp
organization and reorganization. Contributing the note puts a million dollar nut within the
corporate shell, exposing Peracchi to the cruel nutcracker of corporate creditors in the
event NAC goes bankrupt. And it does so to the tune of $1,060,000, the full face amount
of the note. Without the note, no matter how deeply the corporation went into debt,
creditors could not reach Peracchi’s personal assets. With the note on the books, however,
creditors can reach into Peracchi’s pocket by enforcing the note as an unliquidated asset
of the corporation.
The key to solving this puzzle, then, is to ask whether bankruptcy is significant enough a
contingency to confer substantial economic effect on this transaction. If the risk of
bankruptcy is important enough to be recognized, Peracchi should get basis in the note:
He will have increased his exposure to the risks of the business – and thus his economic
investment in NAC – by $1,060,000. If bankruptcy is so remote that there is no realistic
possibility it will ever occur, we can ignore the potential economic effect of the note as
speculative and treat it as merely an unenforceable promise to contribute capital in the
future.
When the question is posed this way, the answer is clear. Peracchi’s obligation on the note
was not conditioned on NAC’s remaining solvent. It represents a new and substantial
increase in Peracchi’s investment in the corporation.30 The Code seems to recognize that
economic exposure of the shareholder is the ultimate measuring rod of a shareholder’s
investment. Cf. § 465 (at-risk rules for partnership investments). Peracchi therefore is
entitled to a step-up in basis to the extent he will be subjected to economic loss if the
underlying investment turns unprofitable. [citations omitted].
The economics of the transaction also support Peracchi’s view of the matter. The
transaction here does not differ substantively from others that would certainly give
Peracchi a boost in basis. For example, Peracchi could have borrowed $1 million from a
30 We confine our holding to a case such as this where the note is contributed to an operating business which is

subject to a non-trivial risk of bankruptcy or receivership. NAC is not, for example, a shell corporation or a
passive investment company; Peracchi got into this mess in the first place because NAC was in financial trouble
and needed more assets to meet Nevada’s minimum premium-to-asset ratio for insurance companies.

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bank and contributed the cash to NAC along with the properties. Because cash has a basis
equal to face value, Peracchi would not have faced any § 357(c) gain. NAC could then
have purchased the note from the bank for $1 million which, assuming the bank’s original
assessment of Peracchi’s creditworthiness was accurate, would be the fair market value of
the note. In the end the corporation would hold a million dollar note from Peracchi – just
like it does now – and Peracchi would face no § 357(c) gain. 31 The only economic
difference between the transaction just described and the transaction Peracchi actually
engaged in is the additional costs that would accompany getting a loan from the bank.
Peracchi incurs a “cost” of $1 million when he promises to pay the note to the bank; the
cost is not diminished here by the fact that the transferor controls the initial transferee. The
experts seem to agree: “Section 357(c) can be avoided by a transfer of enough cash to
eliminate any excess of liabilities over basis; and since a note given by a solvent obligor
in purchasing property is routinely treated as the equivalent of cash in determining the
basis of the property, it seems reasonable to give it the same treatment in determining the
basis of the property transferred in a § 351 exchange.” BITTKER & EUSTICE ¶ 3.06[4][b].
We are aware of the mischief that can result when taxpayers are permitted to calculate
basis in excess of their true economic investment. See Commissioner v. Tufts, 461 U.S.
300 (1983). For two reasons, however, we do not believe our holding will have such
pernicious effects. First, and most significantly, by increasing the taxpayer’s personal
exposure, the contribution of a valid, unconditional promissory note has substantial
economic effects which reflect his true economic investment in the enterprise. The main
problem with attributing basis to nonrecourse debt financing is that the tax benefits
enjoyed as a result of increased basis do not reflect the true economic risk. Here Peracchi
will have to pay the full amount of the note with after-tax dollars if NAC’s economic
situation heads south. Second, the tax treatment of nonrecourse debt primarily creates
problems in the partnership context, where the entity’s loss deductions (resulting from
depreciation based on basis inflated above and beyond the taxpayer’s true economic

31 In a similar vein, Peracchi could have first swapped promissory notes with a third party. Assuming the bona

fides of each note, Peracchi would take a cost basis in the third party note equal to the face value of the note he
gave up. Peracchi could then contribute the third party note to NAC, and (thanks to the added basis) avoid any
§ 357(c) gain. NAC could then close the circle by giving the third party note back to the third party in exchange
for Peracchi’s note, leaving Peracchi and NAC in exactly the same position they occupy now.
The IRS might attack these maneuvers as step transactions, but that would beg the question: Does the
contribution of a shareholder’s note to his wholly-owned corporation have any real economic effect, or is it just
so much window dressing? If the debt has real economic effect, it shouldn’t matter how the shareholder
structures the transaction.
The only substantive difference between the avoidance techniques just discussed – swapping notes or borrowing
from a third party – and the case here is the valuation role implicitly performed by the third party. A bank would
not give Peracchi the face value of the note unless his credit warranted it, while we have no assurance that NAC
wouldn’t do so. We readily acknowledge that our assumptions fall apart if the shareholder isn’t creditworthy.
Here, the government has stipulated that Peracchi’s net worth far exceeds the value of the note, so
creditworthiness is not at issue. But we limit our holding to cases where the note is in fact worth approximately
its face value.

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investment) can be passed through to the taxpayer. It is the pass-through of losses that
makes artificial increases in equity interests of particular concern. [citation omitted]. We
don’t have to tread quite so lightly in the C Corp context, since a C Corp doesn’t funnel
losses to the shareholder.32
We find further support for Peracchi’s view by looking at the alternative: What would
happen if the note had a zero basis? The IRS points out that the basis of the note in the
hands of the corporation is the same as it was in the hands of the taxpayer. Accordingly, if
the note has a zero basis for Peracchi, so too for NAC. See § 362(a).33 But what happens
if NAC – perhaps facing the threat of an involuntary petition for bankruptcy – turns around
and sells Peracchi’s note to a third party for its fair market value? According to the IRS’s
theory, NAC would take a carryover basis of zero in the note and would have to recognize
$1,060,000 in phantom gain on the subsequent exchange, even though the note did not
appreciate in value one bit. That can’t be the right result.
Accordingly, we hold that Peracchi has a basis of $1,060,000 in the note he wrote to NAC.
The aggregate basis exceeds the liabilities of the properties transferred to NAC under §
351, and Peracchi need not recognize any § 357(c) gain.
Genuine Indebtedness or Sham?
The Tax Court never reached the issue of Peracchi’s basis in the note. Instead, it ruled for
the Commissioner on the ground that the note is not genuine indebtedness. The court
emphasized two facts which it believed supported the view that the note is a sham: (1)
NAC’s decision whether to collect on the note is wholly controlled by Peracchi and (2)
Peracchi missed the first two years of payments, yet NAC did not accelerate the debt.
These facts certainly do suggest that Peracchi paid imperfect attention to his obligations
under the note, as frequently happens when debtor and creditor are under common control.
But we believe the proper way to approach the genuine indebtedness question is to look at
the face of the note and consider whether Peracchi’s legal obligation is illusory. And it is
not. First, the note’s bona fides are adequate: The IRS has stipulated that Peracchi is

32 Our holding therefore does not extend to the partnership or S Corp context.
33 But see Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989). In Lessinger, the Second Circuit analyzed a

similar transaction. It agreed with the IRS’s (faulty) premise that the note had a zero basis in the taxpayer’s
hands. But then, brushing aside the language of § 362(a), the court concluded that the note had a basis in the
corporation’s hands equal to its face value. The court held that this was enough to dispel any § 357(c) gain to
the taxpayer, proving that two wrongs sometimes do add up to a right.
We agree with the IRS that Lessinger’s approach is untenable. Section 357(c) contemplates measuring basis of the
property contributed in the hands of the taxpayer, not the corporation. Section 357 appears in the midst of the
Code sections dealing with the effect of capital contributions on the shareholder; §§ 361 et seq., on the other
hand, deal with the effect on a corporation, and § 362 defines the basis of property contributed in the hands of
the corporation. Because we hold that the note has a face value basis to the shareholder for purposes of § 357(c),
however, we reach the same result as Lessinger.

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creditworthy and likely to have the funds to pay the note; the note bears a market rate of
interest commensurate with his creditworthiness; the note has a fixed term. Second, the
IRS does not argue that the value of the note is anything other than its face value; nothing
in the record suggests NAC couldn’t borrow against the note to raise cash. Lastly, the note
is fully transferable and enforceable by third parties, such as hostile creditors. On the basis
of these facts we hold that the note is an ordinary, negotiable, recourse obligation which
must be treated as genuine debt for tax purposes. [citation omitted].
The IRS argues that the note is nevertheless a sham because it was executed simply to
avoid tax. Tax avoidance is a valid concern in this context; § 357(a) does provide the
opportunity for a bailout transaction of sorts. For example, a taxpayer with an
unencumbered building he wants to sell could take out a nonrecourse mortgage, pocket
the proceeds, and contribute the property to a newly organized corporation. Although the
gain would be preserved for later recognition, the taxpayer would have partially cashed
out his economic investment in the property: By taking out a nonrecourse mortgage, the
economic risk of loss would be transferred to the lender. [footnote omitted]. Section 357(b)
addresses this sort of bailout by requiring the recognition of gain if the transaction lacks a
business purpose. [footnote omitted]
Peracchi’s capital contribution is not a bailout. Peracchi contributed the buildings to NAC
because the company needed additional capital, and the contribution of the note was part
of that transaction. The IRS, in fact, stipulated that the contribution had a business purpose.
Bailout potential exists regardless of whether the taxpayer contributes a note along with
the property; § 357(b), not 357(c), is the sword the Service must use to attack bailout
transactions.
Is the note a gift?
The IRS also offers a more refined version of the sham transaction argument: The note
was really a gift to NAC because Peracchi did not receive any consideration from the
exchange. The IRS admits that the tax deferral resulting from avoiding § 357(c) gain is a
benefit to Peracchi. It argues, nonetheless, that this is not enough to make the bargain
enforceable because it works no detriment to NAC. This argument would classify all
contributions of capital as gifts. A corporation never gives up anything explicitly when it
accepts a capital contribution. Instead, the corporation implicitly promises to put the
money to good use, and its directors and officers undertake the fiduciary duty to generate
the highest possible return on the investment. The contribution of the note was no more a
gift than the contribution of $1 million in cash to the corporation would have been; it does
not reflect the “detached and disinterested generosity” which characterizes a gift for
purposes of federal income taxation. See Commissioner v. Duberstein, 363 U.S. 278, 285
(1960).

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The Aftermath
We take a final look at the result to make sure we have not placed our stamp of approval
on some sort of exotic tax shelter. We hold that Peracchi is entitled to a step up in basis
for the face value of the note, just as if he contributed cash to the corporation. See § 358.
If Peracchi does in fact keep his promise and pay off the note with after tax dollars, the tax
result is perfectly appropriate: NAC receives cash, and the increase in basis Peracchi took
for the original contribution is justified. Peracchi has less potential gain, but he paid for it
in real dollars.
But what if, as the IRS fears, NAC never does enforce the note? If NAC goes bankrupt,
the note will be an asset of the estate enforceable for the benefit of creditors, and Peracchi
will eventually be forced to pay in after tax dollars. Peracchi will undoubtedly have worked
the deferral mechanism of § 351 to his advantage, but this is not inappropriate where the
taxpayer is on the hook in both form and substance for enough cash to offset the excess of
liabilities over basis. By increasing his personal exposure to the creditors of NAC, Peracchi
has increased his economic investment in the corporation, and a corresponding increase in
basis is wholly justified.34
Conclusion
We hold that Peracchi has a basis of $1,060,000 in the note, its face value. As such, the
aggregate liabilities of the property contributed to NAC do not exceed its basis, and
Peracchi does not recognize any § 357(c) gain. The decision of the Tax Court is
REVERSED. The case is remanded for entry of judgment in favor of Peracchi.
FERNANDEZ, Circuit Judge, Dissenting:
Is there something that a taxpayer, who has borrowed hundreds of thousands of dollars
more than his basis in his property, can do to avoid taxation when he transfers the property?
Yes, says Peracchi, because by using a very clever argument he can avoid the strictures of
§ 357(c). He need only make a promise to pay by giving a “good,” though unsecured,
promissory note to his corporation when he transfers the property to it. That is true even
though the property remains subject to the encumbrances. How can that be? Well, by
preparing a promissory note the taxpayer simply creates basis without cost to himself. But
see 26 U.S.C. § 1012; Rev. Rul. 68-629, 1968-2 C.B. 154; Alderman v. Commissioner, 55
T.C. 662, 665 (1971). Thus he can extract a large part of the value of the property, pocket

34 What happens if NAC does not go bankrupt, but merely writes off the note instead? Peracchi would then face

discharge of indebtedness income to the tune of $1,060,000. This would put Peracchi in a worse position than
when he started, since discharge of indebtedness is normally treated as ordinary income. Peracchi, having
increased his basis in the stock of the corporation by $1,060,000 would receive a capital loss (or less capital gain)
to that extent. But the shift in character of the income will normally work to the disadvantage of a taxpayer in
Peracchi’s situation.

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the funds, use them, divest himself of the property, and pay the tax another day, if ever at
all.
But as with all magical solutions, the taxpayer must know the proper incantations and
make the correct movements. He cannot just transfer the property to the corporation and
promise, or be obligated, to pay off the encumbrances. That would not change the fact that
the property was still subject to those encumbrances. According to Peracchi, the
thaumaturgy that will save him from taxes proceeds in two simple steps. He must first
prepare a ritualistic writing – an unsecured promissory note in an amount equal to or more
than the excess of the encumbrances over the basis. He must then give that writing to his
corporation. That is all.35 But is not that just a “promise to pay,” which “does not represent
the paying out or reduction of assets?” Don E. Williams Co. v. Commissioner, 429 U.S.
569, 583 (1977). Never mind, he says. He has nonetheless increased the total basis of the
property transferred and avoided the tax. I understand the temptation to embrace that
argument, but I see no real support for it in the law.
Peracchi says a lot about economic realities. I see nothing real about that maneuver. I see,
rather, a bit of sortilege that would have made Merlin envious. The taxpayer has created
something – basis – out of nothing.
Thus, I respectfully dissent.

Questions and comments:
1. Judge Kozinski’s opinion nicely summarizes all of the tax law that this chapter
considers. Take note.
2. Be aware that the issue may not be resolved. As the court in Peracchi noted, Alderman
v. Commissioner, 55 T.C. 662, 665 (1971) held on indistinguishable facts directly contrary
to what the CA9 held. In relevant part, the Tax Court said: “The Aldermans incurred no
cost in making the note, so its basis to them was zero. The basis to the corporation was the
same as in the hands of the transferor, i.e., zero.”
3. The court in Peracchi noted the increase in the taxpayer’s personal liability exposure.
But a shareholder guarantee of the liabilities that the corporation assumes does not prevent
the application of § 357(c). See Seggerman Farms, Inc. v. Commissioner, 308 F.3d 803,
807 (7th Cir. 2002) (“‘personal guaranties of corporate debt are not the same as incurring
indebtedness to the corporation because a guaranty is merely a promise to pay in the future
35 What is even better, he need not even make payments on the note until after the IRS catches up with him. I,

by the way, am dubious about the proposition that the Tax Court clearly erred when it held that the note was
not even a genuine indebtedness.

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if certain events should occur. [Their] guaranties do not constitute economic outlays’”
(quoting Tax Court)); Owen v. Commissioner, 881 F.2d 832, 835-36 (9th Cir.), cert. denied,
493 U.S. 1070 (1990) (shareholders remained liable on liabilities they guaranteed that the
corporation assumed; § 357(c) applicable).
4. Thaumaturgy: capability of a magician or a saint to work magic or miracles.

VI. Section 351 and Assignment of Income
Recall the essence of Lucas v. Earl, 281 U.S. 111, 114-15 (1930): Income is taxed to the
one who earned it, not to the one to whom it is contractually assigned. This has
implications when the right to income is reflected in accounts receivable. Suppose that the
account receivable is earned by a cash method taxpayer who transfers it to a corporation
which is then taxed to the corporation upon collection. If we treat an account receivable as
“property,” we facilitate avoidance of the “assignment of income” principle. [This problem
does not arise when the taxpayer who transfers an account receivable to a corporation is
an accrual method taxpayer. Why not?]

Hempt Bros., Inc. v. United States, 490 F.2d 1172 (3d Cir. 1974)
ALDISERT, Circuit Judge
In this appeal by a corporate taxpayer from a grant of summary judgment in favor of the
government in a claim for refund, we are called upon to decide the proper treatment of
accounts receivable and of inventory transferred from a cash basis partnership to a
corporation organized to continue the business under 26 U.S.C. § 351(a). [footnote
omitted]. This appeal illustrates the conflict between the statutory purpose of § 351,
postponement of recognition of gain or loss, and the assignment of income and tax benefit
doctrines.
….
From 1942 until February 28, 1957, a partnership comprised of Loy T. Hempt, J.F. Hempt,
Max C. Hempt, and the George L. Hempt Estate was engaged in the business of quarrying
and selling stone, sand, gravel, and slag; manufacturing and selling ready-mix concrete
and bituminous material; constructing roads, highways, and streets, primarily for the
Pennsylvania Department of Highways and various political subdivisions of Pennsylvania,
and constructing driveways, parking lots, street and water lines, and related accessories.
The partnership maintained its books and records, and filed its partnership income tax
returns, on the basis of a calendar year and on the cash method of accounting, so that no
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income was reported until actually received in cash. Accordingly, in computing its income
for federal income tax purposes, the partnership did not take uncollected receivables into
income, ... although ... accounts receivable reflecting sales already made ... existed to a
substantial extent at the end of each of the partnership’s taxable years. ...
On March 1, 1957, the partnership business and most of its assets were transferred to the
taxpayer solely in exchange for taxpayer’s capital stock, the 12,000 shares of which were
issued to the four members of the partnership. These shares constituted 100% of the issued
and outstanding shares of the taxpayer. This transfer was made pursuant to § 351(a) ...
Thereafter, the taxpayer conducted the business formerly conducted by the partnership.
Among the assets transferred by the partnership to the taxpayer for taxpayer’s shares of
stock were accounts receivable in the amount of $662,824.40 arising from performance of
construction projects, sales of stone, sand, gravel, etc., and rental of equipment prior to
March 1, 1957. ...
Commencing with its initial fiscal year (which) ended February 28, 1958, taxpayer
maintained its books and filed its corporation income tax returns on the cash method of
accounting and, accordingly, did not take uncollected receivables into income ... In its
taxable years ending in 1958, 1959, and 1960, taxpayer collected the respective amounts
of $533,247.87, $125,326.71 and $4,249.72 of the accounts receivable in the aggregate
amount of $662,824.40 that transferred to it, and included those amounts in income in
computing its income for its federal income tax returns for those years, respectively.
As a result of an examination extending over a period of years, ... income was adjusted ...
to accrue unreported sales (accounts receivable) made during the taxable years in question
... The result was an increase in taxpayer’s taxable income for the fiscal year ended
February 28, 1958, in the amount of $258,201.35.
The Commissioner of Internal Revenue assessed deficiencies in taxpayer’s federal income
taxes for its fiscal years ending February 28, 1958, and 1959. The taxpayer paid the
amounts in 1964, and in 1965 filed claims for refund of $621,218.09 plus assessed interest.
[footnote omitted]. The claims were disallowed in full on September 24, 1968, and the
district court action was timely instituted on December 5, 1968.
The district court held: ... taxpayer was properly taxable upon collections made with
respect to accounts receivable which were transferred to it in conjunction with the § 351
incorporation ...
I.
Taxpayer argues here, as it did in the district court, that because the term ‘property’ as
used in § 351 does not embrace accounts receivable, the Commissioner lacked statutory
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authority to apply principles associated with § 351. The district court properly rejected the
legal interpretation urged by the taxpayer.
….
We fail to perceive any special reason why a restrictive meaning should be applied to
accounts receivables so as to exclude them from the general meaning of ‘property.’
Receivables possess the usual capabilities and attributes associated with jurisprudential
concepts of property law. They may be identified, valued, and transferred. Moreover, their
role in an ongoing business must be viewed in the context of § 351 application. The
presence of accounts receivable is a normal, rather than an exceptional accoutrement of
the type of business included by Congress in the transfer to a corporate form. They are
‘commonly thought of in the commercial world as a positive business asset.’ E.I. Du Pont
de Nemours and Co. v. United States, 471 F.2d 1211, 1218 (Ct. Cl. 1973). As aptly put by
the district court: ‘There is a compelling reason to construe ‘property’ to include ...
(accounts receivable): a new corporation needs working capital, and accounts receivable
can be an important source of liquidity.’ [footnote omitted]. ...
The taxpayer next makes a strenuous argument that ‘the government is seeking to tax the
wrong person.’ [footnote omitted]. It contends that the assignment of income doctrine as
developed by the Supreme Court applies to a § 351 transfer of accounts receivable so that
the transferor, not the transferee-corporation, bears the corresponding tax liability. It
argues that the assignment of income doctrine dictates that where the right to receive
income is transferred to another person in a transaction not giving rise to tax at the time of
transfer, the transferor is taxed on the income when it is collected by the transferee; that
the only requirement for its application is a transfer of a right to receive ordinary income;
and that since the transferred accounts receivable are a present right to future income, the
sole requirement for the application of the doctrine is squarely met. In essence, this is a
contention that the nonrecognition provision of § 351 is in conflict with the assignment of
income doctrine and that § 351 should be subordinated thereto. Taxpayer relies on the
seminal case of Lucas v. Earl, 280 U.S. 538 (1929), and its progeny [footnote omitted] for
support of its proposition that the application of the doctrine is mandated whenever one
transfers a right to receive ordinary income.
On its part, the government concedes that a taxpayer may sell for value a claim to income
otherwise his own and he will be taxable upon the proceeds of the sale. Such was the case
in Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958), in which the taxpayer
corporation assigned its oil payment right to its president in consideration for his
cancellation of a $600,000 loan. Viewing the oil payment right as a right to receive future
income, the Court applied the reasoning of the assignment of income doctrine, normally
applicable to a gratuitous assignment, and held that the consideration received by the
taxpayer-corporation was taxable as ordinary income since it essentially was a substitute
for that which would otherwise be received at a future time as ordinary income.
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Turning to the facts of this case, we note that here there was the transfer of accounts
receivable from the partnership to the corporation pursuant to § 351. We view these
accounts receivable as a present right to receive future income. In consideration of the
transfer of this right, the members of the partnership received stock – a valid consideration.
The consideration, therefore, was essentially a substitute for that which would otherwise
be received at a future time as ordinary income to the cash basis partnership. Consequently,
the holding in Lake would normally apply, and income would ordinarily be realized, and
thereby taxable, by the cash basis partnership-transferor at the time of receipt of the stock.
But the terms and purpose of § 351 have to be reckoned with. By its explicit terms § 351
expresses the Congressional intent that transfers of property for stock or securities will not
result in recognition. It therefore becomes apparent that this case vividly illustrates how §
351 sometimes comes into conflict with another provision of the Internal Revenue Code
or a judicial doctrine, [footnote omitted] and requires a determination of which of two
conflicting doctrines will control.
As we must, when we try to reconcile conflicting doctrines in the revenue law, we
endeavor to ascertain a controlling Congressional mandate. Section 351 has been
described as a deliberate attempt by Congress to facilitate the incorporation of ongoing
businesses and to eliminate any technical constructions which are economically unsound.
[footnote omitted].
Appellant-taxpayer seems to recognize this and argues that application of the Lake
rationale when accounts receivable are transferred would not create any undue hardship to
an incorporating taxpayer. ‘All a taxpayer (transferor) need do is withhold the earned
income items and collect them, transferring the net proceeds to the Corporation. Indeed ...
the transferor should retain both accounts receivable and accounts payable to avoid income
recognition at the time of transfer and to have sufficient funds with which to pay accounts
payable. Where the taxpayer (transferor) is on the cash method of accounting (as here),
the deduction of the accounts payable would be applied against the income generated by
the accounts receivable.’
While we cannot fault the general principle ‘that income be taxed to him who earns it,’ to
adopt taxpayer’s argument would be to hamper the incorporation of ongoing businesses;
additionally it would impose technical constructions which are economically and
practically unsound. None of the cases cited by taxpayer, including Lake itself, persuades
us otherwise. In Lake the Court was required to decide whether the proceeds from the
assignment of the oil payment right were taxable as ordinary income or as long term capital
gains. Observing that the provision for long term capital gains treatment ‘has always been
narrowly construed so as to protect the revenue against artful devices,’ 356 U.S. at 265,
the Court predicated its holding upon an emphatic distinction between a conversion of a
capital investment – ‘income-producing property’ – and an assignment of income per se.
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‘The substance of what was assigned was the right to receive future income. The substance
of what was received was the present value of income which the recipient would otherwise
obtain in the future.’ Ibid., at 266. A § 351 issue was not presented in Lake. Therefore the
case does not control in weighing the conflict between the general rule of assignment of
income and the Congressional purpose of nonrecognition upon the incorporation of an
ongoing business. [footnote omitted].
We are persuaded that, on balance, the teachings of Lake must give way in this case to the
broad Congressional interest in facilitating the incorporation of ongoing businesses. As
desirable as it is to afford symmetry in revenue law, we do not intend to promulgate a hard
and fast rule. [footnote omitted]. We believe that the problems posed by the clash of
conflicting internal revenue doctrines are more properly determined by the circumstances
of each case. Here we are influenced by the fact that the subject of the assignment was
accounts receivable for partnership’s goods and services sold in the regular course of
business, that the change of business form from partnership to corporation had a basic
business purpose and was not designed for the purpose of deliberate tax avoidance, and by
the conviction that the totality of circumstances here presented fit the mold of the
Congressional intent to give nonrecognition to a transfer of a total business from a
noncorporate to a corporate form.
But this too must be said. Even though § 351(a) immunizes the transferor from immediate
tax consequences, § 358 [footnote omitted] retains for the transferors a potential income
tax liability to be realized and recognized upon a subsequent sale or exchange of the stock
certificates received. As to the transferee-corporation, the tax basis of the receivables will
be governed by § 362. [footnote omitted]
….
... [T]he judgment of the district court will be affirmed.

Questions and comments:
1. Why was the corporate taxpayer in the relatively unusual position of arguing that what
shareholders had transferred to the corporation was not property within § 351?
2. The case is authority for the position that accounts receivable are “property” for
purposes of § 351(a). This creates problems for individuals and partnerships who keep
their accounts on the cash method if they incorporate and become accrual method
taxpayers. As in Hempt, a big tax bill may come due at once.
•How can taxpayers prevent this from happening?

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3. The case involves accounts receivable transferred to an accrual method corporation.
Consider what problems arise if the transfer of an existing business is made to a cash
method corporation?

Rev. Rul. 80-198, 1980-2 C.B. 113
ISSUE
Under the circumstances described below, do the nonrecognition of gain or loss provisions
of § 351 of the Internal Revenue Code apply to a transfer of the operating assets of an
ongoing sole proprietorship (including unrealized accounts receivable) to a corporation in
exchange solely for the common stock of a corporation and the assumption by the
corporation of the proprietorship liabilities?
FACTS
Individual A conducted a medical practice as a sole proprietorship, the income of which
was reported on the cash receipts and disbursements method of accounting. A transferred
to a newly organized corporation all of the operating assets of the sole proprietorship in
exchange for all of the stock of the corporation, plus the assumption by the corporation of
all of the liabilities of the sole proprietorship. The purpose of the incorporation was to
provide a form of business organization that would be more conducive to the planned
expansion of the medical services to be made available by the business enterprise.
The assets transferred were tangible assets having a fair market value of $40,000 and an
adjusted basis of $30,000 and unrealized trade accounts receivable having a face amount
of $20,000 and an adjusted basis of zero. The liabilities assumed by the corporation
consisted of trade accounts payable in the face amount of $10,000. The liabilities assumed
by the corporation also included a mortgage liability, related to the tangible property
transferred, of $10,000. A had neither accumulated the accounts receivable nor prepaid
any of the liabilities of the sole proprietorship in a manner inconsistent with normal
business practices in anticipation of the incorporation. If A had paid the trade accounts
payable liabilities, the amounts paid would have been deductible by A as ordinary and
necessary business expenses under § 162 of the Code. The new corporation continued to
utilize the cash receipts and disbursements method of accounting.
LAW AND ANALYSIS
The applicable section of the Code is § 351(a), which provides that no gain or loss shall
be recognized when property is transferred to a corporation in exchange solely for stock
and securities and the transferor is in control (as defined by § 368(c)) of the transferee
corporation immediately after the transfer.
In Hempt Bros., Inc. v. United States, 490 F.2d 1172 (3d Cir. 1974), cert. denied, 419 U.S.
826 (1974), the United States Court of Appeals for the Third Circuit held … that a cash
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basis transferee corporation was taxable on the monies it collected on accounts receivable
that had been transferred to it by a cash basis partnership in a transaction described in §
351(a) of the Code. The corporate taxpayer contended that it was not obligated to include
the accounts receivable in income; rather the transferor partnership should have been taxed
on the stock the partnership received under the assignment of income doctrine which is
predicated on the well established general principle that income be taxed to the party that
earned it.
The court in Hempt Bros. solved the conflict between the assignment of income doctrine
and the statutory nonrecognition provisions of § 351 of the Code by reasoning that if the
cash basis transferor were taxed on the transfer of the accounts receivable, the specific
congressional intent reflected in § 351(a) that the incorporation of an ongoing business
should be facilitated by making the incorporation tax free would be frustrated.
The facts of the instant case are similar to those in Hempt Bros. in that there was a valid
business purpose for the transfer of the accounts receivable along with all of the assets and
liabilities of A’s proprietorship to a corporate transferee that would continue the business
of the transferor. Further, A had neither accumulated the accounts receivable nor prepaid
any of the account payable liabilities of the sole proprietorship in anticipation of the
incorporation, which is an indication that, under the facts and circumstances of the case,
the transaction was not designed for tax avoidance.
HOLDING
The transfer by A of the operating assets of the sole proprietorship (including unrealized
accounts receivable) to the corporation in exchange solely for the common stock of the
corporation and the assumption by the corporation of the proprietorship liabilities
(including accounts payable) is an exchange within the meaning of § 351(a) of the Code.
Therefore, no gain or loss is recognized to A with respect to the property transferred,
including the accounts receivable. ... [T]he assumption of the trade accounts payable that
would give rise to a deduction if A had paid them is not, pursuant to § 357(c)(3),
considered as an assumption of a liability for purposes of §§ 357(c)(1) and 358(d). [citation
omitted]. The corporation, under the cash receipts and disbursements method of
accounting, will report in its income the account receivables as collected, and will be
allowed deductions under § 162 for the payments it makes to satisfy the assumed trade
accounts payable when such payments are made.
A’s basis in the stock received in the exchange of property for stock under § 358(a)(1) of
the Code is $20,000 which is calculated by decreasing A’s $30,000 basis in the assets
transferred by the $10,000 mortgage liability under §§ 358(a)(1)(A)(ii) and 358(d)(1). No
adjustment to such basis is made under § 358(a)(1)(A)(ii) because of the assumption by
the corporation of the $10,000 in accounts payable inasmuch as the general rule of §
358(d)(1), which requires the basis in the stock received to be decreased by the liabilities
assumed, does not apply by reason of § 358(d)(2), which provides that § 358(d)(1) does
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not apply to the amount of any liabilities defined in § 357(c)(3) such as accounts payable
that would have been deductible by A as ordinary and necessary business expenses under
§ 162 in the taxable year paid if A had paid these liabilities prior to the exchange. [citation
omitted].
LIMITATIONS
Section 351 of the Code does not apply to a transfer of accounts receivable which
constitute an assignment of an income right in a case such as Brown v. Commissioner, 40
B.T.A. 565 (1939), aff’d 115 F.2d 337 (2d Cir. 1940). In Brown, an attorney transferred to
a corporation, in which he was the sole owner, a one-half interest in a claim for legal
services performed by the attorney and his law partner. In exchange, the attorney received
additional stock of the corporation. The claim represented the corporation’s only asset.
Subsequent to the receipt by the corporation of the proceeds of the claim, the attorney gave
all of the stock of the corporation to his wife. The United States Court of Appeals for the
Second Circuit found that the transfer of the claim for the fee to the corporation had no
purpose other than to avoid taxes and held that in such a case the intervention of the
corporation would not prevent the attorney from being liable for the tax on the income
which resulted from services under the assignment of income rule of Lucas v. Earl, 281
U.S. 111 (1930). Accordingly, in a case of a transfer to a controlled corporation of an
account receivable in respect of services rendered where there is a tax avoidance purpose
for the transaction (which might be evidenced by the corporation not conducting an
ongoing business), the Internal Revenue Service will continue to apply assignment of
income principles and require that the transferor of such a receivable include it in income
when received by the transferee corporation.
Likewise, it may be appropriate in certain situations to allocate income, deductions,
credits, or allowances to the transferor or transferee under § 482 of the Code when the
timing of the incorporation improperly separates income from related expenses. See
Rooney v. United States, 305 F.2d 681 (9th Cir. 1962), where a farming operation was
incorporated in a transaction described in § 351(a) after the expenses of the crop had been
incurred but before the crop had been sold and income realized. The transferor’s tax return
contained all of the expenses but none of the farming income to which the expenses related.
The United States Court of Appeals for the Ninth Circuit held that the expenses could be
allocated under § 482 to the corporation, to be matched with the income to which the
expenses related. Similar adjustments may be appropriate where some assets, liabilities,
or both, are retained by the transferor and such retention results in the income of the
transferor, transferee, or both, not being clearly reflected.

Questions and comments:
1. In the Revenue Act of 1978, P.L. 95-600, § 365(a), (c), Congress added § 357(c)(3) to
the Code. Prior to that time, the courts had adopted contradictory positions that were
111

gravitating towards the rule of § 357(c)(3). Compare Raich v. Comm’r, 46 T.C. 604, 60811
(1966) (accounts receivable have zero basis; tax on excess of liabilities over basis even
though accounts receivable exceed accounts payable) with Focht v. Comm’r, 68 T.C. 223,
229 (1977), acq. 19802 C.B. 1 (“An obligation should not be treated as a liability, under
sections 357 and 358, to the extent that its payment would have been deductible if made
by the transferor;” “the term ‘liability’ [§§ 357(a) and 357(c)] should be limited to those
obligations that, if transferred, cause gain recognition”).
2. Articulate the rules of Brown and Rooney.
3. Read § 482.

VII. Contributions to Capital
How should the Code treat a transfer of capital to a corporation that does not occur in the
context of a § 351 exchange? The question has implications to both the transferor (who
may or may not be a shareholder) and to the transferee corporation.

Commissioner v. Fink, 483 U.S. 89 (1987)
Justice POWELL delivered the opinion of the Court.
The question in this case is whether a dominant shareholder who voluntarily surrenders a
portion of his shares to the corporation, but retains control, may immediately deduct from
taxable income his basis in the surrendered shares.
I
Respondents Peter and Karla Fink were the principal shareholders of Travco Corporation,
a Michigan manufacturer of motor homes. Travco had one class of common stock
outstanding and no preferred stock. Mr. Fink owned 52.2 percent, and Mrs. Fink 20.3
percent, of the outstanding shares.36 Travco urgently needed new capital as a result of
financial difficulties it encountered in the mid-1970's. The Finks voluntarily surrendered
some of their shares to Travco in an effort to “increase the attractiveness of the corporation
to outside investors.” Mr. Fink surrendered 116,146 shares in December 1976; Mrs. Fink
surrendered 80,000 shares in January 1977. As a result, the Finks’ combined percentage
ownership of Travco was reduced from 72.5 percent to 68.5 percent. The Finks received

36 In addition, Mr. Fink’s sister owned 10 percent of the stock, his brother-in-law owned 4.1 percent, and his

mother owned 2.2 percent.

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no consideration for the surrendered shares, and no other shareholder surrendered any
stock. The effort to attract new investors was unsuccessful, and the corporation eventually
was liquidated.
On their 1976 and 1977 joint federal income tax returns, the Finks claimed ordinary loss
deductions totaling $389,040, the full amount of their adjusted basis in the surrendered
shares. [footnote omitted]. The Commissioner of Internal Revenue disallowed the
deductions. He concluded that the stock surrendered was a contribution to the
corporation’s capital. Accordingly, the Commissioner determined that the surrender
resulted in no immediate tax consequences, and that the Finks’ basis in the surrendered
shares should be added to the basis of their remaining shares of Travco stock.
In an unpublished opinion, the Tax Court sustained the Commissioner’s determination for
the reasons stated in Frantz v. Commissioner, 83 T.C. 162, 174-182 (1984), aff’d, 784 F.2d
119 (CA2 1986), cert. [denied, 483 U.S.1019 (1987)]. In Frantz the Tax Court held that a
stockholder’s non pro rata surrender of shares to the corporation does not produce an
immediate loss. The court reasoned that “[t]his conclusion ... necessarily follows from a
recognition of the purpose of the transfer, that is, to bolster the financial position of [the
corporation] and, hence, to protect and make more valuable [the stockholder’s] retained
shares.” Because the purpose of the shareholder’s surrender is “to decrease or avoid a loss
on his overall investment,” the Tax Court in Frantz was “unable to conclude that [he]
sustained a loss at the time of the transaction.” “Whether [the shareholder] would sustain
a loss, and if so, the amount thereof, could only be determined when he subsequently
disposed of the stock that the surrender was intended to protect and make more valuable.”
The Tax Court recognized that it had sustained the taxpayer’s position in a series of prior
cases. [footnote omitted]. But it concluded that these decisions were incorrect, in part
because they “encourage[d] a conversion of eventual capital losses into immediate
ordinary losses.”37
In this case, a divided panel of the Court of Appeals for the Sixth Circuit reversed the Tax
Court. 789 F.2d 427 (1986). The court concluded that the proper tax treatment of this type
of stock surrender turns on the choice between “unitary” and “fragmented” views of stock
ownership. Under the “fragmented view,” “each share of stock is considered a separate
investment,” and gain or loss is computed separately on the sale or other disposition of
each share. According to the “unitary view,” “the ‘stockholder’s entire investment is
viewed as a single indivisible property unit,’” and a sale or disposition of some of the
stockholder’s shares only produces “an ascertainable gain or loss when the stockholder
has disposed of his remaining shares.” The court observed that both it and the Tax Court
generally had adhered to the fragmented view, and concluded that “the facts of the instant
case [do not] present sufficient justification for abandoning” it. It therefore held that the
37 The Court of Appeals for the Second Circuit affirmed the Tax Court’s holding and agreed with its reasoning.

Frantz v. Commissioner, 784 F.2d 119, 123-126 (1986), cert. pending.

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Finks were entitled to deduct their basis in the surrendered shares immediately as an
ordinary loss, except to the extent that the surrender had increased the value of their
remaining shares. The Court of Appeals remanded the case to the Tax Court for a
determination of the increase, if any, in the value of the Finks’ remaining shares that was
attributable to the surrender.
Judge Joiner dissented. Because the taxpayers’ “sole motivation in disposing of certain
shares is to benefit the other shares they hold [,] ... [v]iewing the surrender of each share
as the termination of an individual investment ignores the very reason for the surrender.”
He concluded: “Particularly in cases such as this, where the diminution in the
shareholder’s corporate control and equity interest is so minute as to be illusory, the stock
surrender should be regarded as a contribution to capital.”
We granted certiorari to resolve a conflict among the Circuits, [footnote omitted] and now
reverse.
II
A
It is settled that a shareholder’s voluntary contribution to the capital of the corporation has
no immediate tax consequences. 26 U.S.C. § 263; 26 CFR § 1.263(a)-2(f) (1986). Instead,
the shareholder is entitled to increase the basis of his shares by the amount of his basis in
the property transferred to the corporation. See 26 U.S.C. § 1016(a)(1). When the
shareholder later disposes of his shares, his contribution is reflected as a smaller taxable
gain or a larger deductible loss. This rule applies not only to transfers of cash or tangible
property, but also to a shareholder’s forgiveness of a debt owed to him by the corporation.
26 CFR § 1.61-12(a) (1986). Such transfers are treated as contributions to capital even if
the other shareholders make proportionately smaller contributions, or no contribution at
all. See, e.g., Sackstein v. Commissioner, 14 T.C. 566, 569 (1950). The rules governing
contributions to capital reflect the general principle that a shareholder may not claim an
immediate loss for outlays made to benefit the corporation. Deputy v. Du Pont, 308 U.S.
488 (1940); Eskimo Pie Corp. v. Commissioner, 4 T.C. 669, 676 (1945), aff’d, 153 F.2d
301 (CA3 1946). We must decide whether this principle also applies to a controlling
shareholder’s non pro rata surrender of a portion of his shares.38

38 The Finks concede that a pro rata stock surrender, which by definition does not change the percentage

ownership of any shareholder, is not a taxable event. Cf. Eisner v. Macomber, 252 U.S. 189 (1920) (pro rata
stock dividend does not produce taxable income).

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B
The Finks contend that they sustained an immediate loss upon surrendering some of their
shares to the corporation. By parting with the shares, they gave up an ownership interest
entitling them to future dividends, future capital appreciation, assets in the event of
liquidation, and voting rights. 39 Therefore, the Finks contend, they are entitled to an
immediate deduction. See 26 U.S.C. §§ 165(a) and (c)(2). In addition, the Finks argue that
any non pro rata stock transaction “give[s] rise to immediate tax results.” For example, a
non pro rata stock dividend produces income because it increases the recipient’s
proportionate ownership of the corporation. Koshland v. Helvering, 298 U.S. 441 (1936).40
By analogy, the Finks argue that a non pro rata surrender of shares should be recognized
as an immediate loss because it reduces the surrendering shareholder’s proportionate
ownership.
Finally, the Finks contend that their stock surrenders were not contributions to the
corporation’s capital. They note that a typical contribution to capital, unlike a non pro rata
stock surrender, has no effect on the contributing shareholder’s proportionate interest in
the corporation. Moreover, the Finks argue, a contribution of cash or other property
increases the net worth of the corporation. For example, a shareholder’s forgiveness of a
debt owed to him by the corporation decreases the corporation’s liabilities. In contrast,
when a shareholder surrenders shares of the corporation’s own stock, the corporation’s net
worth is unchanged. This is because the corporation cannot itself exercise the right to vote,
receive dividends, or receive a share of assets in the event of liquidation. G. JOHNSON & J.
GENTRY, FINNEY AND MILLER’S PRINCIPLES OF ACCOUNTING 538 (7th ed. 1974). [footnote
omitted].
III
A shareholder who surrenders a portion of his shares to the corporation has parted with an
asset, but that alone does not entitle him to an immediate deduction. Indeed, if the
shareholder owns less than 100 percent of the corporation’s shares, any non pro rata
contribution to the corporation’s capital will reduce the net worth of the contributing
shareholder.41 A shareholder who surrenders stock thus is similar to one who forgives or
39 As a practical matter, however, the Finks did not give up a great deal. Their percentage interest in the

corporation declined by only 4 percent. Because the Finks retained a majority interest, this reduction in their
voting power was inconsequential. Moreover, Travco, like many corporations in financial difficulties, was not
paying dividends.
40 In most cases, however, stock dividends are not recognized as income until the shares are sold. See 26 U.S.C. §

305.
41 For example, assume that a shareholder holding an 80 percent interest in a corporation with a total liquidation

value of $100,000 makes a non pro rata contribution to the corporation’s capital of $20,000 in cash. Assume
further that the shareholder has no other assets. Prior to the contribution, the shareholder’s net worth was
$100,000 ($20,000 plus 80 percent of $100,000). If the corporation were immediately liquidated following the

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surrenders a debt owed to him by the corporation; the latter gives up interest, principal,
and also potential voting power in the event of insolvency or bankruptcy. But, as stated
above, such forgiveness of corporate debt is treated as a contribution to capital rather than
a current deduction. The Finks’ voluntary surrender of shares, like a shareholder’s
voluntary forgiveness of debt owed by the corporation, closely resembles an investment
or contribution to capital. See B. BITTKER & J. EUSTICE, FEDERAL INCOME TAXATION OF
CORPORATIONS AND SHAREHOLDERS § 3.14, p. 3-59 (4th ed. 1979) (“If the contribution is
voluntary, it does not produce gain or loss to the shareholder”). We find the similarity
convincing in this case.
The fact that a stock surrender is not recorded as a contribution to capital on the
corporation’s balance sheet does not compel a different result. Shareholders who forgive
a debt owed by the corporation or pay a corporate expense also are denied an immediate
deduction, even though neither of these transactions is a contribution to capital in the
accounting sense. [footnote omitted]. Nor are we persuaded by the fact that a stock
surrender, unlike a typical contribution to capital, reduces the shareholder’s proportionate
interest in the corporation. This Court has never held that every change in a shareholder’s
percentage ownership has immediate tax consequences. Of course, a shareholder’s receipt
of property from the corporation generally is a taxable event. See 26 U.S.C. §§ 301, 316.
In contrast, a shareholder’s transfer of property to the corporation usually has no
immediate tax consequences. § 263.
The Finks concede that the purpose of their stock surrender was to protect or increase the
value of their investment in the corporation.42 They hoped to encourage new investors to
provide needed capital and in the long run recover the value of the surrendered shares
through increased dividends or appreciation in the value of their remaining shares. If the
surrender had achieved its purpose, the Finks would not have suffered an economic loss.
See Johnson, Tax Models for Nonprorata Shareholder Contributions, 3 VA. TAX. REV. 81,
104-108 (1983). In this case, as in many cases involving closely held corporations whose
shares are not traded on an open market, there is no reliable method of determining whether
the surrender will result in a loss until the shareholder disposes of his remaining shares.
Thus, the Finks’ stock surrender does not meet the requirement that an immediately
deductible loss must be “actually sustained during the taxable year.” 26 CFR § 1.165-1(b)
(1986).
Finally, treating stock surrenders as ordinary losses might encourage shareholders in
failing corporations to convert potential capital losses to ordinary losses by voluntarily

contribution, the shareholder would receive only $96,000 (80 percent of $120,000). Of course such a non pro
rata contribution is rare in practice. Typically a shareholder will simply purchase additional shares.
42 Indeed, if the Finks did not make this concession their surrender probably would be treated as a nondeductible

gift. See 26 CFR § 25.2511-1(h)(1) (1986).

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surrendering their shares before the corporation fails. In this way shareholders might avoid
the consequences of 26 U.S.C. § 165(g)(1), which provides for capital-loss treatment of
stock that becomes worthless. [footnote omitted]. Similarly, shareholders may be
encouraged to transfer corporate stock rather than other property to the corporation in order
to realize a current loss. [footnote omitted].
We therefore hold that a dominant shareholder who voluntarily surrenders a portion of his
shares to the corporation, but retains control, does not sustain an immediate loss deductible
from taxable income. Rather, the surrendering shareholder must reallocate his basis in the
surrendered shares to the shares he retains. 43 The shareholder’s loss, if any, will be
recognized when he disposes of his remaining shares. A reallocation of basis is consistent
with the general principle that “[p]ayments made by a stockholder of a corporation for the
purpose of protecting his interest therein must be regarded as [an] additional cost of his
stock,” and so cannot be deducted immediately. Eskimo Pie Corp. v. Commissioner, 4
T.C., at 676. Our holding today is not inconsistent with the settled rule that the gain or loss
on the sale or disposition of shares of stock equals the difference between the amount
realized in the sale or disposition and the shareholder’s basis in the particular shares sold
or exchanged. See 26 U.S.C. § 1001(a); 26 CFR § 1.10121(c)(1) (1986). We conclude only
that a controlling shareholder’s voluntary surrender of shares, like contributions of other
forms of property to the corporation, is not an appropriate occasion for the recognition of
gain or loss.
IV
For the reasons we have stated, the judgment of the Court of Appeals for the Sixth Circuit
is reversed.
It is so ordered.
Justice BLACKMUN concurs in the result.
Justice WHITE, concurring [omitted].
Justice SCALIA, concurring [omitted].
Justice STEVENS, dissenting [omitted].
43 The Finks remained the controlling shareholders after their surrender. We therefore have no occasion to

decide in this case whether a surrender that causes the shareholder to lose control of the corporation is
immediately deductible. In related contexts, the Code distinguishes between minimal reductions in a
shareholder’s ownership percentage and loss of corporate control. See § 302(b)(2) (providing “exchange” rather
than dividend treatment for a “substantially disproportionate redemption of stock” that brings the shareholder’s
ownership percentage below 50 percent); § 302(b)(3) (providing similar treatment when the redemption
terminates the shareholder’s interest in the corporation).
In this case we use the term “control” to mean ownership of more than half of a corporation’s voting shares.
We recognize, of course, that in larger corporations – especially those whose shares are listed on a national
exchange – a person or entity may exercise control in fact while owning less than a majority of the voting shares.
See Securities Exchange Act of 1934, § 13(d), 48 Stat. 894, 15 U.S.C. § 78m(d) (requiring persons to report
acquisition of more than 5 percent of a registered equity security).

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Questions and comments:
1. Describe the calculations that CA6’s holding in this case would require anytime a
shareholder surrenders shares of stock to a corporation. Is your description an argument in
favor of the Supreme Court’s holding?
2. Part IIA of the Court’s opinion provides a statement of the tax rules governing any
contribution of a shareholder to the capital of a corporation. Learn and understand these
rules.
3. What was it that the Finks were trying to accomplish by surrendering some shares of
common stock to the corporation?
•There’s more to the story than is revealed in our edited version of the case. A
lender told the corporation to raise $900,000 of new capital – $700,000 in equity
and $200,000 in subordinated debt. The corporation decided to raise the new equity
by issuing 700,000 shares of $1 par preferred stock convertible into 1,400,000
shares of common stock. Obviously the conversion ratio was 2:1.
•The shareholders felt that it would be easier to find an angel if the corporation
could promise control of the corporation to an investor. Hence, it would be
necessary to have outstanding fewer than 1,400,000 shares of common stock.
Taxpayers hit on the idea of transferring back to the corporation the shares
involved in this case.
•Query: why not simply increase the conversion ratio?
•When no outside investor was forthcoming, the surrendering shareholders
purchased the newly issued convertible preferred stock.
4. What if the surrender of stock in Fink had caused taxpayers to lose control of the
corporation? Would that justify a conclusion that an immediate loss had occurred? In the
last footnote of our edited version of the case, the Court made clear that it was not
answering this question – nor did it “suggest” an answer.
5. The Court adopted the unitary view of stock ownership in the context of a dominant
shareholder.
6. For the shareholder, a voluntary contribution to the capital of the corporation has no
immediate tax consequences. Instead, the basis of what the shareholder contributes is
added to shareholder’s basis in his stock in the corporation.
7. Section 118(a) provides that a corporation’s gross income does not include “any”
contribution to its capital. The basis of property that the corporation receives from a
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shareholder as a contribution to capital carries over from the one who contributed it. §
362(a)(2). However, § 118(b) excepts from this provision contributions in aid of
construction or a contribution as a customer or potential customer. Such “contributions”
are too much like consideration for an exchange with the corporation. It also excepts “any
contribution by any governmental entity or civic group (other than a contribution made by
a shareholder as such.”
•Payments from government entities to induce corporations to locate facilities
within a particular jurisdiction may no longer be excluded from a corporation’s
gross income.
8. Contributions to the capital of a corporation by nonshareholders are not included in the
income of the corporation under § 118(a)(1). But under § 362(c)(1), the corporation’s basis
in noncash property contributed by a nonshareholder is $0. Moreover, the adjusted basis
of any property acquired by the corporation within 12 months after a nonshareholder’s
contribution of money must be reduced by the amount of that money, and any excess must
be used to reduce the basis of other property held by the corporation on the last day of the
12-month period in accord with regulations prescribed by the Secretary of the Treasury. §
362(c). Why should nonshareholder contributions be given such unfavorable treatment to
the corporation as compared with shareholder contributions?
•contributions by shareholders are essentially treated as payments for additional
stock.
•in the case of nonshareholders, their contributions are accessions to the
corporation’s wealth, but the corporation’s recognition of the gain is delayed by
reducing the basis of assets acquired or already owned by the corporation.

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Chapter 3: Dividends
Read IRC §§ 301, 311, 312, 316, 317.
Introductory Note: Ownership of stock entitles a shareholder to, among other things,
receive dividends from the corporation. How and when corporations may distribute
dividends is a matter of state corporate law. The legal tax issues arising in this context
mainly involve identification of distributions that constitute the payment of dividends.44
In this chapter, we identify the tax consequences of a corporation’s payment of dividends
and the shareholder’s receipt of dividends.
We have assumed that our corporations are profitable and that shareholders want a share
of those profits. A dividend is some portion of a corporation’s after-tax profit that it
distributes to its shareholders. The distribution must be comprised of “property.” § 316(a).
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).” § 317(a). 45 It does however include an obligation of the distributing
corporation. § 317(a).
A dividend distribution is one that a corporation makes to a shareholder “with respect to”
the shareholder’s stock. § 301(a). A distribution with respect to the shareholder’s stock
does not affect the shareholder’s ongoing interest in the corporation. It does not alter the
shareholder’s basis. The shareholder gives no consideration for the distribution.
Ownership of stock is the reason for the distribution – as opposed to a distribution because
the recipient transacts with the corporation in the capacity of employee, lender, seller,
lessor, or the like. Moreover, “[e]xcept as otherwise provided ..., every [corporate]
distribution is made out of earnings and profits to the extent thereof” and therefore
constitutes a dividend. § 316(a) (carryout ¶).
Recall that a corporation may not deduct a dividend distribution to its shareholder(s) from
its taxable income. Thus, the corporate income that upon distribution becomes a dividend
is subject to two levels of tax. At one time, an individual who received dividend income
was subject to the same rate of tax on that income as the tax on her wage income, i.e.,
ordinary rates. Now individual taxpayers pay the same rate of income tax on their

44 Section 301(a) makes the distribution of “dividends” a residual

distribution – i.e., “[e]xcept as otherwise
provided in this chapter, a distribution of property ... shall be treated in the manner provided in [§ 301(c)].” There
are, as we shall see, several places in “this chapter” that “otherwise provide,” e.g., redemptions, distributions in
liquidation of the corporation.
45 This does not mean that the Code might treat the distribution of a corporation’s own stock as if it were a

dividend. See § 305(b); chapter 5, infra.

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“qualified dividends” 46 that they pay on long-term capital gains, i.e., net capital gain. ” As
we have noted,47 this second level of income tax drove many taxpayers to characterize
distributions as something besides the payment of a dividend.
Income taxation of a shareholder’s dividend income requires that there be a distribution
from the corporation to the shareholder from its earnings. Otherwise, a distribution cannot
be a dividend. This naturally flows from the fact that a corporation is an entity separate
and apart from its shareholders.
As is well known, a corporation, except in a few instances, is an entity, distinct
from the stockholders. When it has earnings, the stockholders do not, by reason of
that fact, have income. When it segregates those earnings, even though such
earnings have accumulated in a surplus, and declares a dividend payable in money,
then the stockholder receives income; or if the corporation takes from its surplus,
assets and distributes them in kind to the stockholders, the latter derives income.
If the corporation keeps its earnings or profits and allows them to accumulate thus
building up a surplus, the surplus belongs to the corporation, not the stockholders,
and while the value of the stock may increase, the stockholders do not realize on
the profits until the surplus, or part thereof is distributed to them, or until they
dispose of their stock.
Sprouse v Commissioner, 122 F.2d 973, 976 (CA9 1941), aff’d, 318 US 604 (1943)
(footnotes omitted) (non-taxable stock dividend).
In this chapter, we first examine the capacity of a corporation to pay dividends – i.e., the
corporation’s “earnings and profits” (e&p). We then examine some instances of a
corporation’s payment of dividends by providing a benefit to a shareholder.48 Specifically,
corporations may permit shareholders to make personal use of corporate property, pay
shareholder’s personal obligations, or engage in bargain transactions with shareholders.
We consider the tax consequences both to the shareholder and to the corporation of
distributions of property to the shareholder. This includes consideration of how
46 Beginning in 2003, the income tax for individuals (and those who determine their income tax liability under § 1

of the Code) on their “qualified” dividend income was reduced to the rate applicable to their long-term capital
gain income. § 1(h)(11) (“net capital gain” includes “qualified dividend income”). P.L. 108-27, § 302(a). “Qualified
dividend income” includes dividends paid by domestic corporations. § 1(h)(11)(B)(i)(I). It also includes dividends
paid by “qualified foreign corporations,” § 1(h)(11)(B)(i)(II), i.e., a corporation incorporated in a U.S. possession,
a corporation entitled to the benefits of an income tax treaty, or a corporation whose stock is readily tradable on
an established U.S. securities market. § 1(h)(11)(C). The maximum income tax rate on “net capital gain” is now
20%. § 1(h)(1)(D). However, § 1(h)(11) does not change the character of dividend income – it is still “ordinary
income.” Thus, capital losses do not offset dividend income.
47

See Chapter 1, supra.

In chapter 1, we examined this topic in the context of payment of salaries to shareholders who are also
employees.

48

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distributions of money and property affect a corporation’s e&p. Finally, we examine the
Code’s treatment of a corporation’s receipt of dividends from another corporation in which
it owns stock.

I. A Corporation’s Earnings and Profits
Read Reg. § 1.316-2(a, b, c), § 312.
The Code implicitly assumes that at least some shareholders of a corporation purchased
stock from the corporation, and that the corporation used the proceeds of such sales to
purchase capital goods that enable it to make income. The money (or property)
shareholders exchanged for shares became the corporation’s “capital account,” for which
it separately accounts. The corporation then separately accounts for the profits it earns
from the use of such capital in what is variously called the corporation’s “surplus” account,
“profits” account, “earnings” account, or something similar.
Corporations pay dividends to their shareholders from their profits – not from their capital
accounts from which they purchase capital assets with money (or other property) that their
shareholders exchanged for shares or simply contributed. This dichotomy between capital
and profits is embedded in the Code. Section 61(a)(7) provides that “gross income”
includes dividends. A dividend is a distribution that a corporation makes to its shareholders
from the corporation’s retained earnings and profits (e&p). “[T]o render the stockholder
taxable, there must be both earnings made and a dividend paid. Neither earnings without
dividend nor a dividend without earnings subject the stockholder to taxation ...” Eisner v.
Macomber, 252 U.S. 189, 231-32 (1919) (Brandeis, J., dissenting).
Section 316(a) provides that a dividend is a corporation’s distribution of property to its
shareholder from its current earnings and profits (e&p) and from its accumulated e&p.
Neither the Code nor the regulations define “earnings and profits.” Hence, we must fill in
some blanks from certain information that we know. Section 312 names adjustments to a
corporation’s e&p that the corporation makes once it had established a starting figure.
Those adjustments manifest a corporation’s increasing or decreasing capacity to make
distributions to shareholders.
A corporation’s e&p do not necessarily reflect the corporation’s after-tax income, although
the computation of e&p should begin with that figure.
Although earnings and profits can be derived by adjustments to surplus, it is more
common to start with taxable income, and, to the extent that the Code and
regulations define “earnings and profits,” both ordinarily take taxable income as

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In Eisner v. Macomber, 252 U.S. 189
(1919) shareholder Macomber
owned shares of Standard Oil stock.
Standard
had
accumulated
substantial profits. Rather than
distribute those profits to its
shareholders, Standard declared a
one-for-two stock dividend. Its
purpose was to convert the surplus
(i.e., profits) to capital – presumably
reducing its profits account. The
distribution of dividends pro rata to
all shareholders would not change
the value of any shareholder’s
holding, and Standard Oil would not
have segregated any assets for any
shareholder’s separate use. Under
such circumstances, the United States
Supreme Court held that Macomber
had not realized any gross income
by receipt of such stock.
•The Code implicitly regards a
corporation’s assets as either capital
– i.e., assets that the corporation uses
to make profits – or as profits. A
corporation may issue stock to
convert its profits to capital, but the
Code does not recognize that the
corporation’s capacity to pay
dividends has been diminished by
such a transaction. Cf. § 312 (no
provision providing for adjustment to
corporation’s e&p account by such a
distribution).

the point of departure. BORIS I. BITTKER & JAMES
S. EUSTICE, FEDERAL INCOME TAXATION OF
CORPORATIONS AND SHAREHOLDERS ¶ 8.03[2] at
8-22 (Student ed. 2000). Earnings and profits of
the current year are reduced by federal income and
excess profits taxes for such year – for such money
is not available for distribution to shareholders.
Some transactions may have tax consequences
without affecting the corporation’s capacity to make
a distribution to its shareholders. On the other hand,
some transactions might not have tax consequences
and yet affect the corporation’s capacity to make a
distribution to its shareholders.
Section 312 reflects these points.
Corporations may, if they choose, not pay
dividends to shareholders but instead invest their
profits in more capital assets. Such an investment
does not affect the amount of the corporation’s
earnings – but of course it reduces its capacity to
make a distribution to shareholders. A
corporation’s e&p are not (necessarily) kept in a
separate and identifiable account. Rather they
reflect the corporation’s current and historical
profitability and its past distribution of dividends.
“[E]arnings and profits is an economic concept
that the tax law utilizes ‘to approximate a
corporation’s power to make distributions which
are more than just a return of investment.’” Estate
of Uris v. Commissioner, 605 F.2d 1258, 1265
(CA2 1979) (citation omitted). The tax
consequence of a distribution from earnings and
profits is governed by § 301(c). What rule(s) does
§ 301(c) state?

Section 316(a) contemplates that a U.S. corporation has two e&p accounts: (1) an
“accumulated” e&p account, and (2) a “current” e&p account, i.e., the corporation’s e&p
for the entire current tax year. The corporation is deemed to make distributions first from
current e&p to the extent thereof, and second from accumulated e&p to the extent thereof.

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Reg. § 1.316-2(a).49 At the close of a taxable year, a corporation adds its remaining current
e&p account to its accumulated e&p account.
A distribution from a corporation’s e&p quite naturally reduces the corporation’s e&p. §
312(a)(1). The definition of “current” and “accumulated” e&p creates questions of when
a reduction for a distribution(s) occurs and by how much. The following revenue ruling
illustrates some fundamental principles concerning the effect(s) of dividend distributions
on a corporation’s e&p.

Rev. Rul. 74-164, 1974-1 C.B. 74
X corporation and Y corporation each using the calendar year for Federal income tax
purposes made distributions of $15,000 to their respective shareholders on July 1, 1971,
and made no other distributions to their shareholders during the taxable year. The
distributions were taxable as provided by § 301(c) of the Internal Revenue Code of 1954.
Situation 1.
At the beginning of its taxable year 1971, X corporation had earnings and profits
accumulated after February 28, 1913, of $40,000. It had an operating loss for the period
January 1, 1971 through June 30, 1971, of $50,000 but had earnings and profits for the
entire year 1971 of $5,000.
Situation 2.
At the beginning of its taxable year 1971, Y corporation had a deficit in earnings and
profits accumulated after February 28, 1913, of $60,000. Its net profits for the period
January 1, 1971 through June 30, 1971, were $75,000 but its earnings and profits for the
entire taxable year 1971 were only $5,000.
Situation 3.
Assume the same facts as in Situation 1 except that X had a deficit in earnings and profits
of $5,000 for the entire taxable year 1971.
Situation 4.
Assume the same facts as in Situation 1 except that X had a deficit in earnings and profits
of $55,000 for the entire taxable year 1971.

49 ... and third to e&p accumulated before March 1, 1913, and fourth to other sources.

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Section 301(a) and 301(c) of the Code provides, in part, that: (1) the portion of a
distribution of property made by a corporation to a shareholder with respect to its stock
which is a dividend (as defined in § 316), shall be included in the shareholder’s gross
income; (2) the portion of the distribution which is not a dividend shall be applied against
and reduce the adjusted basis of the stock; and (3) the portion which is not a dividend to
the extent that it exceeds the adjusted basis of the stock and is not out of increase in value
accrued before March 1, 1913, shall be treated as gain from the sale or exchange of
property.
Section 316(a) of the Code provides that the term ‘dividend’ means any distribution of
property made by a corporation to its shareholders out of its earnings and profits
accumulated after February 28, 1913, or out of its earnings and profits of the taxable year
computed as of the close of the taxable year without diminution by reason of any
distribution made during the year, and without regard to the amount of earnings and profits
at the time the distribution was made.
Section 1.316-2(a) of the Income Tax Regulations provides, in part, that in determining
the source of a distribution, consideration should be given first, to the earnings and profits
of the taxable year; and second, to the earnings and profits accumulated since February
28, 1913, only in the case where, and to the extent that, the distributions made during the
taxable year are not regarded as out of the earnings and profits of that year.
Applying the foregoing principles, in Situation 1, the earnings and profits of X corporation
for the taxable year 1971 of $5,000 and the earnings and profits accumulated since
February 28, 1913, and prior to the taxable year 1971, of $40,000 were applicable to the
distribution paid by it on July 1, 1971. Thus, $5,000 of the distribution of $15,000 was
paid from the earnings and profits of the taxable year 1971 and the balance of $10,000 was
paid from the earnings and profits accumulated since February 28, 1913. Therefore, the
entire distribution of $15,000 was a dividend within the meaning of § 316 of the Code.
In Situation 2 the earnings and profits of Y corporation for the taxable year 1971 of $5,000
were applicable to the distribution paid by Y corporation on July 1, 1971. Y corporation
had no earnings and profits accumulated after February 28, 1913, available at the time of
the distribution. Thus, only $5,000 of the distribution by Y corporation of $15,000 was a
dividend within the meaning of § 316 of the Code. The balance of such distribution,
$10,000 which was not a dividend, applied against and reduced the adjusted basis of the
stock in the hands of the shareholders, and to the extent that it exceeded the adjusted basis
of the stock was gain from the sale or exchange of property.
In the case of a deficit in earnings and profits for the taxable year in which distributions
are made, the taxable status of distributions is dependent upon the amount of earnings and
profits accumulated since February 28, 1913, and available at the dates of distribution. In
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determining the amount of such earnings and profits, § 1.316-2(b) of the regulations
provides, in effect, that the deficit in earnings and profits of the taxable year will be
prorated to the dates of distribution.
Applying the foregoing to Situations 3 and 4 the distribution paid by X corporation on July
1, 1971, in each situation was a dividend within the meaning of § 316 of the Code to the
extent indicated as follows:
Situation #3
Accumulated Earnings and Profits: (E&P) 1/1

$40,000

E&P deficit for entire taxable year
($5,000) Prorate to date of distribution 7/1 (½ of $5,000)

(2,500)

E&P available 7/1

$37,500

Distribution 7/1 ($15,000)

(15,000) taxable as a dividend

E&P deficit from 7/1-12/31

(2,500)

Accumulated E&P balance 12/31

$20,000

Situation #4
Accumulated E&P 1/1

$40,000

E&P deficit for entire taxable year ($55,000)
Prorate to date of distribution 7/1 (½ of $55,000)

(27,500)

E&P available 7/1

$12,500

Distribution 7/1 ($15,000)

(12,500) taxable as a dividend

E&P deficit from 7/1 to 12/31

(27,500)

Accumulated E&P balance 12/31

($27,500)

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Why should there be two e&p accounts when a
corporation (obviously) must maintain profitability
to pay dividends? In the Revenue Act of 1936,
Congress responded to President Roosevelt’s
request to tax the undistributed earnings and
profits of corporations, deeming it unfair that
shareholders who received a dividend owed a
surtax on it whereas those who did not receive
dividends from profitable corporations in which
they owned shares did not owe a surtax. The
solution to this unfairness was to make
corporations subject to a surtax on “undistributed
net income.” “Undistributed net income” did not
include dividends that the corporation paid to its
shareholders. Corporations were given a
“dividend credit” for dividends that they paid.
Under the “undistributed net income” surtax, it was
possible for a corporation that had a deficit in its
accumulated earnings and profits account to be
profitable in the current year and owe a surtax.
So:
In order to enable corporations without
regard to deficits existing at the beginning
of the taxable year to obtain the benefit
of the dividends-paid credit for the
purposes of the undistributed-profits
surtax, § 115(a) changes the definition of
a dividend so as to include distributions out
of the earnings or profits of the current
taxable year. The amendment simplifies
the determination by providing that
distributions during the year, not
exceeding in amount the current earnings,
are dividends constituting taxable income
to the shareholder and a dividends paid
credit to the corporation. As respects such
dividends the complicated determination
of accumulated earnings or profits is
rendered unnecessary.
S. REP. NO. 2156 (74th Cong., 2d Sess., 1936),
reprinted at 1939-1 (part 2) C.B. 667, 689. The
“undistributed net income” tax lasted only from
1936 to 1939. The substance of old § 115(a)
lives on in § 316(a).

127

Questions and comments:
1. The IRS said: “In determining the
amount of such earnings and profits, §
1.316-2(b) of the regulations provides,
in effect, that the deficit in earnings and
profits of the taxable year will be
prorated to the dates of distribution.”
Read the last sentence of Reg. § 1.3162(b). Does it support the conclusion that
the IRS stated?
2. At the close of the current tax year,
the corporation’s e&p (which is no
longer “current”) is added to or
subtracted from its accumulated e&p.

Problems:
1. Pelican Corporation is a calendar
year taxpayer. At the beginning of year
1, it had an accumulated e&p of minus
$15,000. On September 15, its current
e&p was $35,000. On December 31, its
current e&p was $30,000. On
September 15, it distributed $35,000 to
Quigley, its only shareholder. Quigley’s
basis in her stock is $20,000.
•How much is Quigley’s dividend
income? What is the basis of Quigley’s
stock at the beginning of year 2? What
is Pelican Corporation’s accumulated
e&p at the beginning of year 2?
2. Same as #1, except that Pelican
Corporation waited until January 15 of
year 2, after it had closed its books on
year 1, and distributed $30,000 to
Quigley. For all of year 2, Pelican
Corporation’s current e&p was $0. How
does this affect your answers to
question 1, i.e., for year 1?

3. Maximart Corporation has four equal shareholders. It began the year with $10,000 of
accumulated e&p. For the current year, its current e&p is $0. On December 31 of the
current year, it distributed $3000 to each of its four shareholders. How much of the
distribution should be taxed as a dividend to each shareholder? What is Maximart’s
accumulated e&p at the start of the following year?
•Think: from what you know about e&p at this point, should it be possible for a
corporation to have a negative e&p – either accumulated or current?
•If so, should a corporation’s distribution be an occasion that can take the
corporation’s e&p – accumulated or current – negative? Why or why not?
•See Reg. § 1.316-1(a)(2) (“Where a corporation distributes property to its
shareholders …, the amount of the distribution which is a dividend to them may not
exceed the earnings and profits of the distributing corporation.”).
4. Pelican Corporation is a calendar-year taxpayer. It has one class of common stock
outstanding. At the beginning of this year, Pelican Corporation had $60,000 of
accumulated e&p. Pelican Corporation’s current e&p for this year is $40,000. On February
1, it distributed $30,000 to shareholder Quigley. On June 1, it distributed $30,000 to
shareholder Robin. On September 1, it distributed $30,000 to shareholder Saxon. On
December 1, it distributed $30,000 to shareholder Tilbury. How much dividend income
did each shareholder receive? Read Reg. § 1.316-2(a, b, c), especially Reg. § 1.316-2(c)
(Example).
•Suppose that shareholder Tilbury had sold her shares to Ursula on September 30.
Pelican Corporation pays Ursula $30,000 on December 1. How much dividend
income did Ursula receive?
5. Same as #4, except that Pelican also had one class of preferred stock outstanding. The
corporate charter provides that holders of preferred stock are to be paid a dividend of
$6/share before the corporation pays a dividend to holders of any other class of stock. On
December 31, Pelican Corporation paid Victoria – the only holder of Pelican preferred
stock – $6/share. Victoria owned 1000 shares of Pelican preferred. Other distributions
were made as in #4.
•How would this affect your answer to question 4. See Rev. Rul. 69-440, 1969-2
C.B. 46.

Do the CALI exercise:
Corporate Taxation: Distributions: Distributions of Cash by C Corporations.

128

II. Distributions “With Respect to [Shareholder’s] Stock”
To be a dividend, a corporation’s distribution must be “with respect to” the shareholder’s
stock. § 301(a). The distribution cannot be with respect to another relationship with the
corporation, e.g., employer/employee, buyer/seller, lender/borrower.
In Boulware v. United States, 552 U.S. 421 (2008), the United States Supreme Court refused
to define the contours of the phrase “with respect to stock.” There must be some “nexus
between the corporate distribution and stock ownership …” United States v. Boulware, 558
F.3d 971, 977 (CA9), cert. denied, 558 U.S. 1048 (2009). A corporation may distribute a
dividend without per se intending to do so. See, e.g., Honigman v. Commissioner, 466 F.2d
69, 73-74 (CA6 1972), infra. Similarly, “a distributee accused of criminal tax evasion may
claim return-of-capital treatment without producing evidence that either he or the
corporation intended a capital return when the distribution occurred.” Boulware v. United
States, 552 U.S. at 424. It is sufficient to show that the corporation lacked any e&p from
which to pay a dividend. Absent such e&p, there can be no tax evasion because there is no
income tax on a dividend to evade.

Problem:
1. Minimax Corporation (a calendar year taxpayer) has been profitable since its founding
yet has never paid its shareholders a dividend. Its accumulated e&p at the beginning of
this year was $40,000. Its current e&p for this year is $25,000. On December 31 of this
year it pays Jaymar, one of its four shareholders who works full-time for the corporation,
a year-end bonus of $10,000. How much of the payment should be taxed as a dividend to
Jaymar? See Reg. § 1.301-1(c).
•What effect would your answer have on the corporation’s e&p, either current or
accumulated?
•With “respect to” what was the bonus paid?

III. Disguised Dividends
A. Use of Corporate Property
Tanner v. Commissioner, 45 T.C.M. 1419 (1983), T.C. Memo 1983-230
WILES, Judge
Respondent determined deficiencies in petitioners’ 1977 and 1978 Federal income taxes
in the amounts of $522 and $517, respectively. After concessions, the issues for decision
are whether petitioners received constructive dividends from their personal use of
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automobiles owned by their closely held corporation and, if so, the amount of such
dividends.
Findings of Fact
….
At all relevant times, petitioners [Ray and Patricia Tanner] were minority shareholders in
Ray Tanner Motors, Inc. (hereinafter Tanner Motors or the corporation), an Arizona
corporation with a principal office in Phoenix, Arizona. The officers of Tanner Motors
include: Ray Tanner, Sr. [footnote omitted], President; petitioner, Ray Tanner, Jr., Vice
President; and George Wylie, Vice President. During the years in issue, it was the policy
of Tanner Motors to provide each officer with the use of new Volvo automobiles under a
personal car purchase plan for which documents of title and license registrations were held
in the name of the corporation. Between 1977 and 1978, petitioners obtained three
automobiles exclusively for personal use under this plan. Petitioners used each automobile
for approximately one year before obtaining a new model each spring. [footnote omitted].
Petitioners did not own any other vehicles during the years in issue and they did not
reimburse Tanner Motors for the personal use of these automobiles.
The cost to the corporation of providing these vehicles to petitioners was approximately
$500 per year which included maintenance expenses, licensing and registration fees, and
insurance premiums on each vehicle. Petitioners paid all gasoline costs. Each of the cars
was covered by the manufacturer’s warranty during the periods that petitioners used them,
and repair costs charged to the corporation were paid by the manufacturer. After each car
was driven approximately 6,000 miles, it was sold at a profit through the corporation’s
used car sales department. All such profit was included in the income of Tanner Motors.
In the notice of deficiency, respondent determined that the fair market value of petitioners’
personal use of Volvo automobiles owned by Tanner Motors constituted constructive
dividends in the amounts of $1,440 in each of 1977 and 1978. Accordingly, their taxable
income was increased by $1,440 in both 1977 and 1978, resulting in deficiencies in their
Federal income taxes of $522 and $517, respectively.
Opinion
The issue for decision is whether petitioners received constructive dividends from their
personal use of corporate automobiles and, if so, the amount of such dividends.
It is well settled that corporate expenditures, or the making available of corporate-owned
property to stockholders for their personal benefit, may constitute constructive dividends
taxable to those stockholders. Nicholls, North, Buse Co. v. Commissioner, 56 T.C. 1225,
1238 (1971); Challenge Manufacturing Co. v. Commissioner, 37 T.C. 650 (1962);
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American Properties, Inc. v. Commissioner, 28 T.C. 1100 (1957), aff’d, 262 F.2d 150 (9th
Cir. 1958). Under §§ 301 and 316, a dividend is any corporate distribution to its
shareholders out of earnings and profits. That the formalities of a dividend are lacking or
that the distribution is not recorded on the corporation books is of no consequence.
Silverstein v. Commissioner, 36 T.C. 438 (1961); Sachs v. Commissioner, 32 T.C. 815,
820 (1959), aff’d, 277 F.2d 879, 882 (8th Cir.), cert. denied, 364 U.S. 833 (1960). The
amount of a constructive dividend generally is equal to the fair market value of the benefits
conferred. Challenge Manufacturing Co. v. Commissioner, supra at 663; § 301(b)(1)(A).
The record in the instant case establishes that petitioners enjoyed, for their personal benefit,
the free use of Volvo automobiles owned by Tanner Motors. Petitioners have failed to
prove that Tanner Motors did not have earnings and profits for the years in issue in
amounts at least equal to the fair market value of the use of the Volvo automobiles. See §§
301(c) and 316(a). … [W]e uphold respondent’s determination that petitioners’ use of the
Volvo automobiles owned by Tanner Motors constituted constructive dividends for 1977
and 1978 in the amount of $1,440 per year. Welch v. Helvering, 290 U.S. 111 (1933); Rule
142(a), Tax Court Rules of Practice and Procedure.
To reflect the foregoing,
Decision will be entered for the respondent.

Questions and comments:
1. What issues would have been raised if taxpayers had argued that their use of the
automobiles was salary rather than dividend. The corporation could have deducted
payment of salary. See Gardner v. Comm’r, T.C. Memo. 1976-349, aff’d, 613 F.2d 160
(6th Cir. 1980) (taxpayer has burden of proving intent to provide automobile intended as
salary).
•Was it the policy of Tanner Motors to provide its employees with the use of new
Volvo automobiles?
2. There are many other devices by which corporations may try to get money to their
shareholders in a transaction on which either the shareholder or the corporation would pay
no income tax. Corporations may pay more than a reasonable salary, more than the fair
market value of property it purchases, more than the fair rental value of property that it
rents, etc. We considered these topics in chapter 1, supra.

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B. Corporate Payment of Personal Obligations
Sullivan v. United States, 363 F.2d 724 (8th Cir. 1966)
STEPHENSON, District Judge
This is an appeal by the taxpayer [footnote omitted] from the District Court’s judgment
denying recovery for that portion of his 1956 income taxes alleged to have been assessed
and collected wrongfully. The taxpayer made a timely claim for a refund. …
... [T]he taxpayer Sullivan purchased the assets of an automobile dealership in Blytheville,
Arkansas in 1941. He then formed a corporation to operate the dealership. The individual
who became resident manager of the dealership, Loy Eich, eventually acquired 120 shares
of the 300 shares of stock outstanding – the rest being owned by taxpayer Sullivan. When
Eich terminated his management of the dealership in February 1948, Sullivan purchased
his 120 shares of stock. Thereafter, in September, 1948, Frank Nelson became the resident
manager of the dealership under an arrangement which included an agreement permitting
Nelson to acquire up to forty (40) per cent of the stock and further providing for taxpayer’s
repurchase of said stock upon Nelson’s termination of his employment. After acquiring
approximately 38% of the corporation’s outstanding stock, Nelson announced his
intention to depart from his position in 1956 and offered to sell his stock to taxpayer
Sullivan. The corporation’s Board of Directors then authorized the redemption of Nelson’s
stock by the corporation.
The ultimate question before the District Court involved a determination of whether the
payment by the corporation in redemption of Nelson’s stock constituted a taxable
distribution to taxpayer Sullivan, the sole remaining stockholder of the corporation. The
District Court found that taxpayer Sullivan was unconditionally and primarily obligated to
purchase Nelson’s stock in 1956 and that said stock was purchased by the Corporation out
of profits distributable as a dividend and therefore held that the taxpayer constructively
received income equivalent to a dividend in the amount paid by the Corporation for said
stock, ($198,334.58). ...
... The District Court was justified in concluding that Sullivan was unconditionally
obligated to purchase Nelson’s stock. [footnote omitted].
At this juncture, the payment by the corporation to Nelson presents … [this] question[]:
… Was that payment in actuality a dividend and therefore includable in Sullivan’s gross
income under §§ 61(a)(7), 316(a) and 301(c)(1) of the Internal Revenue Code? … This
court has recognized that … [this] question[ is] … to be resolved as [a] fact issue[]. Idol
v. Commissioner of Internal Revenue, 319 F.2d 647 (8th Cir. 1963). If a finding is
supported by substantial evidence on the record as a whole and is not against or induced
by an erroneous view of the law, it will not be disturbed on appeal.
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When an individual shareholder receives an economic benefit through a diversion of
corporate earnings and profits, such a receipt may be taxed as a constructive dividend.
[footnote omitted]. This court set forth a criteria [sic criterion] for determining whether a
payment constitutes a constructive dividend in Sachs v. Commissioner of Internal
Revenue, 277 F.2d 879, 882-883 (8th Cir. 1960):
“The motive, or expressed intent of the corporation is not determinative, and
constructive dividends have been found contrary to the expressed intent of the
corporation. The courts, as arbiters of the true nature of corporate payments, have
consistently used as a standard the measure of receipt of economic benefit as the
proper occasion for taxation.” (footnote omitted).
…
The general net effect and the purpose of and circumstances surrounding the transaction
involved herein must be carefully scrutinized to ascertain whether Sullivan received a
taxable dividend. Prior to the transaction, Sullivan held approximately 62% of the shares
outstanding while Nelson owned the remaining shares. As previously discussed, Sullivan
was unconditionally obligated to purchase Nelson’s stock if it was offered to him for sale.
After the transaction was completed, the relevant facts were essentially as follows: (1)
Sullivan’s personal obligation had been discharged (2) Sullivan owned all of the
outstanding shares of stock of the corporation (3) the corporation’s assets were decreased
by the amount paid to Nelson for his stock (4) Nelson’s stock was held by the corporation
as treasury stock. It is true that in terms of the financial worth of Sullivan’s interest in the
corporation, it was the same after the transaction as it was before.50 The transaction still
resulted in an economic benefit to Sullivan, however, because he was relieved of his
personal obligation to purchase Nelson’s stock. [footnote omitted]. After careful
consideration this court concludes that there was no corporate business purpose or other
factor which justifies the taxpayer’s position that as to him the payment must be considered
a stock redemption and not the equivalent of a dividend. [footnote omitted]. On the facts
of this case, Sullivan received a taxable dividend as the result of the corporation’s purchase
of Nelson’s stock.
This court is aware that it is often difficult to distinguish true substance from mere form.
Tax law places some weight and significance on form and the choice of one alternative
rather than another for achieving a desired end is often critical and may be determinative

50 Prior to the transfer of Nelson’s stock Sullivan owned 186 shares of the 300 shares outstanding. His stock at

this time was worth approximately $323,597.00. After the transfer, his 186 shares were the only outstanding
stock of the corporation. Due to the corporate purchase of Nelson’s stock, however, the value of the taxpayer’s
shares remained at approximately $323,597.00.

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of the tax effect of a transaction. [footnote omitted]. The taxpayer has failed to establish
grounds for reversal. The judgment of the District Court is affirmed.

Questions and comments:
1. When persons form a closely-held corporation, it should not be too difficult for them
to anticipate that one or more of them might wish to sell her shares. Or a majority might
want to buy out the shares of one shareholder. Or a shareholder might die. Etc. There will
be situations where it is necessary for the other shareholders or for the corporation to buy
out the interest of that shareholder.
Life insurance can play a role. Remember: payment of life insurance premiums is not
deductible, but receipt of life insurance proceeds paid by reason of death is not included
in the beneficiary’s gross income. If life insurance is to play a role, who should own the
policy? Who should pay the premiums? Would it ever be possible for the life insurance
policy to outlast its usefulness, and if so, what should happen to the policy?
2. Consider the options that the following important revenue ruling present for corporate
planning.

Rev. Rul. 69-608, 1969-2 C.B. 42
... Where the stock of a corporation is held by a small group of people, it is often considered
necessary to the continuity of the corporation to have the individuals enter into agreements
among themselves to provide for the disposition of the stock of the corporation in the event
of the resignation, death, or incapacity of one of them. Such agreements are generally
reciprocal among the shareholders and usually provide that on the resignation, death, or
incapacity of one of the principal shareholders, the remaining shareholders will purchase
his stock. Frequently such agreements are assigned to the corporation by the remaining
shareholder and the corporation actually redeems its stock from the retiring shareholder.
Where a corporation redeems stock from a retiring shareholder, the fact that the
corporation in purchasing the shares satisfies the continuing shareholder’s executory
contractual obligation to purchase the redeemed shares does not result in a distribution to
the continuing shareholder provided that the continuing shareholder is not subject to an
existing primary and unconditional obligation to perform the contract and that the
corporation pays no more than fair market value for the stock redeemed.
On the other hand, if the continuing shareholder, at the time of the assignment to the
corporation of his contract to purchase the retiring shareholder’s stock, is subject to an
unconditional obligation to purchase the retiring shareholder’s stock, the satisfaction by
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the corporation of his obligation results in a constructive distribution to him. The
constructive distribution is taxable as a distribution under § 301 of the Internal Revenue
Code of 1954.
If the continuing shareholder assigns his stock purchase contract to the redeeming
corporation prior to the time when he incurs a primary and unconditional obligation to pay
for the shares of stock, no distribution to him will result. If, on the other hand, the
assignment takes place after the time when the continuing shareholder is so obligated, a
distribution to him will result. While a pre-existing obligation to perform in the future is a
necessary element in establishing a distribution in this type of case, it is not until the
obligor’s duty to perform becomes unconditional that it can be said a primary and
unconditional obligation arises.
The application of the above principles may be illustrated by the situations described
below.
Situation 1
A and B are unrelated individuals who own all of the outstanding stock of corporation X.
A and B enter into an agreement that provides in the event B leaves the employ of X, he
will sell his X stock to A at a price fixed by the agreement. The agreement provides that
within a specified number of days of B’s offer to sell, A will purchase at the price fixed
by the agreement all of the X stock owned by B. B terminates his employment and tenders
the X stock to A. Instead of purchasing the stock himself in accordance with the terms of
the agreement, A causes X to assume the contract and to redeem its stock held by B. In
this case, A had a primary and unconditional obligation to perform his contract with B at
the time the contract was assigned to X. Therefore, the redemption by X of its stock held
by B will result in a constructive distribution to A. See William J. and Georgia K. Sullivan
v. United States of America, 244 F. Supp. 605 (1965), aff’d, 363 F.2d 724 (1966),
certiorari denied, 387 U.S. 905 (1967).
Situation 2
A and B are unrelated individuals who own all of the outstanding stock of corporation X.
An agreement between them provides unconditionally that within ninety days of the death
of either A or B, the survivor will purchase the decedent’s stock of X from his estate.
Following the death of B, A causes X to assume the contract and redeem the stock from
B’s estate.
The assignment of the contract to X followed by the redemption by X of the stock owned
by B’s estate will result in a constructive distribution to A because immediately on the
death of B, A had a primary and unconditional obligation to perform the contract.
Situation 3
...
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Situation 4
A and B owned all of the outstanding stock of X corporation. A and B entered into a
contract under which, if B desired to sell his X stock, A agreed to purchase the stock or to
cause such stock to be purchased. If B chose to sell his X stock to any person other than
A, he could do so at any time. In accordance with the terms of the contract, A caused X to
redeem all of B’s stock in X.
At the time of the redemption, B was free to sell his stock to A or to any other person, and
A had no unconditional obligation to purchase the stock and no fixed liability to pay for
the stock. Accordingly, the redemption by X did not result in a constructive distribution to
A. See S.K. Ames, Inc., v. Commissioner, 46 B.T.A. 1020 (1942), acq., C.B. 1942-1, 1.
Situation 5
A. and B owned all of the outstanding stock of X corporation. An agreement between A
and B provided that upon the death of either, X will redeem all of the X stock owned by
the decedent at the time of his death. In the event that X does not redeem the shares from
the estate, the agreement provided that the surviving shareholder would purchase the
unredeemed shares from the decedent’s estate. B died and, in accordance with the
agreement, X redeemed all of the shares owned by his estate.
In this case A was only secondarily liable under the agreement between A and B. Since A
was not primarily obligated to purchase the X stock from the estate of B, he received no
constructive distribution when X redeemed the stock.
Situation 6
B owned all of the outstanding stock of X corporation. A and B entered into an agreement
under which A was to purchase all of the X stock from B. A did not contemplate
purchasing the X stock in his own name. Therefore, the contract between A and B
specifically provided that it could be assigned by A to a corporation and that, if the
corporation agreed to be bound by the terms, A would be released from the contract.
A organized Y corporation and assigned the stock purchase contract to it. Y borrowed
funds and purchased all of the X stock from B pursuant to the agreement. Subsequently Y
was merged into X and X assumed the liabilities that Y incurred in connection with the
purchase of the X stock and subsequently satisfied these liabilities.
The purchase by Y of the stock of X did not result in a constructive distribution to A. Since
A did not contemplate purchasing the X stock in his own name, he provided in the contract
that it could be assigned to a corporation prior to the closing date. A chose this latter
alternative and assigned the contract to Y. A was not personally subject to an unconditional
obligation to purchase the X stock from B. See Arthur J. Kobacker and Sara Jo Kobacker,

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et al. v. Commissioner, 37 T.C. 882 (1962), acq., C.B. 1964-2, 6. Compare Ray Edenfield
v. Commissioner, 19 T.C. 13 (1952), acq., C.B. 1953-1, 4.
Situation 7
A and B owned all of the outstanding stock of X corporation. An agreement between the
shareholders provided that upon the death of either, the survivor would purchase the
decedent’s shares from his estate at a price provided in the agreement. Subsequently, the
agreement was rescinded and a new agreement entered into which provided that upon the
death of either A or B, X would redeem all of the decedent’s shares of X stock from his
estate.
The cancellation of the original contract between the parties in favor of the new contract
did not result in a constructive distribution to either A or B. At the time X agreed to
purchase the stock pursuant to the terms of the new agreement, neither A nor B had an
unconditional obligation to purchase shares of X stock. The subsequent redemption of the
stock from the estate of either pursuant to the terms of the new agreement will not
constitute a constructive distribution to the surviving shareholder.

Questions and comments:
1. How might taxpayer Sullivan have planned better?

C. Bargain Sales to Shareholders
Reg. § 1.301-1(j) provides in part: “If property is transferred by a corporation to a
shareholder which is not a corporation for an amount less than its fair market value in a
sale or exchange, such shareholder shall be treated as having received a distribution to
which § 301 applies. In such case, the amount of the distribution shall be the difference
between the amount paid for the property and its fair market value.”
•Examine § 311(a). How does the rule of § 311(b) apply to the distribution of
property to which § 301 applies?

Honigman v. Commissioner, 466 F.2d 69 (6th Cir. 1972)
PHILLIPS, Chief Judge
This is an appeal and cross-appeal from a decision of the United States Tax Court ... We
affirm as to the issues on appeal and reverse as to the issue on cross-appeal.

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The principal controversy involves the tax consequences of the sale of corporate property
below market value to a minority shareholder. …
I.
... The National Building Corporation was incorporated under the laws of Michigan in
1946 to engage in the ownership and operation of commercial real estate. Its principal
stockholders were the Honigman family (35%), the Silberstein family (35%) and the
Galperin family (20%). A member of each family held a position as a director and officer
of National.
In early 1963 steps were undertaken to effect a complete liquidation of National. A
preliminary agreement to sell its principal asset, the First National Building in Detroit, was
entered into in February 1963. At that time, National’s only unsuccessful investment was
the Pantlind Hotel in downtown Grand Rapids, Michigan, which it had acquired in 1951.
Taxpayers were aware that the Pantlind should be sold prior to adoption of the liquidation
plan in order to permit the corporation to recognize the loss on this sale while shielding it
from recognition of the substantial gains to be realized from the sale of the remaining
assets. During this time, unsuccessful efforts were made to sell the hotel at offering prices
ranging from $200,000 to $250,000 over its $590,000 mortgage. At an informal meeting
of the directors in April, Jason Honigman proposed that the property be sold for a
“nominal” price of $50,000 over mortgage. The hotel had not been offered previously at
this price, nor was such an offer ever made to outsiders. Ben Silberstein initially indicated
an interest in the transaction, but subsequently declined the purchase. Honigman later
decided to buy the property at the “nominal” price.
[Honigman purchased the hotel] for some $661,000, representing assumption of the
mortgage and a $21,000 tax liability, and $50,000 cash. … Title was transferred on May
27, 1963. Two days later a further adjustment of about $38,000 was paid to National. At
the time of the sale, National’s adjusted basis in the Pantlind was approximately
$1,486,000.
In August 1963 National adopted a qualified liquidation plan. All assets were sold within
one year and the proceeds distributed pro rata to the shareholders.
The Honigmans reported no income from the May transaction on their 1963 joint income
tax return. National deducted the difference between the sale price and the basis of the
Pantlind as a business loss on its corporate tax return. The Commissioner determined a
deficiency against the Honigmans individually, asserting that they had received a taxable
dividend from the Pantlind sale equal to the excess of the fair market value over the
purchase price. ...
These deficiencies were contested in a consolidated Tax Court proceeding. The Tax Court
found that the fair market value of the Pantlind at the time of sale was $830,000. The court
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held the transaction to have been a dividend to the Honigmans to the extent of the
difference between the market value and sale price and a sale to the extent of the difference
between adjusted basis and market value. The former was held to be includible as income
to the Honigmans and not deductible by National. The latter was held to be deductible by
National.
... On the record before us, we decline to set aside the Tax Court’s finding of fair market
value in the amount of $830,000.
The principal legal argument on behalf of the taxpayers is that the excess of fair market
value over purchase price of an asset purchased from a corporation by a stockholder is a
necessary but not sufficient condition for the declaration of a constructive dividend to the
extent of the excess. It is urged that there also must be an intent to distribute a dividend
and that such intent is negated by a showing that the sale was made in good faith for a
valid business purpose to a noncontrolling stockholder.
We do not accept this argument. ...
As stated by the Supreme Court:
“[I]t is clear that when a corporation sells corporate property to stockholders or
their assignees at less than its fair market value, thus diminishing the net worth of
the corporation, it is engaging in a ‘distribution of property’ as that term is used in
§ 316. Such a sale thus results in a dividend to shareholders unless some specific
exception or qualification applies.” Commissioner v. Gordon, 391 U.S. 83, 89-90
(1968) (footnote omitted).
“If a distribution meets the requirements of the statutory definition of a dividend,
then it is regarded as such notwithstanding the fact that it was intended to be a
payment of some other kind. Christopher v. Burnet, 55 F.2d 527, 528 (CADC
1931); [citation omitted]. It is not necessary that the dividend be formally declared,
or that the payment be termed a dividend, or that the payment be made to all the
shareholders. [citations omitted]. For example, distributions have been regarded as
dividends where a corporation makes a loan to a shareholder and later cancels the
indebtedness, or sells property to a shareholder for a purchase price far below its
fair market value, or pays compensation to an office-shareholder in an amount in
excess of the value of his services. In cases such as these and others involving the
same problem, courts have had little difficulty in holding the distribution or that
part of it in excess of the quid pro quo, to be a dividend, notwithstanding the fact
that neither the shareholder nor the corporation ‘intended’ that a dividend be paid.
It is not the intent of the parties that governs the characterization of the distribution,
but rather the economic and consequent legal effect of their actions.” Dynamics
Corporation of America v. United States, 392 F.2d 241, 246-247 (Ct. Cl. 1968).
[citation omitted].
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Taxpayers’ reliance on Palmer v. Commissioner of Internal Revenue, 302 U.S. 63 (1937),
is misplaced. As noted in Palmer, a constructive dividend results where a “transaction is
in purpose or effect used as an implement for the distribution of corporate earnings to the
stockholders.” Id. at 70 (emphasis supplied).
The Tax Court found that the sale of the Pantlind below market diminished the net worth
of National. There was no question that National had sufficient earnings and profits to
support a dividend in the amount stated in the deficiency notice. ...
….
II.
We turn next to the cross appeal of the Commissioner. The Tax Court held that the sale of
the Pantlind Hotel by National to the Honigmans was partly a constructive dividend and
partly a sale. To reiterate the details of this transaction, the hotel had an adjusted basis to
National of $1,468,168.51. The Honigmans purchased the hotel for $661,280.21. The Tax
Court found that its fair market value was $830,000. It held that the transfer of the hotel to
the Honigmans was to be treated for tax purposes as in part a dividend to the Honigmans
in an amount equal to the difference between the purchase price and the hotel’s fair market
value (i.e., a constructive dividend of $168,719.79); and in part a sale to the extent of the
excess of basis over fair market value. The Tax Court thus fragmented the transaction into
part dividend, part sale. It further held that only the sale portion constituted a taxable event
with respect to National. National was allowed a recognizable loss on this transaction to
the extent of the difference between the fair market value of the hotel and its adjusted
basis. Under the holding, National was allowed to allocate 100 per cent of the hotel’s basis
to the sale portion of the transaction.
The Commissioner asserts that this part of the decision of the Tax Court is in direct
contravention of the Congressional purpose and nonrecognition mandate contained in §
311(a), which provides that no gain or loss shall be recognized to a corporation on
distributions to a shareholder with respect to its stock. The Commissioner contends that
the purpose of § 311 is to segregate and remove from gain or loss recognition those
distributions which are made to shareholders on account of their status as shareholders.
We agree with the Commissioner.
The portion of the hotel transaction which the Tax Court held to be a constructive dividend
distribution to the Honigmans represented a distribution to shareholders with respect to
National’s stock under § 301. The non-recognition of loss provision contained in § 311
would prohibit any recognition of loss on this part of the transaction. Yet, by allowing
National a loss on the transaction measured by the difference between the hotel’s adjusted
basis and its fair market value, the Tax Court has permitted National to receive the benefit
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of a loss on that portion of the transaction held to be a distribution with respect to
National’s stock. We agree with the Commissioner that in order to give effect to the
requirement of § 311, the basis of the hotel must be fragmented proportionately between
the sales aspect and the distribution aspect of the transaction. The sale portion should be
given recognition only to the extent that the basis allowable to the sale exceeds the
consideration paid. Since the Honigmans paid $661,280 for the hotel property which had
a fair market value of $830,000, they have purchased in their capacity as buyers a
fractional interest represented by $661,280/$830,000. The loss resulting to National from
the sale portion of the transaction thus should be computed by allocating a like per cent of
the adjusted basis ($1,174,534) to the sale portion, which would result in a recognized loss
to National of the difference between the consideration paid and the proportionate share
of the basis allocated to the consideration paid.
In the present case, using approximate figures for the purchase price ($660,000), market
value ($830,000) and adjusted basis ($1,470,000), approximately 66/83 of the property
was sold and 17/83 was distributed as a dividend.
Therefore, we reverse as to that part of the decision of the Tax Court covered by the
crossappeal of the Commissioner. We remand for recomputation of the loss properly
recognizable by National and the resulting amount of transferee liability for each of the
taxpayers.
III.
…
Affirmed in part, reversed in part, and remanded for further proceedings consistent with
this opinion.

Questions and comments:
1. Articulate the difference in the way the Tax Court treated the distribution from National
to the Honigmans and the way the Sixth Circuit treated the distribution – for both National
and the Honigmans.
2. A corporation may not claim a loss on the distribution of property to a shareholder. §
311(a). A corporation may claim a loss when it sells property to a nonshareholder for less
than its adjusted basis. What trap awaits a closely-held corporation that sells loss property
to a shareholder? See §§ 267(a), 267(b)(2), 267(c).
3. The court quoted from Gordon. The excerpt reminds us that corporation/shareholder
loans that are never repaid, sales of corporate property to shareholders at a bargain price,
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and corporate payments of excess compensation to a shareholder/employee are methods
of paying shareholders disguised dividends.
4. In General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), the Supreme
Court held that the distribution of appreciated property to shareholders was not a taxable
event to the corporation. Section 311(a) codified this result. If the corporation in Honigman
had held the Pantlind Hotel through a liquidation, its loss would only have offset nontaxed gain. Hence, the corporation wanted to sell property prior to liquidation.
Section 311(b) reversed the result with respect to the distribution of gain property. Now a
corporation must recognize gain on the distribution of appreciated property to a
shareholder. Honigman of course involved the distribution of loss property. Its loss on a
distribution to shareholders would not be allowed, but it would be allowed if the
distribution was part of a liquidation. § 336(a).

D. Below-Market Loans, § 7872, and Other Ploys
Read IRC § 7872.
The unfavorable tax treatment of dividends may impel corporations and shareholders to
enter into other transactions whereby the corporation can get money into the hands of
shareholders or otherwise provide an accession to wealth. As always, tax consequences
turn on the reality of the transaction. Corporations may loan money to shareholders for
little or no interest, and with little prospect of repayment. The shareholder’s use of the
corporation’s money without payment of interest is certainly an accession to wealth.
Nevertheless, courts at one time held that a shareholder of a corporation did not realize
gross income because she received an interest-free loan from the corporation. See Beaton
v. Comm’r, 664 F.2d 315 (CA1 1981) (president and sole shareholder; adhering to rule of
Dean v. Comm’r, 35 T.C. 1083 (1961)); Suttle v. Comm’r, 625 F.2d 1127 (CA4 1980)
(adhering to rule of Dean). In 1984, Congress added § 7872 to the Code. Deficit Reduction
Act of 1984 (DEFRA), Pub. L. 98-369, § 172(a), 98 Stat. 699. Section 7872 applies to
below market loans in several contexts, but our concern is with corporation/shareholder
loans.
Sections 7872(a), (b), (c)(1)(C), (e), (f)(1), and (f)(2) address below-market loans between
corporations and shareholders.
•A corporation/shareholder loan may be a demand loan or a term loan. A “demand
loan” is a loan which is payable in full at any time on the demand of the lender. …
[S]uch term also includes any loan with an indefinite maturity.” § 7872(f)(5). A
“term loan” is “any loan which is not a demand loan.” § 7872(f)(6).

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•If a below-market loan is a demand loan, § 7872(a) provides that foregone interest
is treated first as paid by the lender to the borrower, and then paid by the borrower
to the lender. So, if a corporation lends money to a shareholder at below market
rates, the difference between market interest rate and the interest rate charged is
treated as paid by the corporation to the shareholder. Such a payment would be
given dividend treatment under the rules of § 301(c). The shareholder’s payment
would be treated as a contribution to the corporation’s capital.
•If such a loan is not a demand loan, § 7872(b) provides that the amount borrowed
minus the present value of repayments is to be treated as transferred from lender
to borrower. A corporation would be treated as having paid a dividend in that
amount.
Section 7872 applies to corporation/shareholder loans only if the aggregate amount of
loans is more than $10,000, § 7872(c)(3)(A), unless tax avoidance is one of the principal
purposes of the arrangement. § 7872(c)(3)(B).
In KTA-Tator, Inc. v. Comm’r, 108 T.C. 100, 106-07 (1997), the tax court offered the
following (dated) example:
In the case of a below-market demand loan from a corporation to a shareholder,
the corporation is treated as transferring to the shareholder, and the shareholder is
treated as paying to the corporation, an amount equal to the foregone interest. The
deemed transfer from the corporation to the shareholder is treated as a distribution,
which generally is taxed as a dividend to the shareholder. §§ 61(a)(7), 301(c)(1);
H. CONF. REPT. 98-861 [at 1013 (1984), 1984-3 C.B. [1,] at 267. … The
corporation, on the other hand, is subject to tax on the foregone interest but is not
entitled to a deduction for the deemed distribution it made to the shareholder.
Therefore, it has no deduction to offset the interest income from the loan. Similarly,
petitioner … is not entitled to a deduction for the deemed distribution it made ….

Problem:
Assume that the Applicable Federal Rate is 10%. Corporation loans $100,000 to one of its
shareholders who uses the proceeds to pay for her daughter’s university tuition.
A. If the loan is a demand loan, what would be the tax consequences to Corporation and
to shareholder at the end of year 1?
B. If the loan is a term loan, how would you determine the tax consequences to
Corporation and to shareholder at the end of year 1?

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IV. Corporate Distributions: Tax Consequences to Shareholder
Read §§ 61(a)(7), 301, 311.
A corporate distribution to a shareholder with respect
to her stock does not affect the shareholder’s
ownership interest in the corporation. However, the
tax consequences to the shareholder depend upon
whether the distribution is less or more than the
corporation’s e&p. Section 61(a)(7) provides that
gross income includes dividends. Section 301(c)
informs whether a corporate distribution is in fact a
“dividend.”
How much is the distribution? The amount of the
distribution is the fair market value of the property (§
301(b)(1)) on the date of distribution (§ 301(b)(3))
less any corporate liability that the shareholder
assumes (§ 301(b)(2)(A)) or any liability to which the
distributed property is subject (§ 301(b)(2)(B)). The
fmv of the property presumptively is not less than a
liability to which the property is subject. § 311(b)(2),
cross-referencing § 336(b).

Corporate distributions of loss
property: A corporation must
recognize the built-in gain on any
property it distributes to a
shareholder. It may not recognize
loss. § 311(a). If the Code
permitted a corporation to
recognize loss on a distribution,
the corporation could too easily
manipulate its tax liability through
distributions of loss property to
shareholders. To recognize a loss,
the corporation must engage in a
transaction with someone other
than in the capacity of a
shareholder.

What is the tax treatment of the shareholder who receives a distribution of property?
Section 301(c) governs the shareholder’s treatment of the distribution. If the distribution
is less than the corporation’s e&p available for distribution, all the distribution is dividend
income. § 301(c)(1). If the corporation’s e&p is less than the distribution, the excess first
reduces the shareholder’s basis in her stock, § 301(c)(2), and then is treated as a gain from
the sale or exchange of property, § 301(c)(3).
What is the shareholder’s basis in the property that the corporation distributed to her?
The shareholder takes a fair market value basis in the property she receives as a dividend.
§ 301(d). This is true even if the shareholder takes the property subject to a liability.
•A taxpayer’s basis in property represents her after-tax investment in that property.
Basis is a taxpayer’s money that will not (again) be subject to income tax.
•If a taxpayer receives property subject to a liability, its fair market value net of
liabilities is of course less than its fair market value. However, because shareholder
will have to pay those liabilities with after-tax income and a taxpayer may use debt
to obtain basis, taxpayer should be entitled to a fair market value basis in the
property she receives in a distribution.

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What is the shareholder’s basis in her stock with respect to which the corporation
makes a distribution? A corporation’s distribution of a dividend does not affect her
basis in her stock with respect to which the corporation makes a distribution,51
except when the distribution exceeds the corporation’s e&p.

Problems:
1. Myrna owns common stock in Hannibal Corporation, a calendar year taxpayer. Myrna’s
basis in her stock is $10,000. Hannibal Corporation had $4000 of accumulated e&p at the
beginning of this year. In the current year, Hannibal has $3000 of current e&p. Hannibal
distributed to Myrna Blackacre (ab to Hannibal Corporation = $10,000; fmv = $10,000).
This was the only distribution that Hannibal Corporation made this year.
•What are the tax consequences of the distribution to Myrna?
•What is the tax consequence of the distribution to Hannibal Corporation?
•What is Hannibal Corporation’s accumulated e&p on January 1 of the next year?
2. Same as #1, but the fmv of Blackacre is $16,000 at the time of distribution.
3. Same as #1, but the fmv of Blackacre is $8000 at the time of distribution.
4. Same as #3, except that Hannibal Corporation sold Blackacre to Myrna for $5000.
5. Same as #1, except that Blackacre is subject to a $4000 liability that Myrna assumes.
6. Same as #1, except that Blackacre is subject to a $12,000 liability that Hannibal incurred
two years after purchasing Blackacre. Myrna assumes the loan.

V. Income Tax Consequences to Corporation of Distributions to Shareholders
and Their Effect on Earnings and Profits, § 312
Read §§ 311, 312.
A corporation’s e&p is a measure of a corporation’s ongoing profitability reduced by the
distributions the corporation has made to its shareholders. A corporation’s e&p is not kept
in a special bank account. In fact, a corporation’s e&p may be unavailable for distribution
because the corporation has invested its after-tax income in the corporation’s business.
51 This is unlike the treatment of a distribution of profits by a partnership or an S corporation where the partner

or shareholder reduces her basis by the amount of the distribution. §§ 705(a)(2), 1367(a), 1368(d).

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Such investments do not reduce the corporation’s e&p. A corporation’s e&p reflects its
capacity to pay a dividend, even if it does not actually pay a dividend or make a
distribution.
Recall that computation of a corporation’s e&p begins with its after-tax income. Section
312 prescribes adjustments – additions and subtractions – to the corporation’s e&p
account. A corporation’s treatment of various items for income tax purposes and for e&p
purposes vary – generally in recognition that earnings and profits reflect a corporation’s
capacity to make distributions to its shareholders without impairing its capital – and that
this may not coincide with what the Code deems to be the corporation’s income on which
it should pay income tax. In addition to the specific rules that § 312 sets forth, courts and
the IRS resolve questions of the effect of distributions on a corporation’s e&p consistent
with these principles.
Naturally a corporation’s distribution of cash to shareholders reduces a corporation’s e&p
dollar-for-dollar. § 312(a)(1). More difficult questions arise when the corporation
distributes property other than money.
Distributions of Loss Property and the
Income tax consequences to the corporation of Corporation’s e&p: A corporation
distributions of appreciated or depreciated property: may not recognize loss on the
Section 311(b) requires the corporation to recognize distribution of loss property to a
gain upon its distribution of appreciated property to a shareholder. In such a case, the
corporation reduces its e&p by the
shareholder. When a corporation distributes property
adjusted basis of the loss property.
other than cash to a shareholder, we treat the transaction
In effect, the corporation does
the same as we would treat the corporation’s sale of the
recognize loss for purposes of e&p.
asset for its fair market value followed by a distribution Do you see how this occurs?
of the amount realized to the shareholder. The “use of
appreciated property to pay for something is a recognition event.” Here, that “something”
is a distribution to a shareholder(s). The corporation must recognize taxable gain on the
distribution of appreciated property to a shareholder. § 311(b)(1). The corporation may not
recognize loss on the distribution of property to a shareholder. § 311(a).
Effect of corporate distributions of appreciated or depreciated property on corporation’s
e&p: A corporation’s distribution of appreciated property is simultaneously a tax
recognition event to the corporation and a distribution to shareholder(s) with implications
for the corporation’s e&p. On such a distribution, § 312(b) requires that the corporation
first increase its e&p by the amount of the property’s built-in gain, and second reduce its
e&p by the fmv of the property distributed. The net result is the corporation reduces its
e&p by the basis of the property it distributed to a shareholder.
•Example: Corporation Q has accumulated e&p of $25,000 and current e&p of $0,
except for whatever e&p the following transaction produces. For now, disregard
the effect of income tax liability on Corporation Q’s e&p. Corporation Q
distributes some stock of Corporation R that it purchased several years ago to
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shareholder S. Corporation Q’s basis in its Corporation R’s stock is $25,000. Its
fmv at the time of distribution is $31,000. On how much income must Corporation
Q pay income tax? How much is shareholder S’s dividend? What is Corporation
Q’s e&p after the distribution?
•Corporation Q must recognize $6000 on the distribution. This tax
treatment is the same as the tax treatment of a sale for $31,000 followed by
a distribution of the sales proceeds to shareholder S. This taxable gain will
produce $6000 of current e&p for Corporation Q.
•Shareholder S’s dividend is $31,000, the fmv of the stock that she
received. Corporation Q has $31,000 of e&p ($25,000 accumulated e&p
and $6000 current e&p).
•Corporation Q’s e&p after the distribution is $0. $25,000 (accumulated
e&p) + $6000 (excess of fmv over adjusted basis) − $31,000 (fmv of
distribution)
When a corporation distributes loss property – which the corporation should not want to
do – § 312(b) has no application. Section 312(a)(3) requires the corporation to reduce its
e&p by the basis of the property distributed.
The corporation’s capacity to pay dividends: In computing its tax liability, a corporation
may benefit from Code provisions that exclude certain income from its taxable income,
that accelerate deductions, or that defer recognition of taxable income. Such provisions do
not affect a corporation’s profitability, and therefore do not affect its capacity to pay
dividends. We see this in the adjustments to a corporation’s e&p that § 312 requires. A
corporation may not reduce its e&p to the extent that a depreciation allowance is greater
than that allowable under the straight-line method. § 312(k). 52 A corporation must
compute its e&p without regard to the installment method. § 312(n)(5). A taxpayer that
uses inventory accounting must compute its e&p with the FIFO (first in first out) method,
even if it computes its tax liability using the LIFO (last in first out) method. § 312(n)(4).
Reg. § 1.312-6(b) brings within the scope of e&p income exempted by statute, income not
taxable under the Constitution, and all items of gross income includible in gross income
under § 61.

Problems:
1. Corporation A distributes to its sole shareholder Benes property with a fair market value
of $10,000 and a basis of $15,000. It has $20,000 of earnings and profits.

52 Expensing under §§ 179, 179B, 179C, 179D, and 179E reduces a corporation’s e&p ratably over five years. §

312(k)(3)(B).

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•How much loss may Corporation A recognize on this distribution for income tax
purposes?
•If Corporation A makes no other distributions during the year, what should be its
e&p after the distribution?
•What is Benes’s basis in the property?
See Reg. § 1.312-1(c) (Example 2).
2. Same facts, except that Corporation A’s basis in the property is $7500.
•How much gain must Corporation A recognize on this distribution for income tax
purposes?
•If Corporation A makes no other distributions during the year, what should be its
e&p after the distribution?
•What is Benes’s basis in the property?
3. Same facts as #2, except that the property is subject to a $1500 liability that Benes
assumed.
•How much gain must Corporation A recognize on this distribution for income tax
purposes?
•If Corporation A makes no other distributions during the year, what should be its
e&p after the distribution?
•What is Benes’s basis in the property?
See § 312(c).
4. What should be the effect on a corporation’s e&p of its receipt of tax exempt interest
income? Reg. § 1.312-6(b).
5. Payment of life insurance premiums is not deductible because the receipt of life
insurance proceeds paid by reason of death is excluded from gross income. § 101(a)(1).
How should a corporation treat the payment of life insurance premiums for e&p purposes?
If a corporation receives life insurance proceeds paid by reason of death, should the
corporation include such amounts in its e&p? See Rev. Rul. 54-230, 1954-1 C.B. 114.
6. Under certain circumstances, a taxpayer who makes a charitable contribution of
appreciated property may deduct the fmv of the property without ever paying income tax
on the built-in long-term gain on the property. § 170(e)(1). If a corporation donates
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property with built-in long-term gain to a charity under the circumstances that § 170(e)
prescribes and deducts the fmv of the property without paying income tax on the built-in
gain – what should be the effect of the contribution on the corporation’s e&p? See Rev.
Rul. 78-123, 1978-1 C.B. 87.
7. How should a corporation adjust its e&p when it makes a bargain sale to a shareholder?
See Dellinger v. Comm’r, 32 T.C. 1178 (1959).
8. What should be the effect on a corporation’s e&p of the portion of a dividend it receives
from another corporation that it deducts?
9. Section 108(a) excludes from the gross income of certain taxpayers discharge of debt
income. Taxpayer must reduce the tax attributes named in § 108(b). Taxpayer may elect
to reduce its adjusted basis in depreciable property pursuant to the rules of § 1017. §
108(b)(5).
•What is the rule concerning adjustments to e&p provided by § 312(l)(1)? Why
should that rule be different than it is for discharge of debt that either is not
excluded from the corporation’s gross income or that the corporation applies to
reduce other tax attributes, e.g., net operating loss carryovers?

Do the CALI exercise:
Corporate Taxation: Distributions: Calculation of C Corporation Earnings and Profits.

Do the CALI exercise:
Corporate Taxation: Distributions: Distributions of Property by C Corporations.

VI. Corporate Shareholders
Read § 243.
Corporations who receive dividends from corporations in which they own stock may
deduct a substantial portion of the dividend that they receive. This is because such
corporations are themselves owned by shareholders. When those shareholders receive their
share of corporate profits as dividends, such profits already have been subject to two (or
more) levels of income tax. Section 61(a)(7) provides that dividends are gross income, but
§ 243 allows corporations to deduct a portion of the dividends they receive from a domestic
corporation, the portion depending on the proportion of the dividend paying corporation
that the dividend-receiving corporation owns. Specifically, a corporation that owns less
than 20% by vote and value of another corporation may deduct 50% of the dividends it
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receives from that other corporation. § 243(a)(1). A corporation that owns at least 20% but
less than 80% by vote and value of another corporation may deduct 65% of the dividends
it receives from that other corporation. §§ 243(a)(1), 243(c)(1). A corporation that owns
at least 80% of the stock by vote and value of another corporation may deduct 100% of
the dividends it receives from that other corporation. §§ 243(a)(3), 243(b).
We have seen that much of corporate tax caselaw is
driven by individual shareholder’s desire to avoid
characterizing corporate distributions as dividends.
Corporations do not enjoy a preferential tax rate on their
capital gains, and they may deduct a substantial portion
of their dividend income. Not surprisingly, corporations
will view receipt of dividend income quite differently
than individuals view receipt of dividend income.
Corporations often seek tax treatment contrary to what
individuals would want.

Litton Indus., Inc. v. Commissioner, 89 T.C. 1086
(1987)
CLAPP, Judge

The Tax Cuts and Jobs Act
reduced the dividends-received
deduction. The deduction had
been 70% of the dividend for
corporations owning less than
20% by vote and value of the
stock of another corporation,
80% of the dividend for a
corporation owning at least 20%
but less than 80% of the
dividend-paying
corporation,
and 100% of the dividend for a
member of an affiliated group.
The justification for such reductions
was that the maximum corporate
tax rate on taxable income was
reduced from 35% to 21%, a
40% decrease.

Respondent determined a deficiency in petitioner’s
Federal corporate income tax for the year ended July 29,
1973 in the amount of $11,583,054. After concessions, the issue for decision is whether
Litton Industries received a $30,000,000 dividend from Stouffer Corporation, its wholly
owned subsidiary, or whether that sum represented proceeds from the sale of Stouffer
stock to Nestle Corporation.
FINDINGS OF FACT
….

Litton Industries, Inc. (petitioner) and its subsidiaries manufactured and sold, inter alia,
business systems and equipment, defense and marine systems, industrial systems and
equipment, and microwave cooking equipment. ...
On October 4, 1967, petitioner acquired all the outstanding stock of Stouffer Corporation
(Stouffer), a corporation whose common stock was listed and traded on the New York
stock exchange. Stouffer manufactured and sold frozen prepared food and operated hotels
and food management services and restaurants. ...

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….
... In early 1972, Charles B. Thornton (Thornton), the chairman of Litton’s board of
directors, Joseph Imirie, president of Stouffer, and James Biggar, an executive of Stouffer,
discussed project ‘T.I.B.,’ i.e., the sale of Stouffer. In July 1972, Litton’s board of directors
discussed the mechanics and problems of selling Stouffer. As of August 1, 1972 Stouffer’s
accumulated earnings and profits exceeded $30,000,000. On August 23, 1972, Stouffer
declared a $30,000,000 dividend which it paid to Litton in the form of a $30,000,000
negotiable promissory note, and at that time, Thornton believed that Litton would have no
difficulty in receiving an adequate offer for Stouffer. Two weeks later, on September 7,
1972, petitioner announced publicly its interest in disposing of Stouffer. Subsequent to
said announcement, Litton received inquiries from a number of interested sources,
including TWA, Green Giant, investment banking houses, and business brokers about the
possible purchase of all or part of the Stouffer business.
Beginning in mid-September 1972, Litton and several underwriters discussed the
feasibility of a public offering of Stouffer Stock. In early September 1972, Litton
negotiated with Lehman Brothers for a public offering of Stouffer stock, but Lehman
Brothers decided not to participate in the offering. During October 1972, Litton, Stouffer
and Merrill Lynch, a brokerage firm that thought Stouffer had an excellent outlook,
prepared a public offering of Stouffer stock. During November 1972, petitioner, Stouffer,
and Hornblower and Weeks prepared a partial public offering of Stouffer stock. Merrill
Lynch had a policy of not effecting partial distributions of corporate subsidiaries and thus
did not participate in the negotiations with Hornblower and Weeks. In mid-December
1972, Litton decided that a complete public offering was preferable and abandoned the
idea of a partial public offering. The S-1 Registration Statement, which Stouffer filed with
the Securities and Exchange Commission, stated that $30,000,000 of the proceeds would
be used to pay the promissory note which Litton received as a dividend.
On March 1, 1973, Nestle Alimentana S.A. Corporation (Nestle), a Swiss corporation,
offered to buy all of Stouffer’s stock for $105,000,000. On March 5, 1973, Nestle paid
Litton $74,962,518 in cash for all the outstanding stock of Stouffer and $30,000,000 in
cash for the promissory note. Because Litton sold Stouffer to Nestle, the underwriters
stopped work on the scheduled public offering.
OPINION
The issue for decision is whether the $30,000,000 dividend declared by Stouffer on August
23, 1972, and paid to its parent, Litton by means of a negotiable promissory note was truly
a dividend for tax purposes or whether it should be considered part of the proceeds
received by Litton from the sale of all of Stouffer’s stock on March 1, 1973. If, as petitioner
contends, the $30,000,000 constitutes a dividend, petitioner may deduct 85 percent of that
amount as a dividend received credit pursuant to § 243(a), [footnote omitted] as that
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section read during the year at issue. However, if the $30,000,000 represents part of the
selling price of the Stouffer stock, as contended by respondent, the entire amount will be
added to the proceeds of the sale and taxed to Litton as additional capital gain.
Respondent’s approach, of course produces the larger amount of tax dollars.
The instant case is substantially governed by Waterman Steamship Corp. v. Commissioner,
50 T.C. 650 (1968), rev’d, 430 F.2d 1185 (5th Cir. 1970), cert. denied, 401 U.S. 939
(1971). Respondent urges us to follow the opinion of the Fifth Circuit, which in substance
adopted the position of Judge Tannenwald’s dissent (concurred in by three other judges)
from our Court-reviewed opinion. If we hold for respondent, we must overrule our
majority opinion in Waterman Steamship. Petitioner contends that the reasoning of the
Fifth Circuit in Waterman Steamship should not apply since the facts here are more
favorable to petitioner. Additionally, petitioner points out that several business purposes
were served by the distribution here which provide additional support for recognition of
the distribution as a dividend. For the reasons set forth below, we conclude that the
$30,000,000 distribution constituted a dividend which should be recognized as such for
tax purposes. We believe that the facts in the instant case lead even more strongly than did
the facts in Waterman Steamship to the conclusion that the $30,000,000 was a dividend.
Accordingly, we hold that the Stouffer distribution to Litton was a dividend within the
meaning of § 243(a).
In many respects, the facts of this case and those of Waterman Steamship are parallel. The
principal difference, and the one which we find to be most significant, is the timing of the
dividend action. In Waterman Steamship, the taxpayer corporation received an offer to
purchase the stock of two of its wholly-owned subsidiary corporations, Pan-Atlantic and
Gulf Florida, for $3,500,000 cash. The board of directors of Waterman Steamship rejected
that offer but countered with an offer to sell the two subsidiaries for $700,000 after the
subsidiaries declared and arranged for payments of dividends to Waterman Steamship
amounting in the aggregate to $2,800,000. Negotiations between the parties ensued, and
the agreements which resulted therefrom included, in specific detail, provisions for the
declaration of a dividend by Pan-Atlantic to Waterman Steamship prior to the signing of
the sales agreement and the closing of that transaction. Furthermore, the agreements called
for the purchaser to loan or otherwise advance funds to Pan-Atlantic promptly in order to
pay off the promissory note by which the dividend had been paid. Once the agreement was
reached, the entire transaction was carried out by a series of meetings commencing at 12
noon on January 21, 1955, and ending at 1:30 p.m. the same day. At the first meeting the
board of directors of Pan-Atlantic met and declared a dividend in the form of a promissory
note in the amount of $2,799,820. The dividend was paid by execution and delivery of the
promissory note. At 12:30 p.m., the board of directors of the purchaser’s nominee
corporation (‘Securities’) met and authorized the purchase and financing of Pan-Atlantic
and Gulf Florida. At 1 p.m., the directors of Waterman authorized the sale of all
outstanding stock of Pan-Atlantic and Gulf Florida to Securities. Immediately following
that meeting, the sales agreement was executed by the parties. The agreement provided
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that the purchaser guaranteed prompt payment of the liabilities of Pan-Atlantic and Gulf
Florida including payment of any notes given by either corporation as a dividend.
Finally at 1:30 p.m., the new board of directors of Pan-Atlantic authorized the borrowing
of sufficient funds from the purchaser personally and from his nominee corporation to pay
off the promissory note to Waterman Steamship, which was done forthwith. As the Fifth
Circuit pointed out, ‘[b]y the end of the day and within a ninety minute period, the financial
cycle had been completed. Waterman had $3,500,000, hopefully tax-free, all of which
came from Securities and McLean, the buyers of the stock.’ This Court concluded that the
distribution from Pan-Atlantic to Waterman was a dividend. The Fifth Circuit reversed,
concluding that the dividend and sale were one transaction.
The timing in the instant case was markedly different. The dividend was declared by
Stouffer on August 23, 1972, at which time the promissory note in payment of the divided
was issued to Litton. There had been some general preliminary discussions about the sale
of Stouffer, and it was expected that Stouffer would be a very marketable company which
would sell quickly. However, at the time the dividend was declared, no formal action had
been taken to initiate the sale of Stouffer. It was not until 2 weeks later that Litton publicly
announced that Stouffer was for sale. There ensued over the next 6 months many
discussions with various corporations, investment banking houses, business brokers, and
underwriters regarding Litton’s disposition of Stouffer through sale of all or part of the
business to a particular buyer, or through full or partial public offerings of the Stouffer
stock. All of this culminated on March 1, 1973, over 6 months after the dividend was
declared, with the purchase by Nestle of all of Stouffer’s stock. Nestle also purchased the
outstanding promissory note for $30,000,000 in cash.
In the instant case, the declaration of the dividend and the sale of the stock were
substantially separated in time in contrast to Waterman Steamship where the different
transactions occurred essentially simultaneously. In Waterman Steamship, it seems quite
clear that no dividend would have been declared if all of the remaining steps in the
transaction had not been lined up in order on the closing table and did not in fact take
place. Here, however, Stouffer declared the dividend, issued the promissory note and
definitely committed itself to the dividend before even making a public announcement that
Stouffer was for sale. Respondent argues that the only way petitioner could ever receive
the dividend was by raising revenue through a sale of Stouffer. Therefore, respondent
asserts the two events (the declaration of the dividend and then the sale of the company)
were inextricably tied together and should be treated as one transaction for tax purposes.
In our view, respondent ignores the fact that Stouffer could have raised sufficient revenue
for the dividend from other avenues, such as a partial public offering or borrowing.
Admittedly, there had been discussions at Litton about the sale of Stouffer which was
considered to be a very saleable company. However, there are many slips between the cup
and the lip, and it does not take much of a stretch of the imagination to picture a variety of
circumstances under which Stouffer might have been taken off the market and no sale
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consummated. Under these circumstances it is unlikely that respondent would have
considered the dividend to be a nullity. On the contrary, it would seem quite clear that
petitioner would be charged with a dividend on which it would have to pay a substantial
tax. Petitioner committed itself to the dividend and, thereby, accepted the consequences
regardless of the outcome of the proposed sale of Stouffer stock. [citation omitted].
Since the facts here are distinguishable in important respects and are so much stronger in
petitioner’s favor, we do not consider it necessary to consider further the opinion of the
Fifth Circuit in Waterman Steamship.
The term ‘dividend’ is defined in § 316(a) as a distribution by a corporation to its
shareholders out of earnings and profits. The parties have stipulated that Stouffer had
earnings and profits exceeding $30,000,000 at the time the dividend was declared. This
Court has recognized that a dividend may be paid by a note. T.R. Miller Mill Co. v.
Commissioner, 37 B.T.A. 43, 49 (1938), aff’d, 102 F.2d 599 (5th Cir. 1939). Based on
these criteria, the $30,000,000 distribution by Stouffer would clearly constitute a dividend
if the sale of Stouffer had not occurred. We are not persuaded that the subsequent sale of
Stouffer to Nestle changes that result merely because it was more advantageous to Litton
from a tax perspective.
… A variety of factors present here preclude a finding of sham or subterfuge. Although
the record in this case clearly shows that Litton intended at the time the dividend was
declared to sell Stouffer, no formal action had been taken and no announcement had been
made. There was no definite purchaser waiting in the wings with the terms and conditions
of sale already agreed upon. At that time, Litton had not even decided upon the form of
sale of Stouffer. Nothing in the record here suggests that there was any prearranged sale
agreement, formal or informal, at the time the dividend was declared.
Petitioner further supports its argument that the transaction was not a sham by pointing out
Litton’s legitimate business purposes in declaring the dividend. Although the code and
case law do not require a dividend to have a business purpose, it is a factor to be considered
in determining whether the overall transaction was a sham. [citation omitted]. Petitioner
argues that the distribution allowed Litton to maximize the gross after-tax amount it could
receive from its investment in Stouffer. From the viewpoint of a private purchaser of
Stouffer, it is difficult to see how the declaration of a dividend would improve the value
of the stock since creating a liability in the form of a promissory note for $30,000,000
would reduce the value of Stouffer by approximately that amount. However, since Litton
was considering disposing of all or part of Stouffer through a public or private offering,
the payment of a dividend by a promissory note prior to any sale had two advantages. First,
Litton hoped to avoid materially diminishing the market value of the Stouffer stock. At
that time, one of the factors considered in valuing a stock, and in determining the market
value of a stock was the ‘multiple of earnings’ criterion. Payment of the dividend by
issuance of a promissory note would not substantially alter Stouffer’s earnings. Since
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many investors were relatively unsophisticated, Litton may have been quite right that it
could increase its investment in Stouffer by at least some portion of the $30,000,000
dividend. Second, by declaring a dividend and paying it by a promissory note prior to an
anticipated public offering, Litton could avoid sharing the earnings with future additional
shareholders while not diminishing to the full extent of the pro rata dividend, the amount
received for the stock. Whether Litton could have come out ahead after Stouffer paid the
promissory note is at this point merely speculation about a public offering which never
occurred. The point, however, is that Litton hoped to achieve some business purpose and
not just tax benefits in structuring the transaction as it did.
Under these facts, where the dividend was declared 6 months prior to the sale of Stouffer,
where the sale was not prearranged, and since Stouffer had earnings and profits exceeding
$30,000,000 at the time the dividend was declared, we cannot conclude that the
distribution was merely a device designed to give the appearance of a dividend to a part of
the sales proceeds. In this case the form and substance of the transaction coincide; it was
not a transaction entered into solely for tax reasons, and it should be recognized as
structured by petitioner.
On this record, we hold that for Federal tax purposes Stouffer declared a dividend to
petitioner on August 23, 1972, and, subsequently, petitioner sold all of its stock in Stouffer
to Nestle for $75,000,000.
Decision will be entered under Rule 155.

Questions and comments:
1. What facts seem particularly important in distinguishing this case from Waterman
Steamship?
2. When the dust settled, what was Stouffer’s accumulated e&p going forward?
•Maybe that’s why this is called “dividend stripping.”
3. When a corporation owns shares in another corporation, it usually prefers dividend
treatment of a distribution to redemption treatment, i.e., sale of a capital asset. Section
301(e) provides that when a corporation owns directly or indirectly 20% or more of
•the voting power of another corporation OR
•the total value of all outstanding stock of another corporation (except for
nonvoting stock that is limited and preferred as to dividends)
and the corporation would be entitled to a dividends received deduction, § 312 is to be
applied without regard to § 312(k) or § 312(n)(1 to 6). The effect of this is to decrease the
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distributing corporation’s e&p and so decrease the amount of a distribution that is a
dividend to so-called “20% corporate shareholders.” Such corporations pay a tax of 21%
of such amounts exceeding the dividend.
4. Let’s assume and imagine: Assume that all the stock of Corporation S is worth $105M
and that S has $30M cash. Its accumulated e&p are also $30M. Corporation L owns all the
stock of Corporation S and would like to sell it. It may choose to skim off the cash for
itself and sell the stock for $75M. Alternatively, it may choose to sell the stock for $105M.
Why might Corporation N find paying $105M for all the stock of a corporation that holds
$30M cash particularly attractive? Isn’t part of the transaction simply paying $30M for
$30M cash – which therefore amounts to a wash?
Now imagine: Corporation N pays $105M to Corporation L for all the stock of Corporation
S. It skims off the $30M cash. Since Corporation S has $30M of accumulated e&p, all the
distribution from Corporation S to Corporation N is dividend. Since Corporation N owns
80% or more (i.e., 100%) of the stock of Corporation S, it may deduct $30M as a
dividends-received deduction under § 243. All the stock of Corporation S is now worth
presumably $75M. Imagine further that Corporation N sells the stock of Corporation S to
Corporation TWA for $75M. Corporation N now has a capital loss of $30M ($105M −
$75M). Corporation N can use this loss to offset Corporation N’s capital gains. § 1211(a).
[Remember: Corporations may reduce capital gain income only by offsetting capital losses
against it, and corporations do not enjoy a preferential tax rate on their capital gains.
Hence, the $30M loss reduces Corporation N’s income tax according to its marginal tax
bracket, now 21%.] When the dust settles, Corporation N pockets $30M of tax-free cash
and can offset $30M of capital gain income.
•[We might imagine that Corporation L would insist on capturing some of that
$30M and negotiate accordingly with N over the price of the Corporation S stock.]
5. Note 4 (more): Section 1059 addresses this relatively risk-free manufacture of capital
losses. Section 1059(a) provides that a corporation that receives an “extraordinary
dividend” with respect to stock that the corporation has not held for more than two years
before the dividend announcement date must decrease its basis in the stock of the other
corporation by the untaxed portion of the dividend it receives. § 1059(a)(1). If the untaxed
portion of an extraordinary dividend is more than the corporation’s basis in the stock, the
excess is treated as gain from the sale or exchange of the stock. § 1059(a)(2).
•In the case of Corporation N, the untaxed portion of the dividend it received was
100%. Hence, if the dividend was an “extraordinary dividend” with respect to stock
that Corporation N had not held for two years prior to the dividend announcement
date, its basis in Corporation S stock would be reduced from $105M to $75M.
Upon sale for $75M to Corporation TWA, it would recognize no capital gain or
loss.

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An “extraordinary dividend” is a dividend that exceeds 5% of the corporation’s basis in
the stock of the other corporation in the case of preferred stock dividends or that exceeds
10% of the corporation’s basis in the stock of the other corporation in the case of any other
stock. § 1059(b)(1 and 2).53
6. Section 246(c) denies a dividends-received deduction entirely to corporations who have
not held stock in the dividend-paying corporation for at least 45 days in the 91-day period
extending from 45 days before the ex-dividend date. § 246(c)(1). This minimum holding
period is 90 days of a 181-day period extending from 90 days before the ex-dividend date
for preferred dividends attributable to periods aggregating more than 366 days. §
246(c)(2).54
7. Section 246A limits the dividends-received deduction when a corporation owns less
than 50% of the stock by vote and value of another corporation, § 246A(c), and has
financed the purchase of such stock with debt, § 246A(d)(3). Section 246A also applies if
the corporation is one of five or fewer shareholders and holds less than 20% of the stock
by vote and value of the other corporation. § 246A(c)(2)(B). Section 246A(d)(1)
establishes an “average indebtedness percentage,” i.e., the amount borrowed divided by
the basis of the stock purchased. A corporate taxpayer must reduce its dividend-received
deduction by this percentage. § 246A(a).

53 There are more details to the workings of § 1059, but this suffices to give you an idea of how it works.
54 There are a few more details to the workings of § 246(c), but this suffices to give you an idea of how it works.

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Chapter 4: Redemptions of Stock
I. Introduction
Read IRC §§ 302, 317. Skim §§ 303, 304.
Don’t forget that: Ownership of
shares gives a shareholder certain
interests in a corporation. The United
States Court of Appeals for the
Second Circuit said in Himmel v.
Comm’r, 338 F.2d 815, 817 (2d
Cir. 1964):
Ownership of stock can
involve three important
rights: (1) to vote, and
thereby exercise control, (2)
to participate in current
earnings and accumulated
surplus, and (3) to share in
net assets on liquidation.
Ownership of common stock
generally involves all of
these.
Ownership
of
preferred stock generally
involves the last two, but
only to a limited extent,
unless otherwise provided.

We assume that the corporation we established in
chapter 2 has been profitable, and the value of the
shareholders’ shares has increased. There are
various ways that shareholders – as shareholders55
– can reap the increase in the value of their shares.
A corporation may share some of its profits with
its shareholders by distributing a dividend. The
corporation pays tax on its profits, and
shareholders pay tax on the dividends they
receive. 56 A shareholder continues to own the
stock with respect to which the dividend was paid
and retains the rights that he had with respect to
voting control, dividends, and proceeds upon
liquidation. A dividend is a return on the
shareholder’s stock. The corporation’s retained
earnings (i.e., e&p) are diminished by the amount
it has paid out in dividends. Dividends are
“ordinary income” – not capital gains – although
they may be subject to income tax at rates lower
than those generally applicable to ordinary
income. See §§ 1(h)(11) (“qualified dividends”
received by individual taxpayers).

Upon any adjustments, notice what
interests a shareholder surrenders
and what interests he retains.

Alternatively, a shareholder may sell his shares to
another person. The shareholder may sell at a gain
because the corporation has retained or invested
profits that it previously earned. The price at which the shareholder can sell his shares will
reflect the profitability (or belief in future profitability) of the corporation. Of course, if
the shareholder sells his shares, he no longer owns them and cannot share in control of the
corporation, will not share in any future dividends, and does not share in any proceeds
upon liquidation. This much is obvious, but note that the shareholder has reaped the

55 ... and not as lenders, sellers, lessors, employees, etc.
56 We are disregarding corporate shareholders.

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increase in the value of his shares attributable to the profitability of the corporation – and
that the corporation retains the earnings that contributed to the increase in the shares’
value. The sale of shares for a gain gives rise to capital gains. Capital gains offset capital
losses and at least for individual taxpayers, are subject to income tax at rates lower than
those imposed on ordinary income.
There is a middle ground. The corporation may itself Taxing dividends paid to individuals
buy, i.e., redeem, shareholders’ shares from some of its as net capital gain: When stock has
shareholders. Section 317(b) defines a “redemption” to a low basis – perhaps $0 – the
be the corporation’s acquisition of its own stock from a income tax on a dividend or a
shareholder in exchange for “property.” A corporate redemption treated as a sale or
redemption of a shareholder’s stock results in a return of exchange are nearly equal. This
the shareholder’s investment. The shareholder no longer reduces the importance of
owns the shares that the corporation redeems and to that properly
characterizing
a
extent surrenders whatever control, dividend, and corporate distribution as a
liquidation rights those shares represented. In this dividend. However, upon death §
regard, the redemption might resemble a sale. The 1014 increases the basis of stock
corporation does not retain the earnings with which it to its fmv, effectively sheltering a
makes such a purchase. In this regard and from the distribution treated as a sale or
standpoint of the corporation, the redemption resembles exchange from any income tax. Cf.
592 F.2d
the payment of a dividend. “It is possible for such a Rickey v. United States,
th
transaction to resemble, exactly or substantially, either a 1251, 1253 (5 Cir. 1979).
Moreover, the rules governing
dividend or a sale. For tax purposes the payment is
reduction of a corporation’s e&p
considered ordinary income if, by its ‘net effect,’ it is
differ for payments of dividends
‘essentially equivalent to a dividend.’” Himmel v. and distributions in redemption
Comm’r, 338 F.2d 815, 817 (2d Cir. 1964). If the treated as a sale or exchange.
redemption is not “essentially equivalent to a dividend,” Characterization of a distribution
then the shareholder will be treated for tax purposes as as a dividend or as a redemption
if he sold the shares, i.e., a capital transaction.
still matters.
•From the view of the corporation, a redemption
changes the capital structure of the corporation. At the least, there are fewer
outstanding shares. The relative interest(s) of shareholders whose shares the
corporation does not redeem will increase. This might alter the value of those
shares.
•A redemption of shares does not change the identity of the remaining shareholders
as a sale of stock would.
•Redemptions treated as exchanges partake of both distributions of profits
(dividends) and dispositions of capital interests. Corporations pay for redemptions
with after-tax profits. At the same time, the shareholder’s interest in the corporation
is reduced. Others’ interests must perforce increase.
•These points might make a redemption more attractive or less attractive,
depending on circumstances.

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At a very early time, corporations and shareholders figured out ways to make the payment
of dividends appear to be a redemption. To take a simple example, a corporation might issue
a “stock on stock” dividend – say a one share stock dividend for every share each
shareholder owns. The issuance of the stock dividend would not be a taxable event to
shareholders. Eisner v. Macomber, 252 U.S. 189, 199 (1919). The corporation could later
buy back those dividend shares for cash. If all the shareholders sold their dividend shares
back to the corporation, the result would be the same as it would have been if the corporation
had simply paid a cash dividend. The corporation’s earnings would be diminished by what
it paid out, and shareholders would retain their
Tax Cuts and Jobs Act: Large U.S.
rights to control, to future dividends, and to corporations
that
engage
in
proceeds upon liquidation. Such a redemption international business could defer
would be “essentially equivalent to a dividend.” See paying U.S. income tax on profits from
Smith v. United States, 121 F.2d 692, 694 (3d Cir. foreign operations by conducting
1941) (redemption of all shares of preferred stock those operations through foreign
issued to sole shareholder in order to capitalize subsidiaries that the U.S. firm owned.
accumulated
earnings;
“distribution
and The income of foreign subsidiaries was
cancellation or redemption equivalent to the taxable only upon repatriation as
distribution of taxable dividends” within the dividends. U.S. income tax on the
dividend income of subsidiaries was
meaning of the statute); Commissioner v. Ahlborn,
deferrable simply by having the
77 F.2d 700, 700-01 (3d Cir. 1935) (purchase of ⅓ foreign subsidiary not repatriate
of shares of all three shareholders of corporation dividend
income.
Some
U.S.
does not come within redemption provision of corporations
accumulated
vast
Code); Hill v. Comm’r, 66 F.2d 45, 47 (4th Cir. amounts of cash that they held
1933) (no unified plan to distribute surplus but overseas. The Tax Cuts and Jobs Act
issuance of preferred stock dividend followed five added § 245A, which provides a
years later by corporate redemption of all preferred deduction of dividends paid to a U.S.
corporate “shareholder,” one who
stock resulted in payment of dividend).
owns 10% or more of the foreign
Whether a distribution to redeem shares is treated as corporation by vote and value. This
a sale or exchange of a capital asset depends upon will make cash available to domestic
corporations that they may choose to
“the effect [of the distribution] on the shareholder’s
distribute to shareholders to redeem
basic rights vis-a-vis the corporation and other
their shares. As such funds “come
shareholders,” and evaluation of those effects home,” the importance of the topics in
“depends upon many facts.” Himmel v. Comm’r, this chapter will increase.
338 F.2d 815, 817 (2d Cir. 1964). In order that a
redemption not be equivalent to a dividend, there must be a disproportionate reduction in
at least one of the interests that a shareholder owns in a corporation vis-à-vis other
shareholders.57 However, what reductions(s) must occur is not entirely clear. Section 302
governs these questions.
57 … putting to one side for the moment redemptions from noncorporate shareholders in a partial liquidation or

redemptions made by regulated investment companies.

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In measuring a reduction of a shareholder’s interest in a corporation, we should regard the
shares that another person or entity owns as shares of the taxpaying shareholder himself
when the shareholder controls or is controlled by that person or entity or (presumably) acts
with a unity of interest. In short, we should attribute the shares that particular individuals
or entities own to one or more other individuals or entities. Application of attribution rules
may lead to the conclusion that a redemption does not significantly reduce a shareholder’s
interests in the corporation vis-à-vis other shareholders. Rather the distribution would be
essentially equivalent to a dividend. Section 318 establishes rules of attribution that
another provision of subchapter C (§§ 301 to 386) may invoke – and § 302(c)(1) invokes
them. We take up attribution rules in part II, infra.
Section 302(a) provides that a corporation’s redemption of its stock insofar as it is
described in §§ 302(b)(1, 2, 3, 4, or 5) “shall be treated as a distribution in part or full
payment in exchange for the stock.” On the other hand, if a corporation redeems its stock
in a transaction not described in §§ 302(b)(1, 2, 3, 4, or 5) – and no other section in
subchapter C applies58 – then the distribution is treated as one to which § 301 applies, §
302(d), i.e., it is taxed as a dividend.
After considering the attribution rules of § 318, our concern will be with §§ 302(b)(1, 2,
and 3). These provisions treat distributions in redemption of stock as exchanges when there
is a sufficient reduction of a shareholder’s interest in the corporation. We also examine §
302(b)(4), which treats as redemptions corporate redemptions that manifest a genuine
contraction of the corporation’s business activities. We will briefly examine § 302(b)(5).
We will consider § 304, a provision applicable when a shareholder who controls two
corporations sells shares of one corporation to the other; the shareholder might have to
treat the consideration received as the distribution of a dividend. Finally, we will examine
§ 303 which gives exchange treatment to certain distributions whose proceeds are used to
pay death taxes of a decedent whose estate included the shares redeemed.

II. Attribution Rules, § 318
Read § 318(a)(1, 2, and 3).
Section 318 simply presents a number of relationships in which ownership of shares might
be attributed to another. Section 318 states rules of attribution but says nothing about when
such attribution should occur. Other sections of the Code may invoke the attribution rules
of § 318. Sections 302 and 304 both invoke § 318 in determining whether the corporate

Reminder: § 301(a), the section describing the treatment of dividends, begins with the words “[e]xcept as
otherwise provided in this chapter …” This makes § 301 into a residual provision.
58

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distributions to which those sections apply should be treated as an exchange for stock.
Section 303 does not.
As you read through § 318, notice in each provision: from whom (or what) are shares
attributed, and to whom (or what).
•§ 318(a)(1) states rules of attribution within the family. Call this a “1" attribution.
Read it and answer these questions:
•Is a child considered to own shares of stock that his grandparent owns?
•Is a grandparent considered to own shares of stock that his grandchild
owns?
•Is a brother considered to own shares of stock that his sister owns?
•§ 318(a)(2) states rules of attribution from partnerships, trusts, or corporations
(i.e., entities) to partners, beneficiaries, or shareholders. Call this a “2" attribution.
Read it and answer these questions:
•LMN partnership owns 50 shares of Bosco Corporation common stock.
LaJuan is a 1/5 partner in LMN. How many shares of Bosco Corporation
common stock is LaJuan considered to own because he is a partner in the
LMN partnership?
•The Bluenose trust owns 250 shares of Bosco Corporation common stock.
Max has a 1/50 actuarial interest in the Bluenose trust. How many shares
of Bosco common stock is Max considered to own because he is a
beneficiary of the Bluenose trust?
•The Cribble Corporation owns 500 of the 10,000 outstanding shares of
Bosco Corporation common stock. Natalie owns 40 of the 100 outstanding
shares of Cribble Corporation common stock. Cribble Corporation has no
other stock outstanding. How many shares of Bosco common stock is
Natalie considered to own because she owns shares of Cribble
Corporation?
•Same, except that Natalie owns 60 of the 100 outstanding shares of Cribble
Corporation. How many shares of Bosco common stock is Natalie
considered to own because she owns shares of Cribble Corporation?
•§ 318(a)(3) states rules of attribution from partners, beneficiaries, or shareholders
to partnerships, trusts, or corporations (i.e., entities). Call this a “3" attribution.
•LaJuan is a 1/5 partner in the LMN Partnership. He owns 200 of the 1000
outstanding shares of Bosco Corporation common stock. How many shares

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of Bosco Corporation common stock is LMN considered to own because
LaJuan is a 1/5 partner?
•Max has a 1/50 actuarial interest in the Bluenose trust. He also owns 250
of the 1000 outstanding shares of Bosco Corporation common stock. How
many shares of Bosco Corporation common stock is the Bluenose Trust
considered to own because Max is a beneficiary of the Bluenose trust?
•Same facts, except that Max has a 1/10 actuarial interest in the Bluenose
trust?
•Natalie owns 40 of the 100 outstanding shares of Cribble Corporation. She
also owns 500 of the 10,000 outstanding shares of Bosco Corporation
common stock. How many shares of Bosco Corporation is Cribble
Corporation considered to own because Natalie is a shareholder of Cribble
Corporation?
•Same, except that Natalie owns 60 of the 100 outstanding shares of Cribble
Corporation?
Read § 318(a)(5).
•§ 318(a)(5)(A): Stock owned by attribution is to be reattributed to others, but –
•§ 318(a)(5)(B): A “1" attribution cannot follow another “1" attribution, and –
•§ 318(a)(5)(C): A “2" cannot follow a “3" attribution.
•Why do you think a “1" cannot follow a “1,” and a “2" cannot follow a “3?”

Do the CALI exercise:
Corporate Taxation: Redemptions: Constructive Ownership of Stock.
•Have a paper napkin and a pen handy as it will help to diagram the facts of these
questions.

III. Interest-Reducing Redemptions: § 302(b)(1, 2, and 3)
Section 302(a) states the rule that if a corporation redeems its stock in a transaction
described by § 302(b)(1, 2, 3, 4, or 5), the redemption “shall be treated as a distribution in
part or full payment in exchange for the stock.” Assuming the stock is a capital asset, gain
or loss on the exchange computed as (amount realized) minus adjusted basis will be capital
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in character. A distribution not described in § 302(b)(1, 2, 3, 4, or 5) is not treated as an
exchange and is therefore treated as a dividend. § 302(d). A dividend distribution is
included in a taxpayer’s gross income in full – without reduction for adjusted basis.
Sections 302(b)(1, 2, and 3) apply when a corporate redemption sufficiently reduces the
shareholder’s interest in the corporation.

A. Section 302(b)(1): Distributions Not Essentially Equivalent to a Dividend
Read §§ 302(a) and 302(b)(1). What does “not essentially equivalent to a dividend” mean?

United States v. Davis, 397 U.S. 301 (1970)
Justice MARSHALL delivered the opinion of the Court.
In 1945, taxpayer [footnote omitted] and E.B. Bradley organized a corporation. In
exchange for property transferred to the new company, Bradley received 500 shares of
common stock, and taxpayer and his wife similarly each received 250 such shares. Shortly
thereafter, taxpayer made an additional contribution to the corporation, purchasing 1,000
shares of preferred stock at a par value of $25 per share.
The purpose of this latter transaction was to increase the company’s working capital, and
thereby to qualify for a loan previously negotiated through the Reconstruction Finance
Corporation. It was understood that the corporation would redeem the preferred stock
when the RFC loan had been repaid. Although, in the interim, taxpayer bought Bradley’s
500 shares and divided them between his son and daughter, the total capitalization of the
company remained the same until 1963. That year, after the loan was fully repaid and in
accordance with the original understanding, the company redeemed taxpayer’s preferred
stock.
In his 1963 personal income tax return, taxpayer did not report the $25,000 received by
him upon the redemption of his preferred stock as income. Rather, taxpayer considered the
redemption as a sale of his preferred stock to the company – a capital gains transaction
under § 302 of the Internal Revenue Code of 1954 resulting in no tax, since taxpayer’s
basis in the stock equaled the amount he received for it. The Commissioner of Internal
Revenue, however, did not approve this tax treatment. According to the Commissioner,
the redemption of taxpayer’s stock was essentially equivalent to a dividend, and was thus
taxable as ordinary income under §§ 301 and 316 of the Code. Taxpayer paid the resulting
deficiency, and brought this suit for a refund. The District Court ruled in his favor, and, on
appeal, the Court of Appeals affirmed.

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The Court of Appeals held that the $25,000 received by taxpayer was “not essentially
equivalent to a dividend” within the meaning of that phrase in § 302(b)(1) of the Code
because the redemption was the final step in a course of action that had a legitimate
business (as opposed to a tax avoidance) purpose. That holding represents only one of a
variety of treatments accorded similar transactions under § 302(b)(1) in the circuit courts
of appeals. [footnote omitted]. We granted certiorari in order to resolve this recurring tax
question involving stock redemptions by closely held corporations. We reverse.
I
The Internal Revenue Code of 1954 provides generally in §§ 301 and 316 for the tax
treatment of distributions by a corporation to its shareholders; under those provisions, a
distribution is includable in a taxpayer’s gross income as a dividend out of earnings and
profits to the extent such earnings exist. [footnote omitted]. There are exceptions to the
application of these general provisions, however, and among them are those found in §
302, involving certain distributions for redeemed stock. The basic question in this case is
whether the $25,000 distribution by the corporation to taxpayer falls under that section –
more specifically, whether its legitimate business motivation qualifies the distribution
under § 302(b)(1) of the Code. Preliminarily, however, we must consider the relationship
between 302(b)(1) and the rules regarding the attribution of stock ownership found in §
318(a) of the Code.
Under subsection (a) of § 302, a distribution is treated as “payment in exchange for the
stock,” thus qualifying for capital gains, rather than ordinary income treatment, if the
conditions contained in any one of the four paragraphs of subsection (b) are met. [Sections
302(b)(2, 3, and 4) do not apply.] [T]axpayer agrees that, for the purposes of §§ 302(b)(2)
and (3), the attribution rules of § 318(a) apply, and he is considered to own the 750
outstanding shares of common stock held by his wife and children in addition to the 250
shares in his own name. [footnote omitted].
Taxpayer, however, argues that the attribution rules do not apply in considering whether a
distribution is essentially equivalent to a dividend under § 302(b)(1). According to
taxpayer, he should thus be considered to own only 25 percent of the corporation’s
common stock, and the distribution would then qualify under § 302(b)(1) since it was not
pro rata or proportionate to his stock interest, the fundamental test of dividend equivalency.
See Treas. Reg. § 1.302-2(b). However, the plain language of the statute compels rejection
of the argument. In subsection (c) of § 302, the attribution rules are made specifically
applicable “in determining the ownership of stock for purposes of this section.” Applying
this language, both courts below held that § 318(a) applies to all of § 302, including §

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302(b)(1) – a view in accord with the decisions of the other courts of appeals, 59 a
longstanding treasury regulation,60 and the opinion of the leading commentators.61
Against this weight of authority, taxpayer argues that the result under paragraph (1) should
be different because there is no explicit reference to stock ownership, as there is in
paragraphs (2) and (3). Neither that fact, however, nor the purpose and history of §
302(b)(1) supports taxpayer’s argument. The attribution rule designed to provide a clear
answer to what would otherwise be a difficult tax question – formed part of the tax bill
that was subsequently enacted as the 1954 Code. ...
... [I]t was necessary that the attribution rules apply to § 302(b)(1) unless they were to be
effectively eliminated from consideration with regard to §§ 302(b)(2) and (3) also. For if
a transaction failed to qualify under one of those sections solely because of the attribution
rules, it would, according to taxpayer’s argument, nonetheless qualify under § 302(b)(1).
We cannot agree that Congress intended so to nullify its explicit directive. We conclude,
therefore, that the attribution rules of § 318(a) do apply; and, for the purposes of deciding
whether a distribution is “not essentially equivalent to a dividend” under § 302(b)(1),
taxpayer must be deemed the owner of all 1,000 shares of the company’s common stock.
II
After application of the stock ownership attribution rules, this case, viewed most simply,
involves a sole stockholder who causes part of his shares to be redeemed by the
corporation. We conclude that such a redemption is always “essentially equivalent to a
dividend” within the meaning of that phrase in § 302(b)(1),62 and therefore do not reach
the Government’s alternative argument that, in any event, the distribution should not, on
the facts of this case, qualify for capital gains treatment. [footnote omitted].
The predecessor of § 302(b)(1) came into the tax law as § 201(d) of the Revenue Act of
1921, 42 Stat. 228:
A stock dividend shall not be subject to tax but if after the distribution of any such
dividend the corporation proceeds to cancel or redeem its stock at such time and in

59 See Levin v. Commissioner, 385 F.2d 521, 526-527 (2d Cir. 1967); Commissioner v. Berenbaum, 369 F.2d 337,

342 (10th Cir. 1966); Ballenger v. United States, 301 F.2d 192, 199 (4th Cir. 1962; Bradbury v. Commissioner, 29
F.2d 111, 116-117 (1st Cir. 1962).
60 See Treas. Reg. § 1.302-2(b).
61 See

B. BITTKER & J. EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS AND
SHAREHOLDERS 292 n.32 (2d ed.1966).
62 Of course, this just means that a distribution in redemption to a sole shareholder will be treated under the

general provisions of § 301, and it will only be taxed as a dividend under § 316 to the extent that there are
earnings and profits.

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such manner as to make the distribution and cancellation or redemption essentially
equivalent to the distribution of a taxable dividend, the amount received in
redemption or cancellation of the stock shall be treated as a taxable dividend. ...
Enacted in response to this Court’s decision that pro rata stock dividends do not constitute
taxable income, Eisner v. Macomber, 252 U.S. 189 (1920), the provision had the obvious
purpose of preventing a corporation from avoiding dividend tax treatment by distributing
earnings to its shareholders in two transactions – a pro rata stock dividend followed by a
pro rata redemption – that would have the same economic consequences as a simple
dividend. Congress, however, soon recognized that, even without a prior stock dividend,
essentially the same result could be effected whereby any corporation,
especially one which has only a few stockholders, might be able to make a
distribution to its stockholders which would have the same effect as a taxable
dividend.
H.R. REP. NO. 1, 69th Cong., 1st Sess., 5. In order to cover this situation, the law was
amended to apply “(whether or not such stock was issued as a stock dividend)” whenever
a distribution in redemption of stock was made “at such time and in such manner” that it
was essentially equivalent to a taxable dividend. Revenue Act of 1926, § 201(g), 44 Stat.
11.
This provision of the 1926 Act was carried forward in each subsequent revenue act, and
finally became § 115(g)(1) of the Internal Revenue Code of 1939. Unfortunately, however,
the policies encompassed within the general language of § 115(g)(1) and its predecessors
were not clear, and there resulted much confusion in the tax law. At first, courts assumed
that the provision was aimed at tax avoidance schemes, and sought only to determine
whether such a scheme existed. [citation omitted]. Although later the emphasis changed
and the focus was more on the effect of the distribution, many courts continued to find that
distributions otherwise like a dividend were not “essentially equivalent” if, for example,
they were motivated by a sufficiently strong nontax business purpose. ... There was general
disagreement, however, about what would qualify as such a purpose, and the result was a
case-by-case determination with each case decided “on the basis of the particular facts of
the transaction in question.” [citation omitted].
By the time of the general revision resulting in the Internal Revenue Code of 1954, the
draftsmen were faced with what has aptly been described as “the morass created by the
decisions.” Ballenger v. United States, 301 F.2d 192, 196 (CA4 1962). In an effort to
eliminate “the considerable confusion which exists in this area,” and thereby to facilitate
tax planning, H.R. REP. NO. 1337, 83d Cong., 2d Sess., 35, the authors of the new Code
sought to provide objective tests to govern the tax consequences of stock redemptions.

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Thus, the tax bill passed by the House of Representatives contained no “essentially
equivalent” language. Rather, it provided for “safe harbors” where capital gains treatment
would be accorded to corporate redemptions that met the conditions now found in §§
302(b)(2) and (3) of the Code.
It was in the Senate Finance Committee’s consideration of the tax bill that § 302(b)(1) was
added, and Congress thereby provided that capital gains treatment should be available “if
the redemption is not essentially equivalent to a dividend.” Taxpayer argues that the
purpose was to continue “existing law,” and there is support in the legislative history that
§ 302(b)(1) reverted “in part” or “in general” to the “essentially equivalent” provision of
§ 115(g)(1) of the 1939 Code. According to the Government, even under the old law, it
would have been improper for the Court of Appeals to rely on “a business purpose for the
redemption” and “an absence of the proscribed tax avoidance purpose to bail out dividends
at favorable tax rates.” [citations omitted]. However, we need not decide that question, for
we find from the history of the 1954 revisions and the purpose of § 302(b)(1) that Congress
intended more than merely to reenact the prior law.
In explaining the reason for adding the “essentially equivalent” test, the Senate Committee
stated that the House provisions
appeared unnecessarily restrictive, particularly, in the case of redemptions of
preferred stock which might be called by the corporation without the shareholder
having any control over when the redemption may take place.
S. REP. NO. 1622, 83d Cong., 2d Sess., 44. This explanation gives no indication that the
purpose behind the redemption should affect the result. [footnote omitted]. Rather, in its
more detailed technical evaluation of § 302(b)(1), the Senate Committee reported as
follows:
... Your committee ... intends that, in applying this test for the future ..., the inquiry
will be devoted solely to the question of whether or not the transaction, by its
nature, may properly be characterized as a sale of stock by the redeeming
shareholder to the corporation. For this purpose, the presence or absence of
earnings and profits of the corporation is not material. Example: X, the sole
shareholder of a corporation having no earnings or profits, causes the corporation
to redeem half of its stock. Paragraph (1) does not apply to such redemption
notwithstanding the absence of earnings and profits.
S. REP. NO. 1622, supra, at 234.
The intended scope of § 302(b)(1), as revealed by this legislative history, is certainly not
free from doubt. However, we agree with the Government that, by making the sole inquiry
relevant for the future the narrow one whether the redemption could be characterized as a
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sale, Congress was apparently rejecting past court decisions that had also considered
factors indicating the presence or absence of a tax avoidance motive. [footnote omitted].
At least that is the implication of the example given. Congress clearly mandated that pro
rata distributions be treated under the general rules laid down in §§ 301 and 316, rather
than under § 302, and nothing suggests that there should be a different result if there were
a “business purpose” for the redemption. Indeed, just the opposite inference must be
drawn, since there would not likely be a tax avoidance purpose in a situation where there
were no earnings or profits. We conclude that the Court of Appeals was therefore wrong
in looking for a business purpose and considering it in deciding whether the redemption
was equivalent to a dividend. Rather, we agree with the Court of Appeals for the Second
Circuit that “the business purpose of a transaction is irrelevant in determining dividend
equivalence” under § 302(b)(1). Hasbrook v. United States, 343 F.2d 811, 814 (1965).
Taxpayer strongly argues that to treat the redemption involved here as essentially
equivalent to a dividend is to elevate form over substance. Thus, taxpayer argues, had he
not bought Bradley’s shares or had he made a subordinated loan to the company instead
of buying preferred stock, he could have gotten back his $25,000 with favorable tax
treatment. However, the difference between form and substance in the tax law is largely
problematical, and taxpayer’s complaints have little to do with whether a business purpose
is relevant under § 302(b)(1). It was clearly proper for Congress to treat distributions
generally as taxable dividends when made out of earnings and profits, and then to prevent
avoidance of that result without regard to motivation where the distribution is in exchange
for redeemed stock.
We conclude that that is what Congress did when enacting § 302(b)(1). If a corporation
distributes property as a simple dividend, the effect is to transfer the property from the
company to its shareholders without a change in the relative economic interests or rights
of the stockholders. Where a redemption has that same effect, it cannot be said to have
satisfied the “not essentially equivalent to a dividend” requirement of § 302(b)(1). Rather,
to qualify for preferred treatment under that section, a redemption must result in a
meaningful reduction of the shareholder’s proportionate interest in the corporation.
Clearly, taxpayer here, who (after application of the attribution rules) was the sole
shareholder of the corporation both before and after the redemption, did not qualify under
this test. The decision of the Court of Appeals must therefore be reversed, and the case
remanded to the District Court for dismissal of the complaint.
It is so ordered.
Justice DOUGLAS, with whom THE CHIEF JUSTICE and Justice BRENNAN concur,
dissenting. [omitted]

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Questions and comments:
1. The Court accounts for the “not essentially equivalent to a dividend” language of §
302(b)(1).
2. Can you identify any black-letter rules that the Court provides?
3. In the last paragraph of its opinion, the Court said: “Rather, to qualify for preferred
treatment under that section, a redemption must result in a meaningful reduction of the
shareholder’s proportionate interest in the corporation.” How much of a reduction in a
shareholder’s proportionate interest is sufficient to be “meaningful?”
4. Consider the following and determine what bright-line rules exist concerning
“meaningful reduction” about which you would feel comfortable advising a client
prospectively. Note particularly the requisite reduction in voting control, rights to future
dividends, and rights to proceeds upon liquidation.
•Redemption by corporation of shares of its voting common stock (only class of
stock outstanding) that reduces shareholder’s interest from 90 percent to 60 percent
is not meaningful reduction of shareholder’s interest, does not qualify as
distribution not essentially equivalent to dividend within meaning of § 302(b)(1)
and, therefore, is not distribution in exchange for stock under 26 U.S.C. § 302(a).
Rev. Rul. 78-401, 1978-2 CB 127.
•Reduction in shareholder’s percentages of total voting stock from 50.54-percent
preredemption in 1965 to 43.28-percent postredemption in 1969 was
“meaningful.” Roebling v. Comm’r, 77 T.C. 30, 57 (1981).
•A redemption by a corporation of any amount of its nonvoting, nonconvertible,
nonparticipating preferred stock, which is not “section 306 stock,” but which is
preferred as to dividends and in liquidation, and all of which is owned by an
individual who owns none of the corporation’s common stock either directly or by
attribution, qualifies as not essentially equivalent to a dividend under § 302(b)(1).
Rev. Rul. 77-426, 1977-2 CB 87.
•A trust held only nonvoting preferred stock and nonvoting common stock, but
held some voting common by attribution from a beneficiary – who in turn owned
no nonvoting preferred or nonvoting common. The beneficiary and two other
shareholders together owned sufficient shares to elect a majority of the
corporation’s board of directors. A redemption of some of the trust’s nonvoting
preferred was essentially equivalent to a dividend. “[I]t is significant that (as a
result of [attribution]) the redemption did not reduce the trust’s percentage of the
vote in X. It is true that T reduced its percentage interest in current earnings,
accumulated surplus, and net assets upon liquidation, and reduced the fair market
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value of its ownership in X. However, when the redeemed shareholder has a voting
interest (either directly or by attribution), a reduction in voting power is a key
factor in determining the applicability of § 302(b)(1).” Rev. Rul. 85-106, 1985-2
CB 116.
•A corporation had only one class of stock outstanding. A redemption of an estate’s
250 shares of common stock by the corporation, whose remaining 1,500 shares of
such stock are equally divided between the estate’s sole beneficiary and an
unrelated individual, constitutes a meaningful reduction of the estate’s interest and
is not essentially equivalent to a dividend under § 302(b)(1) of the Code. The
redemption reduced the estate’s total voting rights from 57% to 50%. Rev. Rul.
75502, 1975-2 CB 111.
•Redemption of all stock in corporation held directly by inter vivos trust created
by controlling shareholder was not essentially equivalent to dividend since there
was meaningful reduction in trust’s interest in corporation from 30% (direct and
indirect) ownership to 24.3% (indirect). “As a result of the redemption, the trust
experienced a reduction of its voting rights, its right to participate in current
earnings and accumulated surplus, and its right to share in net assets on
liquidation.” Rev. Rul. 75-512, 1975-2 CB 112.
•When a shareholder who holds precisely 0.2% of a publicly traded corporation’s
outstanding stock has a portion of the stock redeemed pursuant to a tender offer
that also reduces the number of shares held by other shareholders so that the
shareholder still holds precisely 0.2% of the corporation’s outstanding stock, the
redemption does not qualify as an exchange within the meaning of §§ 302(a) and
302(b)(1). The pro rata stock interest of the shareholder was not reduced. Rev. Rul.
81-289, 1981-2 C.B. 82.
•A corporation’s redemption of a portion of its stock was not essentially equivalent
to a dividend under § 302(b)(1) with respect to the small number of shares (several
hundred out of a total of 28 million) acquired from a family corporation’s wholly
owned subsidiary. The subsidiary’s stock interest was 96.7% of what it was prior
to the redemption. Its percentage ownership was reduced from .0001118% to
.0001081%. Rev. Rul. 76-385, 1976-2 CB 92.
5. Section 302(b)(6): In addition to § 302(b)(1), § 302(b)(2, 3, and 4) provide for exchange
treatment if certain conditions are met when a corporation distributes property in
redemption of a shareholder’s shares. The requirements of § 302(b)(2, 3, and 4) are more
technical than they are for § 302(b)(1). Section 302(b)(6) provides that a “failed” §
302(b)(2, 3, or 4) redemption must still be tested under § 302(b)(1) for exchange treatment.

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6. A distribution in redemption of stock that is treated as “a payment in exchange for the
stock” presents few problems insofar as the shareholder’s basis in his stock is concerned.
But what of a distribution in redemption of stock that is not treated as “a payment in
exchange for stock?” If the corporation has earnings and profits, the distribution is treated
to that extent as a dividend.
•What happens to the basis that a shareholder had in stock that he no longer owns?
Basis is money that is not subject to income tax in the hands of the owner – usually
because it has already been subject to income tax. The shareholder should not lose
the credit he deserves for having paid that tax.
•After a distribution that is a dividend, the shareholder might own no stock directly
but own some stock by attribution?
Reg. § 1.302-2(c) says that in such cases, “proper
adjustment of the basis of the remaining stock will be
made with respect to the stock redeemed.” The
regulations leave us to glean from examples just what
“proper adjustment of the basis of the remaining
stock” is.
•Read the three examples. What rules can you
articulate?
7. (Note 6 continued): In Notice 2001-45, 2001-33
I.R.B. 129, 2001-2 C.B. 129, the IRS announced that
it would challenge certain basis-shifting transactions
that generate tax losses or reduce tax gains.

Basis Shifting: We assume that
individual taxpayers prefer
distributions to be exchanges
rather than dividends. What if the
taxpayer does not care? Perhaps
the taxpayer does not pay U.S.
income taxes. Such a nontaxpayer might receive a
distribution
in
complete
redemption of all his stock. Let’s
say that the distribution is a
dividend because stock is
attributed to him. To the taxpayer
the distribution carries no income
tax, and the taxpayer shifts the
basis of stock attributed to him
back to the source of the
attribution. Is this fair?

In the transaction, there is a redemption of
stock that is owned by a person (other than the
Taxpayer) that is not subject to U.S. tax or is
otherwise indifferent to the Federal income
tax consequences of the redemption. Purportedly as a result of the application of
the attribution rules of § 318, the redemption of stock is claimed to be a dividend
under § 301 rather than a payment in exchange for stock under § 302(a).

Shifting basis to the party from whom there was attribution enables that party to claim
losses or decrease gain upon sale of his shares. Such basis-shifting is based on the premise
that “an adjustment is appropriate where the redeemed [taxpayer] is required to include
the full redemption proceeds as a dividend in gross income that is subject to U.S. tax and
such [taxpayer] retains no stock to which the basis of the redeemed stock could attach.”
Absent U.S. tax on the dividend, presumably the IRS may challenge the loss or reduced
gain resulting from the additional basis in a subsequent sale.

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Is it fair that the IRS may apply its attribution rules on “facts and circumstances,” but
taxpayers may not? Or does such a question mis-characterize the problem?
•Treasury continues to adhere to the view it stated in Notice 2001-45. REG. –
143686-07, The Allocation of Consideration and Allocation and Recovery of Basis
in Transactions Involving Stock or Securities Withdrawal, 84 Fed. Reg. 11,686,
11,687 (Mar. 28, 2019).

Do the CALI exercise:
Corporate Taxation: Redemptions: Consequences of Redemptions Under Section 302.

Do the CALI exercise:
Corporate Taxation: Redemptions: Redemptions Not Equivalent to Dividends: Section
302(b)(1).
•As always, do not be afraid of learning something.

B. Section 302(b)(2): Substantially Disproportionate Redemption of Stock
Section 302(b)(2) treats a corporate distribution in redemption of a corporation’s stock as
“a payment in exchange for stock” if certain tests are met. Section 302(b)(1) is more
generous in giving exchange treatment to corporate distributions in redemption of their
stock – but § 302(b)(2) can be applied prospectively with considerably more certainty
because its tests are very mechanical. For a distribution in redemption of stock to be treated
as an exchange, § 302(b)(2) requires that –
•the percentage of all the corporation’s voting stock that the shareholder owns after
the redemption is less than 80% of the percentage of all the corporation’s voting
stock that the shareholder held immediately prior to the redemption, §§
302(b)(2)(A and C); AND
•the percentage of all the corporation’s common stock that the shareholder owns
after the redemption is less than 80% of the percentage of all the corporation’s
common stock that the shareholder held prior to the redemption, §§ 302(b)(2)(A
and C); AND
•after the redemption the shareholder whose shares the corporation redeems owns
less than 50% of the total combined voting power of all classes of stock entitled to
vote.

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The attribution rules of § 318 apply in determining the number of shares that a shareholder
is deemed to own both before and after the distribution in redemption of the shareholder’s
stock. § 302(c)(1).

Rev. Rul. 87-88, 1987-2 C.B. 81
ISSUE
If shares of both voting and nonvoting common stock are redeemed from a shareholder in
one transaction, are the two classes aggregated for purposes of applying the substantially
disproportionate requirement in § 302(b)(2)(C)? ...
FACTS
X corporation had outstanding 10 shares of voting common stock and 30 shares of
nonvoting common stock. The fair market values of a share of voting common stock and
a share of nonvoting common stock are approximately equal. A owned 6 shares of X voting
common stock and all the nonvoting common stock. The remaining 4 shares of the X
voting common stock were held by persons unrelated to A within the meaning of § 318(a)
...
X redeemed 3 shares of voting common stock and 27 shares of nonvoting common stock
from A in a single transaction. Thereafter, A owned 3 shares of X voting common stock
and 3 shares of nonvoting common stock. The ownership of the remaining 4 shares of X
voting common stock was unchanged.
LAW AND ANALYSIS
If a distribution in redemption of stock qualifies under § 302(b)(2) ... as substantially
disproportionate, the distribution is treated under § 302(a) as a payment in exchange for
the stock redeemed.
Under § 302(b)(2)(B) and (C) ..., a distribution is substantially disproportionate if (i) the
shareholder owns less than 50% of the total combined voting power of the corporation
immediately after the redemption, (ii) immediately after the redemption the ratio of voting
stock owned by the shareholder to all the voting stock of the corporation is less than 80%
of the same ratio immediately before the redemption, and (iii) immediately after the
redemption the ratio of common stock owned by the shareholder to all of the common
stock of the corporation (whether voting or nonvoting) is less than 80% of the same ratio
immediately before the redemption.

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Under § 302(b)(2)(C) ..., if more than one class of common stock is outstanding, the
determination in (iii) above is made by reference to fair market value. Section 302(b)(2)
applies to a redemption of both voting stock and other stock (although not to the
redemption solely of nonvoting stock). Reg. § 1.302-3(a).
With regard to requirements (i) and (ii) described above, after the redemption, A owned
less than 50% of the voting power of X (43%), and A’s voting power was reduced to less
than 80% of the percentage of voting power in X that A owned before the redemption
(from 60% to 43% for a reduction to 72% of the preredemption level).
With regard to requirement (iii) above, § 302(b)(2)(C) ... provides that, if there is more
than one class of common stock outstanding, the fair market value of all of the common
stock (voting and nonvoting) will govern the determination of whether there has been the
requisite reduction in common stock ownership. The fact that this test is based on fair
market value and is applied by reference to all of the common stock of the corporation
suggests that the requirement concerning reduction in common stock ownership is to be
applied on an aggregate basis rather than on a class-by-class basis. Thus, the fact that A
has no reduction in interest with regard to the nonvoting common stock and continues to
own 100% of this stock does not prevent the redemption of this class of stock from
qualifying under § 302(b)(2) when the whole transaction meets § 302(b)(2) requirements.
To conclude otherwise would require that, notwithstanding a redemption of one class of
common stock in an amount sufficient to reduce the shareholder’s aggregate common
stock ownership by more than 20% in value, every other class of common stock owned by
the shareholder must be subject to a redemption.
Prior to the redemption, A owned 90% of the total fair market value of all the outstanding
X common stock (36 out of the 40 shares of voting and nonvoting common stock). After
the redemption, A owned 60% of the total fair market value of all the X common stock (6
out of 10 shares). The reduction in ownership (from 90% to 60%) was a reduction to less
than 80% of the fraction that A previously owned of the total fair market value of all the X
common stock.
HOLDING
If more than one class of common stock is outstanding, the provisions of § 302(b)(2)(C)
... are applied in an aggregate and not a class-by-class manner. Accordingly, the
redemption by X of 3 shares of voting common stock and 27 shares of nonvoting common
stock qualifies as substantially disproportionate within the meaning of § 302(b)(2), even
though A continues to own 100% of the outstanding nonvoting common stock.

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Questions and comments:
1. Some stock is counted only for fulfilling the first 80% requirement, and some is counted
both for fulfilling the first and second 80% requirement.
2. Reg. § 1.302-3(a)(3) provides in part: “Section 302(b)(2) does not apply to the
redemption solely of nonvoting stock (common or preferred).” Is it sufficient for §
302(b)(2) to be applicable that a corporation redeems the shares of a shareholder who owns
only nonvoting preferred stock if the shareholder holds shares of voting common stock by
attribution?
•A corporation’s redemption of its nonvoting preferred stock that is all owned by
one shareholder, and 20 of the 50 shares of the corporation’s voting common
owned by his son who is unrelated to the corporation’s other shareholder who owns
the remaining 30 shares of voting common, is a substantially disproportionate
distribution as to both the father and son within the meaning of § 302(b)(2) that
qualifies as an exchange under § 302(a). Rev. Rul. 77-237, 1977-2 CB 88.
3. Reg. § 1.302-3(a)(3) also provides in part: “[I]f a redemption is treated as an exchange
to a particular shareholder under the terms of § 302(b)(2), such section will apply to the
simultaneous redemption of nonvoting preferred stock (which is not § 306 stock) owned
by such shareholder and such redemption will also be treated as an exchange.”
•A revenue ruling fills in the picture.
•Redemption of voting preferred stock without reduction in shareholder’s
ownership of common stock may qualify as substantially disproportionate
redemption under 26 U.S.C. § 302(b)(2) even though shareholder owns no
common stock either directly or constructively. Rev. Rul. 81-41, 1981-1 C.B. 121.
4. Read § 302(b)(2)(D). Why do you think that this provision is in the Code? See problem
1 immediately below.
•The determination of whether a plan exists depends on “all the facts and
circumstances.” Reg. § 1.302-3(a)(3) (last sentence).
•For purposes of determining whether a redemption qualifies as substantially
disproportionate, two redemptions must be considered in aggregate, pursuant to 26
U.S.C. § 302(b)(2)(D), when the first shareholder’s redemption is undertaken with
knowledge of the impending redemption of the second shareholder, despite the
absence of any agreement between the two shareholders. Rev. Rul. 85-14 (1985)
1985-1 CB 92.
5. On the other hand, suppose that A and B form a corporation, each owning one half of
the corporation’s shares. The corporation has issued 100 shares. Several years later, they
wish to bring in C. How should the following series of events be treated?
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•A and B each sell 15 shares to C. The corporation then redeems five shares each
from A and B.
•Would the result be the same if the corporation redeemed five shares each
from A and B, and then A and B each sold 15 shares to C?
•A and B cause the corporation to issue 25 new shares to C. The corporation then
redeems 25 shares each from A and B.
•Would the result be the same if the corporation redeemed 25 shares each
from A and B, and then the corporation issued 25 shares to C?
•See Rev. Rul. 75-447, 1975-2 C.B. 113.

Problems:
1. Consider: “Corporation M has outstanding 400 shares of common stock of which A, B,
C, and D each own 100 shares, [i.e.,] 25%. No stock is considered constructively owned
by A, B, C, or D under § 318. Corporation M redeems 55 shares from A, 25 shares from
B, and 20 shares from C.”
•For which shareholders are these redemptions disproportionate under § 302(b)(2)?
See Reg. § 1.302-3(b) Example.
2. Cribble Corporation has one class of voting common, with 1000 shares outstanding.
Alpha and Omega each own 300 shares. They are unrelated to each other. The remaining
400 shares are owned by others who are unrelated to Alpha or Omega. Both Alpha and
Omega have basis in their stock equal to its fmv, and Cribble has ample e&p.
a. On January 1 of the current year, Cribble distributes cash to Alpha and Omega to
redeem 100 shares from both Alpha and Omega. Will this qualify “as a distribution in part
or full payments in exchange for the stock” of Alpha and Omega?
b. Same facts except that Cribble distributes cash to Alpha on January 1 of the current
year and distributes cash to Omega on July 1, 2½ years from now?
3. Dibble Corporation has two classes of stock outstanding – 1000 shares of Class A voting
common and 1000 shares of Class B non-voting common. Beta, Gamma, Delta, and Phi
each own 250 shares of Class A stock. Rho, Lambda, Sigma, and Chi each own 250 shares
of Class B stock. None of the shareholders of either class is related to each other, and no
other person owns any stock of Dibble Corporation. Rho and Beta both have basis in their
stock equal to its fmv. Dibble has ample e&p.
a. On January 1 of the current year, Dibble redeemed 100 shares of Rho’s Class B stock
with a cash distribution. Will this qualify “as a distribution in part or full payment in
exchange for the stock” of Rho?
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b. Same facts, except that the Class B stock is non-voting preferred stock. Will Dibble’s
distribution qualify “as a distribution in part or full payment in exchange for the stock” of
Rho?
c. Same facts as (a) except that Rho is Beta’s father. In addition to redeeming 100 shares
of Rho’s non-voting common stock Dibble Corporation also redeems 100 shares of Beta’s
voting common stock. Will either of Dibble’s distributions to Beta or Rho qualify “as a
distribution in part or full payment in exchange for [their] stock”?
4. Eiffel Corporation has two classes of stock outstanding – 1000 shares of Class A voting
common and 500 shares of Class B nonvoting common. Kappa and Nu each owns 500
Class A shares. Omicron owns all 500 shares of Class B nonvoting common. Omicron is
Kappa’s father. Kappa and Omicron both have basis in their stock equal to its fmv. Eiffel
has ample e&p. Eiffel distributes cash to both Kappa and Omicron to redeem 250 shares
of the stock that they own. Will either Eiffel’s distribution to Kappa or Omicron qualify
“as a distribution in part or full payment in exchange for [their] stock”?
5. Mosky Corporation has 1000 shares of voting common outstanding. It has no other
stock outstanding. It has accumulated ample e&p.
•Belfry Corporation owns 400 shares of Mosky. FATHER owns 60% of Belfry’s
outstanding shares.
•The BBS Partnership owns 210 shares of Mosky. FATHER’S children –
BROTHER1, BROTHER2, and SISTER1 are the three equal partners of BBS.
•SISTER1 owns 190 shares of Mosky.
•The estate of Uncle (the late brother of FATHER) owns 200 shares of Mosky.
FATHER’S children – BROTHER1, BROTHER2, and SISTER2 – are the only
beneficiaries of Uncle’s estate.
a. How many shares of Mosky does FATHER own directly and by attribution?
b. Would Mosky Corporation’s redemption of 100 of SISTER1's shares qualify as “a
distribution in part or full payment in exchange for the stock” as to SISTER1? – as to
FATHER?
6. F Corporation has 100 shares of voting common stock outstanding. This is all of F
Corporation’s outstanding stock. The Estate of P owns 80 of F Corporation’s shares. Emily
holds a 30% interest in the estate. Emily’s son, Frank, holds a 40% interest in the estate.
Greta – who is not related to Emily or to Frank – holds a 25% interest in the estate.

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a. How many shares does Emily own, directly and by attribution?
b. How many shares does Frank own, directly and by attribution?
c. How many shares does Greta own, directly and by attribution?
7. Can you derive a formula to determine the minimum number of shares that a corporation
must redeem from one shareholder in order to qualify the distribution as an exchange under
§ 302(b)(2)? Let’s say that:
N = the number of shares the shareholder holds directly and by attribution;
T = the total number of shares outstanding’
X = the number of shares that must be redeemed.

Do the CALI exercise:
Corporate Taxation: Redemptions: Substantially Disproportionate Redemptions: Section
302(b)(2).
•Have Reg. § 1.302-3 at your fingertips.

C. Section 302(b)(3): Complete Termination of Interest
Read §§ 302(b)(3) and 302(c). By its terms, § 302(b)(3) can apply in an unlimited number
of factual scenarios. However, there are recurring fact patterns that raise issues of its
application. We consider: transfers of a family-held business from one generation to the
next; transfers of a family-held business when there is intra-family hostility; transfers in
furtherance of a distribution plan where the putative distributee has no interest in
participating in the business of the corporation; transfers in the context of a divorce
settlement; and transfers of a corporation from one owner to another. We will also observe
that the complete termination of a shareholder’s interest in a corporation perforce increases
the proportionate interest of the other shareholders. Indeed that is true of any meaningful
reduction of a shareholder’s interest in the corporation.
1. Intergenerational Transfers of Business
Imagine: Parents began a business many years ago, and they incorporated it. They have
children to whom they wish to pass the business on. One or more members of the second
generation begin “helping out” and eventually learn the business. One or more of the
children buys a nominal number of shares. The corporation then redeems all the parents’
shares by giving the parents a sizable promissory note. The parents now own directly none
of the outstanding shares of the corporation, but they own by attribution from their children
all the corporation’s outstanding shares.
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If only we could make family attribution go away: all the payments on the promissory note
would be taxed as long-term capital gain. To the parents, receipt of the payments would
feel the same as receipt of annuity payments – which might be very desirable to retirees.
Section 302(c)(2) provides a procedure to waive family attribution (a “1” attribution) when
the corporation redeems all the stock of a shareholder, thus assuring its treatment as a
distribution in exchange for the corporation’s stock.
But there are conditions and procedures to follow –

Lynch v. Commissioner, 801 F.2d 1176 (9th Cir. 1986)
HALL, Circuit Judge
The Commissioner of the Internal Revenue Service (Commissioner) petitions for review
of a Tax Court decision holding that a corporate redemption of a taxpayer’s stock was a
sale or exchange subject to capital gains treatment. The Commissioner argues that the
taxpayer held a prohibited interest in the corporation after the redemption and therefore
the transaction should be characterized as a dividend distribution taxable as ordinary
income. We agree with the Commissioner and reverse the Tax Court.
I
Taxpayers, William and Mima Lynch, formed the W.M. Lynch Co. on April 1, 1960. The
corporation issued all of its outstanding stock to William Lynch (taxpayer). The taxpayer
specialized in leasing cast-in-place concrete pipe machines.63 He owned the machines
individually but leased them to the corporation which in turn subleased the equipment to
independent contractors.
On December 17, 1975 the taxpayer sold 50 shares of the corporation’s stock to his son,
Gilbert Lynch (Gilbert), for $17,170. Gilbert paid for the stock with a $16,000 check given
to him by the taxpayer and $1,170 from his own savings. The taxpayer and his wife also
resigned as directors and officers of the corporation on the same day.
On December 31, 1975 the corporation redeemed all 2300 shares of the taxpayer’s stock.
In exchange for his stock, the taxpayer received $17,900 of property and a promissory note
63 The cast-in-place process avoids the need to transport precast pipe to the job site. Instead, a trench is dug

wide enough to accommodate the desired pipe diameter. A cast-in-place machine moves along the trench while
fresh cement is poured from transport trucks. The machine casts the bottom third of the pipe first, and then
forms are added to complete the remaining two-thirds.

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for $771,920. Gilbert, as the sole remaining shareholder, pledged his 50 shares as a
guarantee for the note. In the event that the corporation defaulted on any of the note
payments, the taxpayer would have the right to vote or sell Gilbert’s 50 shares.
In the years immediately preceding the redemption, Gilbert had assumed greater
managerial responsibility in the corporation. He wished, however, to retain the taxpayer’s
technical expertise with cast-in-place concrete pipe machines. On the date of the
redemption, the taxpayer also entered into a consulting agreement with the corporation.
The consulting agreement provided the taxpayer with payments of $500 per month for five
years, plus reimbursement for business related travel, entertainment, and automobile
expenses.64 In February 1977, the corporation and the taxpayer mutually agreed to reduce
the monthly payments to $250. The corporation never withheld payroll taxes from
payments made to the taxpayer.
After the redemption, the taxpayer shared his former office with Gilbert. The taxpayer
came to the office daily for approximately one year; thereafter his appearances dwindled
to about once or twice per week. When the corporation moved to a new building in 1979,
the taxpayer received a private office.
In addition to the consulting agreement, the taxpayer had other ties to the corporation. He
remained covered by the corporation’s group medical insurance policy until 1980. When
his coverage ended, the taxpayer had received the benefit of $4,487.54 in premiums paid
by the corporation. He was also covered by a medical reimbursement plan, created the day
of the redemption, which provided a maximum annual payment of $1,000 per member.
Payments to the taxpayer under the plan totaled $96.05.
II
We must decide whether the redemption of the taxpayer’s stock in this case is taxable as a
dividend distribution under 26 U.S.C. § 301 or as long-term capital gain under 26 U.S.C.
§ 302(a). [footnote omitted]. Section 302(a) provides that a corporate distribution of
property in redemption of a shareholder’s stock is treated as a sale or exchange of such
stock if the redemption falls within one of four categories described in § 302(b). If the
redemption falls outside of these categories, then it is treated as a dividend distribution
under § 301 to the extent of the corporation’s earnings and profits.65

64 The corporation leased or purchased a pickup truck for the taxpayer’s use in 1977. If someone at the corporation

needed the truck, the taxpayer would make it available to him.
65 On the date of the redemption, W.M. Lynch Co. had accumulated earnings and profits of $315,863, and had

never paid a dividend.

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Section 302(b)(3) provides that a shareholder is entitled to sale or exchange treatment if
the corporation redeems all of the shareholder’s stock. In order to determine whether there
is a complete redemption for purposes of § 302(b)(3), the family attribution rules of §
318(a) must be applied unless the requirements of § 302(c)(2) are satisfied. Here, if the
family attribution rules apply, the taxpayer will be deemed to own constructively the 50
shares held by Gilbert (100% of the corporation’s stock) and the transaction would not
qualify as a complete redemption within the meaning of § 302(b)(3).
Section 302(c)(2)(A) states in relevant part:
In the case of a distribution described in subsection (b)(3), [the family attribution
rules in] § 318(a)(1) shall not apply if –
(i) immediately after the distribution the distributee has no interest in the
corporation (including an interest as officer, director, or employee), other
than an interest as a creditor. ...
The Commissioner argues that in every case the performance of post-redemption services
is a prohibited interest under § 302(c)(2)(A)(i), regardless of whether the taxpayer is an
officer, director, employee, or independent contractor.
The Tax Court rejected the Commissioner’s argument, finding that the services rendered
by the taxpayer did not amount to a prohibited interest in the corporation. In reaching this
conclusion, the Tax Court relied on a test derived from Lewis v. Commissioner, 47 T.C.
129, 136 (1966) (Simpson, J., concurring):
Immediately after the enactment of the 1954 Code, it was recognized that §
302(c)(2)(A)(i) did not prohibit office holding per se, but was concerned with a
retained financial stake in the corporation, such as a profit-sharing plan, or in the
creation of an ostensible sale that really changed nothing so far as corporate
management was concerned. Thus, in determining whether a prohibited interest
has been retained under § 302(c)(2)(A)(i), we must look to whether the former
stockholder has either retained a financial stake in the corporation or continued to
control the corporation and benefit by its operations. In particular, where the
interest retained is not that of an officer, director, or employee, we must examine
the facts and circumstances to determine whether a prohibited interest has been
retained under § 302(c)(2)(A)(i).
Lynch v. Commissioner, 83 T.C. 597, 605 (1984) (citations omitted).
After citing the “control or financial stake” standard, the Tax Court engaged in a two-step
analysis. First, the court concluded that the taxpayer was an independent contractor rather
than an employee because the corporation had no right under the consulting agreement to
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control his actions.66 Second, the court undertook a “facts and circumstances” analysis to
determine whether the taxpayer had a financial stake in the corporation or managerial
control after the redemption. Because the consulting agreement was not linked to the future
profitability of the corporation, the court found that the taxpayer had no financial stake. The
court also found no evidence that the taxpayer exerted control over the corporation. Thus,
the Tax Court determined that the taxpayer held no interest prohibited by § 302(c)(2)(A)(i).
III
... The Tax Court’s interpretation of what constitutes a prohibited interest under §
302(c)(2)(A)(i) is a question of law reviewed de novo. [citations omitted].
We reject the Tax Court’s interpretation of § 302(c)(2)(A)(i). An individualized
determination of whether a taxpayer has retained a financial stake or continued to control
the corporation after the redemption is inconsistent with Congress’ desire to bring a
measure of certainty to the tax consequences of a corporate redemption. We hold that a
taxpayer who provides post-redemption services, either as an employee or an independent
contractor, holds a prohibited interest in the corporation because he is not a creditor.
The legislative history of § 302 states that Congress intended to provide “definite standards
in order to provide certainty in specific instances.” S. REP. NO. 1622, 83d Cong. 2d Sess.
233, reprinted in 1954 U.S. CODE CONG. & AD. NEWS 4621, 4870. “In lieu of a factual
inquiry in every case, [§ 302] is intended to prescribe specific conditions from which the
taxpayer may ascertain whether a given redemption” will qualify as a sale or be treated as
a dividend distribution. H.R. REP. NO. 1337, 83d Cong. 2d Sess. 35, reprinted 1954 U.S.
CODE CONG. & AD. NEWS 4017, 4210. The facts and circumstances approach created by
the Tax Court undermines the ability of taxpayers to execute a redemption and know the
tax consequences with certainty.
The taxpayer’s claim that the Senate rejected the mechanical operation of the House’s
version of § 302 is misleading. The Senate did reject the House bill because the “definitive
conditions” were “unnecessarily restrictive.” S. REP. NO. 1622, 83d Cong., 2d Sess. 44,
reprinted in 1954 U.S. CODE CONG. & AD. NEWS 4621, 4675. However, the Senate’s
response was to add paragraph (b)(1) to § 302, which reestablished the flexible, but
notoriously vague, “not essentially equivalent to a dividend” test. This test provided that
all payments from a corporation that were not essentially equivalent to a dividend should
be taxed as capital gains. The confusion that stemmed from a case-by-case inquiry into
“dividend equivalence” prompted the Congress to enact definite standards for the safe
66 Finding that the taxpayer was not an employee obviated the need to decide whether the parenthetical language

in § 302(c)(2)(A)(i) prohibited employment relationships per se. See Seda v. Commissioner, 82 T.C. 484, 488
(1984) (court stated that “section 302(c)(2)(A)(i) may not prohibit the retention of all employment
relationships”).

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harbors in § 302(b)(2) and (b)(3). The Tax Court’s refusal to recognize that §
302(c)(2)(A)(i) prohibits all noncreditor interests in the corporation creates the same
uncertainty as the “dividend equivalence” test.
The problem with the Tax Court’s approach is apparent when this case is compared with
Seda v. Commissioner, 82 T.C. 484 (1984). In Seda, a former shareholder, at his son’s
insistence, continued working for the corporation for two years after the redemption. He
received a salary of $1,000 per month. The Tax Court refused to hold that § 302(c)(2)(A)(i)
prohibits the retention of employment relations per se, despite the unequivocal language
in the statute. 67 Instead, the court applied the facts and circumstances approach to
determine whether the former shareholder retained a financial stake or continued to control
the corporation. The Tax Court found that the monthly payments of $1,000 constituted a
financial stake in the corporation. This result is at odds with the holding in Lynch that
payments of $500 per month do not constitute a financial stake in the corporation.
[citations omitted]. The court also found in Seda no evidence that the former shareholder
had ceased to manage the corporation. Again, this finding is contrary to the holding in
Lynch that the taxpayer exercised no control over the corporation after the redemption,
even though he worked daily for a year and shared his old office with his son. [citations
omitted] Seda and Lynch thus vividly demonstrate the perils of making an ad hoc
determination of “control” or “financial stake.”
A recent Tax Court opinion further illustrates the imprecision of the facts and
circumstances approach. In Cerone v. Commissioner, 87 T.C. 1 (1986), a father and son
owned all the shares of a corporation formed to operate their restaurant. The corporation
agreed to redeem all of the father’s shares in order to resolve certain disagreements
between the father and son concerning the management of the business. However, the
father remained an employee of the corporation for at least five years after the redemption,
drawing a salary of $14,400 for the first three years and less thereafter. The father claimed
that he was entitled to capital gains treatment on the redemption because he had terminated
his interest in the corporation within the meaning of § 302(b)(3).
Even on the facts of Cerone, the Tax Court refused to find that the father held a prohibited
employment interest per se. Instead, the Tax Court engaged in a lengthy analysis, citing
both Seda and Lynch. The court proclaimed that Lynch reaffirmed the rationale of Seda,
even though Lynch involved an independent contractor rather than an employee. After
comparing the facts of Seda and Cerone, the Tax Court eventually concluded that the
father in Cerone held a financial stake in the corporation because he had drawn a salary
that was $2,400 per year more than the taxpayer in Seda and had been employed by the
corporation for a longer period after the redemption. However, the Tax Court was still
concerned that prohibited interest in Seda might have been based on the finding in that
67 Eight of the seventeen Tax Court judges who reviewed Seda concurred in the result but would have classified

all officer, director, or employee relationships as prohibited interests under § 302(c)(2)(A)(i).

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case that the taxpayer had both a financial stake and continued control of the corporation.
The Tax Court, citing Lynch, held that the “test is whether he retained a financial stake or
continued to control the corporation.” Thus, the Tax Court found that the father in Cerone
held a prohibited interest because he had a financial stake as defined by Seda.
Although the Tax Court reached the correct result in Cerone, its approach undermines the
definite contours of the safe harbor Congress intended to create with §§ 302(b)(3) and
302(c)(2)(A)(i). Whether a taxpayer has a financial stake according to the Tax Court seems
to depend on two factors, length of employment and the amount of salary. Length of
employment after the redemption is irrelevant because Congress wanted taxpayers to know
whether they were entitled to capital gains treatment on the date their shares were
redeemed. See S. REP. NO. 1622, 83d Cong., 2d Sess. 235-36, reprinted in 1954 U.S. CODE
CONG. & AD. NEWS 4621, 4872-73. See also Treas. Reg. § 1.302-4(a)(1) (taxpayer must
attach a statement disclaiming any interest in the corporation with the first tax return filed
after the distribution). As for the amount of annual salary, the Tax Court’s present
benchmark appears to be the $12,000 figure in Seda. Salary at or above this level will be
deemed to be a financial stake in the enterprise, though the $6,000 annual payments in this
case were held not to be a financial stake. There is no support in the legislative history of
§ 302 for the idea that Congress meant only to prohibit service contracts of a certain worth,
and taxpayers should not be left to speculate as to what income level will give rise to a
financial stake.
In this case, the taxpayer points to the fact that the taxpayers in Seda and Cerone were
employees, while he was an independent contractor. On appeal, the Commissioner
concedes the taxpayer’s independent contractor status. We fail to see, however, any
meaningful way to distinguish Seda and Cerone from Lynch by differentiating between
employees and independent contractors. All of the taxpayers performed services for their
corporations following the redemption. To hold that only the employee taxpayers held a
prohibited interest would elevate form over substance. The parenthetical language in §
302(c)(2)(A)(i) merely provides a subset of prohibited interests from the universe of such
interests, and in no way limits us from finding that an independent contractor retains a
prohibited interest. Furthermore, the Tax Court has in effect come to ignore the
parenthetical language. If employment relationships are not prohibited interests per se,
then the taxpayer’s status as an employee or independent contractor is irrelevant. What
really matters under the Tax Court’s approach is how the taxpayer fares under a facts and
circumstances review of whether he has a financial stake in the corporation or managerial
control.68 Tax planners are left to guess where along the continuum of monthly payments
from $500 to $1000 capital gains treatment ends and ordinary income tax begins.

68 The Tax Court’s focus on managerial control or a financial stake originated with Judge Simpson’s concurrence

in Lewis, 47 T.C. at 136-38. His interpretation of § 302(c)(2)(A) is supported by Bittker, Stock Redemptions and
Partial Liquidations Under the Internal Revenue Code of 1954, 9 STAN. L. REV. 13, 33 n.72 (1956). Professor Bittker
argues that Congress’ goal was to ensure that taxpayers who transferred only ostensible control or maintained a

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Our holding today that taxpayers who provide post-redemption services have a prohibited
interest under § 302(c)(2)(A)(i) is inconsistent with the Tax Court’s decision in Estate of
Lennard v. Commissioner, 61 T.C. 554 (1974). That case held that a former shareholder
who, as an independent contractor, provided post-redemption accounting services for a
corporation did not have a prohibited interest. The Tax Court found that “Congress did not
intend to include independent contractors possessing no financial stake in the corporation
among those who are considered as retaining an interest in the corporation for purposes of
the attribution waiver rules.” We disagree. In the context of Lennard, the Tax Court
appears to be using financial stake in the sense of having an equity interest or some other
claim linked to the future profit of the corporation. Yet, in cases such as Seda and Cerone,
the Tax Court has found that fixed salaries of $12,000 and $14,400, respectively, constitute
a financial stake. Fees for accounting services could easily exceed these amounts, and it
would be irrational to argue that the definition of financial stake varies depending on
whether the taxpayer is an employee or an independent contractor. In order to avoid these
inconsistencies, we conclude that those who provide postredemption services, whether as
independent contractors or employees, hold an interest prohibited by § 302(c)(2)(A)(i)
because they are more than merely creditors.
In addition, both the Tax Court and the Commissioner have agreed that taxpayers who
enter into management consulting contracts after the redemption possess prohibited
interests. Chertkof v. Commissioner, 72 T.C. 1113, 1124-25 (1979), aff’d, 649 F.2d 264
(4th Cir. 1981); Rev. Ruling 70-104, 1970-1 C.B. 66 (1970). Taxpayers who provide such
services are, of course, independent contractors. However, unlike the Commissioner’s
opinion in Rev. Ruling 70-104 that all management consulting agreements are prohibited
interests, the Tax Court applies the financial stake or managerial control test. In Chertkof,
the court found that because the services provided under the contract “went to the essence”
of the corporation’s existence, the taxpayer had not effectively ceded control. Here, the
Tax Court distinguished Chertkof on the ground that the taxpayer did not retain control of
the corporation, but instead provided only limited consulting services. We believe that any
attempt to define prohibited interests based on the level of control leads to the same
difficulties inherent in making a case-by-case determination of what constitutes a financial
stake.69

financial stake in the corporation did not receive the benefit of capital gains treatment. He is no doubt correct.
However, the means selected by Congress to achieve this goal do not allow for an individualized determination
of control and financial stakes. Instead, § 302(c)(2)(A)(i) operates mechanically: the taxpayer must sever all but
a creditor’s interest to avoid the family attribution rules and thereby receive capital gains treatment. Nowhere in
the legislative history of § 302(c) does Congress intimate that courts may use a flexible facts and circumstances
test to determine the existence of managerial control or a financial stake.
Determining the existence of control is particularly difficult in the context of a family-held corporation. The
exercise of control often will not be obvious because a parent may influence a child, and hence corporate
decisionmaking, in myriad ways. Our rule that the provision of services is a prohibited interest eliminates the
need to make a speculative inquiry into whether the parent still controls the corporation after the redemption.

69

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IV
Our decision today comports with the plain language of § 302 and its legislative history.
[citations omitted]. Taxpayers who wish to receive capital gains treatment upon the
redemption of their shares must completely sever all noncreditor interests in the
corporation. 70 We hold that the taxpayer, as an independent contractor, held such a
noncreditor interest, and so cannot find shelter in the safe harbor of § 302(c)(2)(A)(i).
Accordingly, the family attribution rules of § 318 apply and the taxpayer fails to qualify
for a complete redemption under § 302(b)(3). The payments from the corporation in
redemption of the taxpayer’s shares must be characterized as a dividend distribution
taxable as ordinary income under § 301.
REVERSED.

Questions and comments:
1. The court’s extensive review of earlier cases demonstrates that § 302(c)(2)(A)(i) must
be construed literally – as the court did. Otherwise the certainty that Congress desired
would be lost.
2. Section 302(c)(2) permits a distributee to waive family attribution – and only family
attribution – in cases of a complete termination of interest if certain conditions are met.
Not surprisingly, the procedure for waiver and the conditions of waiver should assure that
the one whose shares the corporation redeems truly has no interest in the corporation.
•The redeemed shareholder may not retain an interest in the corporation, including
an interest as officer, director, or employee. The redeemed shareholder may retain
an interest as a creditor. § 302(c)(2)(A)(i).

Of course, no rule could or should prohibit post-redemption parent-child communication concerning the
management of the corporation.
70

Our definition of a prohibited interest still leaves an open question as to the permissible scope of a creditor’s
interest under § 302(c)(2)(A)(i). See, e.g., Treas. Reg. § 1.302-4(d) (a creditor’s claim must not be subordinate to
the claims of general creditors or in any other sense proprietary, i.e., principal payments or interest rates must
not be contingent on the earnings of the corporation).
The taxpayer argues that some creditor relationships might result in an “opportunity to influence” as great or
greater than any officer, director, or employee relationship. He cites Rev. Ruling 77-467, 1977-2 C.B. 92 which
concluded that a taxpayer who leased real property to a corporation, after the corporation redeemed his shares,
held a creditor’s interest under § 302(c)(2)(A)(i). While the taxpayer here may be correct in his assessment of a
creditor’s “opportunity to influence” a corporation, he overlooks the fact that Congress specifically allowed the
right to retain such an interest.

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•The distributee may not acquire any such interest within 10 years of the date of
distribution other than by bequest or inheritance. § 302(c)(2)(A)(ii). AND
•The distributee must file a notice with his first return for the taxable year in which
the distribution occurs. The distributee must represent that he has not acquired a
prohibited interest and that he will notify the IRS of the acquisition of any such
interest other than by bequest or inheritance. § 302(c)(2)(A)(iii), Reg. § 1.302-4(a).
The reacquisition of even one share can make an entire distribution subject to dividend
treatment under § 301.
•However, attribution rules will not apply to determine whether the redeemed
shareholder has acquired a prohibited interest in the corporation. Rev. Rul. 71-562,
1971-2 C.B. 173. In that ruling, father and son-1 each owned 50% of the
outstanding shares of the corporation. The corporation redeemed all of father’s
shares, and waivers were filed. Within ten years, son-2 purchased some shares
from son-1. Son-2's shares were not attributed to father.
3. Note 2 (continued): The waiver rules do not apply to redemptions of stock that the
shareholder acquired directly or indirectly within 10 years prior to the date of distribution
from a person whose ownership of stock would at the time of distribution be attributed to
the distributee. This is the so-called “look-back” rule. § 302(c)(2)(B)(i).
•What fact pattern is this provision intended to address?
Moreover, the waiver rules do not apply to redemptions of stock if another person acquired
shares directly or indirectly from the distributee within 10 years prior to the distribution
where such person’s stock is attributed to the distributee. § 302(c)(2)(B)(ii).
•What fact pattern is this provision intended to address?
These two provisions do not apply if the acquisition or disposition by the respective
distributees did not have “as one of its principal purposes the avoidance of Federal income
tax.” § 302(c)(2)(B) (carryout ¶).
4. Returning to the scenario that we imagined at the outset of this section: How realistic
is it to expect that the first generation will not own what the United States Court of Appeals
for the Third Circuit regards as a prohibited interest?
•Notice that the Tax Court in several cases was willing to consider facts and
circumstances to determine whether the redeemed shareholder had retained a
prohibited interest. Does this provide any insight into the types of considerations
that should be relevant in § 302(b)(3) cases?
5. Within the context of redemptions under § 302, we have seen that § 302(b)(1) provides
a standard that can be uncertain of application. Sections 302(b)(2 and 3) provide “safe
harbors.” The purpose of “safe harbors” is to avoid uncertainty of application. The court
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is no doubt correct in its observations that a “facts and circumstances” approach to §
302(c)(2) will not avoid uncertain application.
6. Theoretically then, cases such as Lynch could be decided under § 302(b)(1). How
should cases such as Lynch fare under that standard?
7. The redeemed shareholder may in fact retain a rather significant interest.
•Landlord relationship: A taxpayer whose stock in a family corporation is
redeemed and who retires as a corporate officer but continues to receive payments,
not dependent on the corporation’s future earnings or subordinate to the
corporation’s general creditors, representing an arm’s length charge for the
corporation’s use of a building owned by the taxpayer, does not have a prohibited
interest in the corporation within the meaning of § 302(c)(2)(A)(i). Rev. Rul.
77467, 1977-2 C.B. 92.
•Unfunded pension: A entered into a pension agreement with X Corporation prior
to X’s redemption of all A’s shares. A’s pension agreement represents the sole
relationship between A and X after the redemption of A’s X stock. The pension
agreement is unfunded. Payments under the agreement are not dependent upon the
future earnings of X. A’s claim to such payments are not subordinate to the claims
of X’s general creditors. The only rights in X retained by A are those contract rights
available to enforce X’s duties under the pension agreement. Such relationship
does not provide A with an interest in X that is prohibited by § 302(c)(2)(A)(i).
Rev. Rul. 84-135, 1984-2 C.B. 80.
8. Might a creditor have rights sufficiently significant to be considered an owner or
manager of the corporation? Read Reg. § 1.302-4(d) (if payments of principal or the
interest rate depend on earnings of corporation, “lender” has “proprietary” interest in
corporation). See the last footnote of the court in Lynch.
•Should retention of a security interest in the redeemed stock constitute a prohibited
interest?

Hurst v. Commissioner, 124 T.C. 16 (2005)
HOLMES, J.
Richard Hurst founded and owned Hurst Mechanical, Inc. (HMI), a thriving small business
in Michigan that repairs and maintains heating, ventilating, and air conditioning (HVAC)
systems. He bought, with his wife Mary Ann, a much smaller HVAC company called RHI;
and together they also own the building where HMI has its headquarters.

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When the Hursts decided to retire in 1997, they sold RHI to HMI, sold HMI to a trio of
new owners who included their son, and remained HMI’s landlord. Mary Ann Hurst stayed
on as an HMI employee at a modest salary and with such fringe benefits as health insurance
and a company car.
The Hursts believe that they arranged these transactions to enable them to pay tax on their
profit from the sale of HMI and RHI at capital gains rates over a period of fifteen years.
The Commissioner disagrees.
FINDINGS OF FACT
….
In April 1979, the Hursts opened their own HVAC business, working out of their basement
and garage. Mr. Hurst handled the technical and sales operations while Mrs. Hurst did the
bookkeeping and accounting. The business began as a proprietorship, but in November of
that year they incorporated it under Michigan law, with Mr. Hurst as sole shareholder of
the new corporation, named Hurst Mechanical, Inc. (HMI). In 1989, HMI elected to be
taxed under subchapter S of the Code, and that election has never changed. [footnote
omitted]. The firm grew quickly, and after five years it had about 15 employees; by 1997,
it had 45 employees and over $4 million in annual revenue.
... The Hursts bought [a] building [on Safety Drive in Belmont, Michigan] in their own
names and leased it to HMI. In early 1994, the Hursts bought another HVAC business,
Refrigerator Man, Inc., which they renamed R.H., Inc. (RHI). Each of the Hursts owned
half of RHI’s stock.
In 1996, with HMI doing well and settled into a stable location, the Hursts began thinking
about retirement. Three employees had become central to the business and were to become
important to their retirement plans. One was Todd Hurst, who had grown up learning the
HVAC trade from his parents. The second was Thomas Tuori. Tuori was hired in the mid
1980s to help Mary Ann Hurst manage HMI’s accounting, and by 1997 he was the chief
financial officer of the corporation. The last of the three was Scott Dixon, brought on in
1996, after Richard Hurst came to believe that HMI was big enough to need a sales
manager. Dixon anticipated the potential problems posed by the Hursts’ eventual
retirement so, before joining the firm, he negotiated an employment contract that included
a stock option. His attorney also negotiated stock option agreements for Tuori and Todd
Hurst at about the same time. These options aimed to protect Dixon and the others if HMI
were sold.
In late 1996, Richard Hurst was contacted by Group Maintenance American Corporation
(GMAC). GMAC was an HVAC consolidator – a company whose business plan was to
buy small HVAC businesses and try to achieve economies of scale – and it offered to buy
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HMI for $2.5 million. Mr. Hurst told Tuori, Dixon, and Todd about GMAC’s offer, and
they themselves confirmed it – only to learn that GMAC had no interest in keeping them
on after a takeover. Convinced they were ready to run the business, they approached Mr.
Hurst in May 1997 with their own bid to buy his HMI stock, matching the $2.5 million
offered by GMAC. Mr. Hurst accepted the offer, confident that the young management
team he had put together would provide a secure future for the corporation he had built up
over nearly twenty years.
Everyone involved sought professional advice from lawyers and accountants who held
themselves out as having expertise in the purchase and sale of family businesses. The
general outline of the deal was soon clear to all. The Hursts would relinquish control of
HMI and RHI to Tuori, Dixon, and Todd Hurst, and receive $2.5 million payable over
fifteen years. HMI, Inc. would continue to lease the Safety Drive property from the Hursts.
The proceeds from the sale of the corporations and the rent from the lease would support
the Hursts during their retirement. Mrs. Hurst would continue to work at HMI as an
employee, joining the firm’s health plan to get coverage for herself and her husband. Tuori,
Dixon, and Todd Hurst would own the company, getting the job security they would have
lacked had HMI been sold.
Everything came together on July 1, 1997: HMI bought 90 percent of its 1000 outstanding
shares from Mr. Hurst for a $2 million note. Richard Hurst sold the remaining 100 shares
in HMI to Todd Hurst (51 shares), Dixon (35 shares), and Tuori (14 shares). The new
owners each paid $2500 a share, also secured by promissory notes. HMI bought RHI from
the Hursts for a $250,000 note. [footnote omitted]. (All these notes, from both HMI and
the new owner, had an interest rate of eight percent and were payable in 60 quarterly
installments.) HMI also signed a new 15-year lease for the Safety Drive property, with a
rent of $8,500 a month, adjusted for inflation. The lease gave HMI an option to buy the
building from the Hursts, and this became a point of some contention – described below –
after the sale. And, finally, HMI also signed a ten-year employment contract with Mrs.
Hurst, giving her a small salary and fringe benefits that included employee health
insurance.
If done right, the deal would have beneficial tax and nontax effects for the Hursts. From a
tax perspective, a stock sale would give rise to long-term capital gain, taxed at lower rates
than dividends.71 And by taking a 15-year note, rather than a lump sum, they could qualify
for installment treatment under § 453, probably letting them enjoy a lower effective tax
rate.

71 This was an important consideration to the Hursts – although HMI was an S corporation at the time of these

transactions, and thus subject only to a single tier of tax, §§ 1363, 1366, it had been a C corporation until 1989
and still had $383,000 in accumulated earnings from those years that had not been distributed to Mr. Hurst.
Without careful planning, these earnings might end up taxed as dividends under § 1368(c).

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There were also nontax reasons for structuring the deal this way. HMI’s regular bank had
no interest in financing the deal, and the parties thought that a commercial lender would
have wanted a security interest in the corporations’ assets. By taking a security interest
only in the stock, the Hursts were allowing the buyers more flexibility should they need to
encumber corporate assets to finance the business.
But this meant that they themselves were financing the sale. And spreading the payments
over time meant that they were faced with a lack of diversification in their assets and a
larger risk of default. To reduce these risks, the parties agreed to a complicated series of
cross-default and cross-collateralization provisions, the net result of which was that a
default on any one of the promissory notes or the Safety Drive lease or Mrs. Hurst’s
employment contract would constitute a default on them all. Since the promissory notes
were secured by the HMI and RHI stock which the Hursts had sold, a default on any of
the obligations would have allowed Mr. Hurst to step in and seize the HMI stock to satisfy
any unpaid debt.
As it turned out, these protective measures were never used, and the prospect of their use
seemed increasingly remote. Under the management of Todd Hurst, Dixon, and Tuori,
HMI boomed. The company’s revenue increased from approximately $4 million annually
at the time of the sale to over $12 million by 2003. Not once after the sale did any of the
new owners miss a payment on their notes or the lease.
The Hursts reported the dispositions of both the HMI and RHI stock on their 1997 tax
return as installment sales of long-term capital assets. The Commissioner disagreed, and
recharacterized these dispositions as producing over $400,000 in dividends and over $1.8
million in immediately recognized capital gains. In the resulting notice of deficiency for
the Hursts’ 1997 tax year, he determined that this (and a few much smaller adjustments)
led to a total deficiency of $538,114, and imposed an accuracy-related penalty under §
6662 of $107,622.80. ...
OPINION
Figuring out whether the Hursts or the Commissioner is right requires some background
vocabulary. In tax law, a corporation’s purchase of its own stock is called a “redemption.”
§ 317(b). The Code treats some redemptions as sales under § 302, but others as a payment
of dividends to the extent the corporation has retained earnings and profits, with any excess
as a return of the shareholder’s basis, and any excess over basis as a capital gain.
Distributions characterized as dividends, return of basis, or capital gains are commonly
called “§ 301 distributions” ...
The rules for redemptions and distributions from S corporations, which are found in § 1368
and its regulations, add a layer of complexity, especially when the corporation has
accumulated earnings and profits (as both HMI and RHI did). These rules require
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computation of an “accumulated adjustments account,” an account which tracks the
accumulation of previously taxed, but undistributed, earnings of an S corporation.
Distributions up to the amount of the accumulated adjustments account are generally tax
free to the extent they do not exceed a shareholder’s basis in his stock. (Some of the Hursts’
proceeds from their sales of their stock benefited from these rules, but that was not a point
of contention in the case.)
For much of the Code’s history (including 1997), noncorporate sellers usually preferred a
redemption to be treated as a sale because that offered the advantage of taxation at capital
gains rates and the possible recognition of that gain over many years under § 453's
provisions for installment sales. This preference led to increasingly elaborate rules for
determining which redemptions qualify as sales and which are treated as dividends or other
§ 301 distributions. The Code has three safe harbors: redemptions that are substantially
disproportionate with respect to the shareholder, § 302(b)(2); redemptions that terminate
a shareholder’s interest, § 302(b)(3); and redemptions of a noncorporate shareholder’s
stock in a corporation that is partially liquidating, § 302(b)(4). Each of these safe harbors
comes with its own regulations and case law.
The Code also allows redemption treatment if a taxpayer can meet the vaguer standard of
proving that a particular redemption is “not essentially equivalent to a dividend.” §
302(b)(1). The relevant regulation notes that success under this standard turns “upon the
facts and circumstances of each case.” Reg. § 1.302–2(b).
Given the stakes involved, the Hursts and their advisers tried to steer this deal toward the
comparatively well-lit safe harbor of § 302(b)(3) – the “termination redemption.”
Reaching their destination depended on redeeming the HMI stock in a way that met the
rules defining complete termination of ownership. And one might think that a termination
redemption would be easy to spot, because whether a taxpayer did or didn’t sell all his
stock looks like a simple question to answer. Congress, however, was concerned that
taxpayers would manipulate the rules to get the tax benefits of a sale without actually
cutting their connection to the management of the redeeming corporation. The problem
seemed especially acute in the case of family-owned businesses, because such businesses
often don’t have strict lines between the roles of owner, employee, consultant, and director.
The Code addresses this problem by incorporating rules attributing stock ownership of one
person to another (set out in § 318) in the analysis of transactions governed by § 302.
Section 318(a)(1)(A)(ii), which treats stock owned by a child as owned by his parents,
became a particular obstacle to the Hursts’ navigation of these rules because their son Todd
was to be one of HMI’s new owners. This meant that the note that Mr. Hurst received from
HMI in exchange for 90 percent of his HMI stock might be treated as a § 301 distribution,
because he would be treated as if he still owned Todd’s HMI stock – making his
“termination redemption” less than “complete”.

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But this would be too harsh a result when there really is a complete termination both of
ownership and control. Thus, Congress provided that if the selling family member elects
to keep no interest in the corporation other than as a creditor for at least ten years, the
Commissioner will ignore the § 318 attribution rules. § 302(c)(2); Reg. § 1.302-4.
[footnote omitted].
[The primary tax issue] ... in this case turns on whether Richard Hurst proved that the sale
of his HMI stock was a termination redemption, specifically whether he kept an interest
“other than an interest as a creditor” in HMI. ...
....
A. Complete Termination of Interest in HMI
The Hursts’ argument is simple – they say that Richard (who had owned all the HMI stock)
walked completely away from the company, and has no interest in it other than making
sure that the new owners keep current on their notes and rent. The Commissioner’s
argument is more complicated. While acknowledging that each relationship between the
Hursts and their old company – creditor under the notes, landlord under the lease,
employment of a non-owning family member – passes muster, he argues that the total
number of related obligations resulting from the transaction gave the Hursts a prohibited
interest in the corporation by giving Richard Hurst a financial stake in the company’s
continued success.
In analyzing whether this holistic view is to prevail, we look at the different types of
ongoing economic benefits that the Hursts were to receive from HMI: (a) The debt
obligations in the form of promissory notes issued to the Hursts by HMI and the new
owners, (b) their lease of the Safety Drive building to HMI; and (c) the employment
contract between HMI and Mrs. Hurst.
1. Promissory Notes
There were several notes trading hands at the deal’s closing. One was the $250,000 note
issued by HMI to the Hursts for their RHI stock. The second was the $2 million, 15-year
note, payable in quarterly installments, issued to Mr. Hurst by HMI in redemption of 90
percent (900 of 1000) of his HMI shares. Mr. Hurst also received three 15-year notes
payable in quarterly installments for the remaining 100 HMI shares that he sold to Todd
Hurst, Dixon, and Tuori. All these notes called for periodic payments of principal and
interest on a fixed schedule. Neither the amount nor the timing of payments was tied to
the financial performance of HMI. Although the notes were subordinate to HMI’s
obligation to its bank, they were not subordinate to general creditors, nor was the amount
or certainty of the payments under them dependent on HMI’s earnings. [citations omitted].
All of these contractual arrangements had cross-default clauses and were secured by the
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buyers’ stock. This meant that should any of the notes go into default, Mr. Hurst would
have the right to seize the stock and sell it. The parties agree that the probable outcome of
such a sale would be that Mr. Hurst would once again be in control of HMI.
Respondent questions the cross-default clauses of the various contractual obligations, and
interprets them as an effective retention of control by Mr. Hurst. But in Lynch v.
Commissioner, 83 T.C. 597 (1984), rev’d. on other grounds, 801 F.2d 1176 (9th Cir.
1986), we held that a security interest in redeemed stock does not constitute a prohibited
interest under § 302. We noted that “[t]he holding of such a security interest is common in
sales agreements, and * * * not inconsistent with the interest of a creditor.” [citation
omitted]. Furthermore, at trial, the Hursts offered credible evidence from their professional
advisers that these transactions, including the grant of a security interest to Mr. Hurst, were
consistent with common practice for seller-financed deals.
2. The Lease
HMI also leased its headquarters on Safety Drive from the Hursts. As with the notes, the
lease called for a fixed rent in no way conditioned upon the financial performance of HMI.
Attorney Ron David, who was intimately familiar with the transaction, testified
convincingly that there was no relationship between the obligations of the parties and the
financial performance of HMI. The transactional documents admitted into evidence do not
indicate otherwise. There is simply no evidence that the payment terms in the lease
between the Hursts and HMI vary from those that would be reasonable if negotiated
between unrelated parties. And the Hursts point out that the IRS itself has ruled that an
arm’s-length lease allowing a redeeming corporation to use property owned by a former
owner does not preclude characterization as a redemption. Rev. Rul. 77–467, 1977–2 C.B.
92.
The Commissioner nevertheless points to the lease to bolster his claim that Mr. Hurst kept
too much control, noting that in 2003 he was able to persuade the buyers to surrender
HMI’s option to buy the property. Exercising this option would have let HMI end its rent
expense at a time of low mortgage interest rates, perhaps improving its cashflow – and so
might well have been in the new owners’ interest. But the Hursts paid a price when the
new owners gave it up. Not only did the deal cancel the option, but it also cut the interest
rate on the various promissory notes owed to the Hursts from eight to six percent. So we
think the Commissioner is wrong in implicitly asserting that the buyers should have
engaged in every behavior possible that would be adverse to the elder Hursts’ interest, and
focus on whether the elder Hursts kept “a financial stake in the corporation or continued
to control the corporation and benefit by its operations.” Lynch, 83 T.C. at 604. Ample and
entirely credible testimony showed that the discussions about HMI’s potential purchase of
the Safety Drive location were adversarial: The Hursts as landlords wanted to keep the
rent flowing, and the new owners wanted to reduce HMI’s cash outlays. Though the Hursts

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kept their rents, the new owners did not give up the option gratuitously – making this a
negotiation rather than a collusion.
3. Employment of Mrs. Hurst
At the same time that HMI redeemed Mr. Hurst’s stock and signed the lease, it also agreed
to a ten-year employment contract with Mrs. Hurst. Under its terms, she was to receive a
salary that rapidly declined to $1000/month and some fringe benefits – including health
insurance, use of an HMI-owned pickup truck, and free tax preparation.
In deciding whether this was a prohibited interest, the first thing to note is that Mrs. Hurst
did not own any HMI stock. Thus, she is not a “distributee” unable to have an “interest in
the corporation (including an interest as officer, director, or employee), other than an
interest as a creditor.” § 302(c)(2)(A)(i). The Commissioner is thus forced to argue that
her employment was a “prohibited interest” for Mr. Hurst. And he does, contending that
through her employment Mr. Hurst kept an ongoing influence in HMI’s corporate affairs.
He also argues that an employee unrelated to the former owner of the business would not
continue to be paid were she to work Mrs. Hurst’s admittedly minimal schedule. And he
asserts that her employment was a mere ruse to provide Mr. Hurst with his company car
and health benefits, bolstering this argument with proof that the truck used by Mrs. Hurst
was the same one that her husband had been using when he ran HMI.
None of this, though, changes the fact that her compensation and fringe benefits were
fixed, and again – like the notes and lease – not subordinated to HMI’s general creditors,
and not subject to any fluctuation related to HMI’s financial performance. Her duties,
moreover, were various administrative and clerical tasks – some of the same chores she
had been doing at HMI on a regular basis for many years. And there was no evidence
whatsoever that Mr. Hurst used his wife in any way as a surrogate for continuing to manage
(or even advise) HMI’s new owners. Cf. Lynch, 801 F.2d at 1179 (former shareholder
himself providing post-redemption services).
It is, however, undisputed that her employment contract had much the same cross-default
provisions that were part of the lease and stock transfer agreements. The Commissioner
questions whether, in the ordinary course of business, there was reason to intertwine
substantial corporate obligations with the employment contract of only one of 45
employees. He points to this special provision as proof that the parties to this redemption
contemplated a continuing involvement greater than that of a mere creditor.
In relying so heavily on the cross-default provisions of the Hursts’ various agreements,
though, the Commissioner ignores the proof at trial that there was a legitimate creditor’s
interest in the Hursts’ demanding them. They were, after all, parting with a substantial
asset (the corporations), in return for what was in essence an IOU from some business
associates. Their ability to enjoy retirement in financial security was fully contingent upon
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their receiving payment on the notes, lease, and employment contract. As William Gedris,
one of the Hursts’ advisers, credibly testified, it would not have been logical for Mr. Hurst
to relinquish shares in a corporation while receiving neither payment nor security.
The value of that security, however, depended upon the financial health of the company.
Repossessing worthless shares as security on defaulted notes would have done little to
ensure the Hursts’ retirement. The cross-default provisions were their canary in the coal
mine. If at any point the company failed to meet any financial obligation to the Hursts, Mr.
Hurst would have the option to retrieve his shares immediately, thus protecting the value
of his security interest instead of worrying about whether this was the beginning of a
downward spiral. This is perfectly consistent with a creditor’s interest, and there was
credible trial testimony that multiple default triggers are common in commercial lending.
We find that the cross-default provisions protected the Hursts’ financial interest as
creditors of HMI, for a debt on which they had received practically no down payment, and
the collection of which (though not “dependent upon the earnings of the corporation” as
that phrase is used in Reg. § 1.302-4(d)) was realistically contingent upon HMI’s
continued financial health. The buyers likewise had a motivation to structure the
transaction as they did – their inability to obtain traditional financing without unduly
burdening HMI’s potential for normal business operations. Even one of the IRS witnesses
showed this understanding of Mr. Hurst’s relationship to the new owners after the
redemption – the revenue agent who conducted the audit accurately testified that Mr. Hurst
was “going to be the banker and wanted his interests protected.”
The number of legal connections between Mr. Hurst and the buyers that continued after
the deal was signed did not change their character as permissible security interests. Even
looked at all together, they were in no way contingent upon the financial performance of
the company except in the obvious sense that all creditors have in their debtors’ solvency.
Moreover, despite the Commissioner’s qualms, we find as a matter of fact that Mr. Hurst
has not participated in any manner in any corporate activity since the redemptions occurred
– not even a Christmas party or summer picnic. His only dealing with HMI after the sale
was when, as noted above, he dickered with the buyers over their purchase option on the
Safety Drive property. These facts do not show a continuing proprietary stake or control
of corporate management.
....
To reflect the foregoing and incorporate other stipulated issues,
Decision will be entered under Rule 155.

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Questions and comments:
1. The court provides a nice overview of the interplay between §§ 302(b)(3), 302(c)(2),
and 318.
2. The Commissioner attacked the arrangements under § 304, but the attack was untimely.
In an omitted part of the opinion, the court held that it could not consider § 304 because it
constituted “new matter.” However, you should not treat this case as not involving § 304
issues. After all, Robert Hurst (through attribution and otherwise) controlled two
corporations, HMI and RHI. He sold stock in RHI to HMI.
•Perhaps the problem is avoided by having Robert Hurst sell his stock in RHI directly
to his son and three business partners rather than to HMI. The parties could adjust
the purchase price accordingly. [Wait until we study § 304 to answer this question.]
•Not surprisingly, the court also overturned the assessment of a penalty.
3. Suppose that the corporation fails to make a payment on a promissory note that it owes
a first generation shareholder. What rights may a creditor reserve to seize property of the
corporation? See Reg. § 1.302-4(e).
•Distinguish Hurst from Reg. § 1.302-4(e).
4. In Lynch, the Tax Court had considered whether taxpayer had retained a sufficient
interest to constitute a financial or managerial interest in the success of the company. The
Third Circuit held that these matters were irrelevant if Mr. Lynch worked in some capacity,
whether as employee or as independent contractor, for the company. In Hurst, does it not
seem that the same considerations find a place in determining whether an interest as a
creditor may constitute a prohibited interest? And the question is appropriate for Mrs.
Hurst’s continuing status as an employee.
5. Articulate the Commissioner’s position in Hurst. Does it not seem to be the flip side of
the same “facts and circumstances” coin that the CA3 rejected in Lynch?
6. How would the Hursts have treated their sale of RHI stock to HMI if they had sold such
stock at a loss? What effect does waiver under § 302(c)(2) have on the applicability of §
267(a)(1)?
7. Avoidance of Federal Income Tax: Consider the following:
•Taxpayer received 80 shares from his grandparent and 20 shares from his father. Father
owned the remaining 500 shares of the corporation. Taxpayer had no interest in managing
the corporation. Two years later, father bought 20 shares from taxpayer for fmv.
Corporation redeemed taxpayer’s other 80 shares. Corporation had no plans to redeem the
20 shares father purchased from taxpayer, and taxpayer was not an officer, director, or
employee of corporation. Taxpayer did not attempt to retain control or an economic
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interest in the corporation. HELD: Father’s “reacquisition from [taxpayer] of the 20 shares
of previously gifted stock, immediately prior to the redemption of [taxpayer’s] remaining
... shares, is not deemed to have had as one of its principal purposes the avoidance of
federal income tax notwithstanding that the gift of such shares and the subsequent
reacquisition of such shares occurred within the 10-year period preceding the redemption
of B’s remaining X shares.” Rev. Rul. 85-19, 1985-1 CB 94.
•Father owned all the stock of X Corporation. He gifted half of it to son, “who is active
and knowledgeable in the affairs of the business of X and who intends to control and
manage the corporation in the future.” X Corporation then redeemed all of father’s
remaining shares. “The gift of stock was intended solely for the purpose of enabling
[father] to retire while leaving the business to [son]. Therefore, the avoidance of Federal
income tax will not be deemed to have been one of the principal purposes of the gift of
stock from [father] to [son], notwithstanding the reduction of the capital gains tax payable
by father as a result of the gift of appreciated stock prior to the redemption. Rev. Rul. 77293, 1977-2 CB 91.

Do the CALI exercise:
Corporate Taxation: Redemptions: Redemptions Terminating Shareholder's Interests:
Section 302(b)(3).

2. Transfers of a Business When There is Intra-Family Hostility
In many of the cases in which taxpayer relies on § 302(b)(3) to obtain redemption
treatment, waiver of family attribution is critical. In the absence of family attribution,
former shareholders would not have much difficulty showing that they do not directly hold
any interest in the corporation. Congress presumably adopted the attribution rules because
it perceived either a unity of interest among the parties or control by one party over
another. Taxpayers not unreasonably may believe that if the presumptions underlying the
attribution rules, especially the family attribution rules, simply are not true, then the rules
should not be applicable. The language of § 318 however does not contemplate a purposedriven approach to application of the family attribution rules; its language establishing
attribution is mandatory (“shall”).
Section 301(b)(6) provides that in determining whether a redemption meets the
requirements of § 302(b)(1) (“not essentially equivalent to a dividend”), the fact that a
redemption fails the tests of §§ 302(b)(2, 3, or 4) is not to be taken into account. Section
302(b)(1) contemplates a “facts and circumstances” approach to determine whether a
distribution is “not essentially equivalent to a dividend.” Reg. § 1.302-2(b)(1). Might

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courts consider the presence of intra-family hostility as a “fact and circumstance” in
resolving § 302(b)(1) questions?
In Haft Trust v. Commissioner, 510 F.2d 43 (CA1 1975), the court said yes:
The effect of the transaction rather than its motivation is determinative. Section
302(b)(1) requires a “meaningful reduction of the shareholder’s proportionate
interest in the corporation,” id. (emphasis supplied). This language certainly seems
to permit, if it does not mandate, an examination of the facts and circumstances to
determine the effect of the transaction transcending a mere mechanical application
of the attribution rules.
Id. at 47. That case involved a father’s ownership of shares that were attributed to four
trusts, each benefitting one of his children. Father and mother divorced, and mother was
given custody of the children. The corporation redeemed all the shares owned by the four
trusts. Mother, a new husband, and children, moved to another city. Father had very little
contact with the children after that. He was indifferent to the children, rarely saw them,
and stopped making court-ordered child support payments. The court remanded the case
for consideration of the fact of such indifference in determining whether the distribution
in redemption of the trust’s shares were “not essentially equivalent to the payment of a
dividend.”
Are there any highly foreseeable and undesirable consequences of such a holding?
Haft Trust has not been endorsed by any other court post Davis. The IRS announced that
it would not follow Haft because a “facts and circumstances” approach is inconsistent with
the mechanical approach that § 318 requires. Rev. Rul. 80-26, 1980-1 CB 66. The Tax
Court and the Fifth Circuit gave Davis a closer look than did the court in Haft Trust and
concluded that family hostility in no way affects applicability of the attribution rules. In
Metzger Trust v. Comm’r, 693 F.2d 459, 466 (CA5 1982), cert. denied, 463 U.S. 1207
(1983), the court said:
The Davis Court was referring to a meaningful reduction in the shareholder’s
interest after application of the attribution rules. It would be strange indeed if what
the Court really meant was that the attribution rules are to be applied before
determining dividend equivalency, but then in the course of determining dividend
equivalency their applicability could be reconsidered. If that were so, the
attribution rules would hardly “provide a clear answer to what would otherwise be
a difficult tax question ...” Davis, 397 U.S. at 306.
Id. at 466 (emphasis in original; footnotes omitted). And in Cerone v. Comm’r, 87 T.C. 1,
16 (1986), the Tax Court said: “[F]amily hostility does not prevent application of the
attribution rules. At most, as we suggested in Metzger Trust, family hostility comes into
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play only in determining, after the attribution rules have been applied, whether any
reduction in stock ownership is meaningful.” In Cerone, all the outstanding remaining
shares after the redemption were attributed to taxpayer from his son. Since taxpayer owned
100% of the shares prior to the redemption – half directly and half by attribution – and
owned 100% of the shares after the redemption – all by attribution – there could not be a
“meaningful” reduction in taxpayer’s interest.
In light of this approach, do you think that intra-family hostility can have much of a role
to play in analyzing cases under § 302(b)(1)?

3. Waiver of Family Attribution by an Entity
Read § 302(c)(2)(C). Congress added this provision to the Code in the Tax Equity and
Fiscal Responsibility Act of 1982.72
Consider the facts of Crawford v. Comm’r, 59 T.C. 830 (1973), nonacq. 1974-2 C.B. 5.73
H and W (residents of California, a community property state) had two sons, S-1 and S-2.
H/W, S-1, and S-2 each owned ⅓ of the stock in each of two corporations. The parties
agreed that in the event of H’s death, all of H and W’s shares owned as community
property would be offered to the respective corporations for redemption. H died. W was
the sole beneficiary of H’s estate. The estate offered its ½ interest in H and W’s shares to
the respective corporations, which redeemed them. Both corporations distributed cash to
W in redemption of her remaining half interest in H and W’s shares. She filed § 302(c)(2)
agreements with her tax return. The estate filed § 302(c)(2) agreements with its tax return.
Under the family attribution rules, shares of S-1 and S-2 would (otherwise) be attributed
to W (i.e., a “1” attribution). The estate sought to waive this attribution. 74 The
Commissioner argued that the estate was not entitled to waive family attribution and that
only family members described in § 318(a)(1)(A) could waive attribution. The
Commissioner argued that half of the distributions to W should be taxed as a dividend.
The Tax Court disagreed and noted that the language of § 318(c)(2) did not restrict the
power to waive family attribution to family members and that it should not matter whether
the estate first distributed the stock to the beneficiary instead of offering it to the
corporation.

72 P.L. 97-248, § 228(a)
73 A case with issues similar to the issues in Crawford and with the same result was Johnson Trust v. Commissioner, 71

T.C. 941 (1979).
74 Notice that if the estate had distributed the shares it received from H, there would have been no problem.

could simply have waived family attribution.

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W

The facts of Crawford and the position of the Commissioner raised two issues: (1) can an
entity waive family attribution; (2) should it matter whether an estate distributes stock
rather than the cash proceeds of a redemption from it because if the estate does not
distribute stock, it technically is the distributee and it would own all the shares. Shares
would be attributed from sons to W to the estate (i.e., a “1" followed by a “3"). As a policy
matter, should it not be rather straight-forward to redeem her shares without other shares
being attributed to her?
In the Tax Equity and Fiscal Responsibility Act of 1982, Congress added § 302(c)(2)(C).
An entity may waive family attribution. It does not matter whether the estate (or other
entity) distributes shares or proceeds to the beneficiary (or partner, beneficiary, or
shareholder). Notice just how narrow § 302(c)(2)(C) is. Exactly what attribution can be
waived and by whom (or what)?
•A “1" followed by a “3” and no other?
•Suppose S-2 had also been a beneficiary of the estate? Would the result in
Crawford have been the same after enactment of § 302(c)(2)(C)? See Estate of
Webber v United States, 263 F. Supp. 703, 707 (E.D. Ky. 1967), aff’d, 404 F.2d
411, (CA6 1968); Rev. Rul. 71-261, 1971-1 CB 108.
Notice also the requirements that § 302(c)(2)(C)(i)(II) imposes for entity waiver.
Now consider the facts of Rickey v. United States, 592 F.2d 1251 (CA5 1979) – a case
decided prior to enactment of § 302(c)(2)(C). Father owned 57% of the outstanding shares
of corporation. His three children owned 35% of the outstanding shares of corporation.
His three children and Wife were the sole legatees under his will. Father died, and the
corporation redeemed all the estate’s shares – the ones Father had owned prior to his death.
Because of the redemption, the three children owned 82% of the outstanding shares of the
corporation. The estate distributed the cash among the four legatees. The Commissioner
treated the distribution as essentially equivalent to a dividend. The court refused to adopt
a “crabbed” reading of § 302(c)(2) and permitted the estate to waive the attribution of §
318(a)(3). Id. at 1258.
•Shortly thereafter, Congress “endorsed” the holding in Rickey by enacting §
302(c)(2)(C). Did it really endorse the holding in Rickey? What family attribution
did the estate waive in Rickey?
Avoidance of Federal Income Tax: In Rev. Rul. 85-19, 1985-1 C.B. 94, the IRS stated:
Tax avoidance ... within the meaning of § 302(c)(2)(B) ... requires both the
presence of a certain state of mind on the part of the taxpayer in connection with
the acquisition or the disposition of stock, coupled with the accomplishment of the
tax avoidance design via a redemption of stock. Tax avoidance, therefore, cannot
be present, for example, merely because there has been a transfer of stock by one
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§ 318(a)(1) relative to another, when such transfer was not in contemplation of
redemption of the balance of the transferor's stock nor of the stock transferred to
the transferee. See Rev. Rul. 56-556, 1956-2 C.B. 177; Rev. Rul. 56-584, 1956-2
C.B. 179; Rev. Rul. 57-387, 1957-2 C.B. 225. Similarly, tax avoidance cannot be
present merely because a shareholder has transferred stock to a related person
within the meaning of § 318(a)(1) even though such transfer may have been in
contemplation of redemption of the balance of the transferor’s stock or of the stock
transferred to the transferee, if in fact no redemption of either the transferor’s stock
or the stock transferred to the transferee actually occurs.

4. Transfers in the Context of a Divorce Settlement
Imagine: Spouses are married and together own a substantial portion – perhaps all –the
stock of a corporation. The corporation grows – often due to the efforts of the spouses.
The spouses divorce. They do not want a court to draft the terms of their dissolution, so
they must work out the terms of alimony and a property settlement. There are essentially
no tax consequences of a property settlement to the parties except for the tax consequences
of gains/losses built in to the property that they receive from the settlement (§ 1041). It
probably will not be prudent (or even possible) for both to continue their involvement in
the corporation; hence one of the spouses must dispose of his stock. As part of the property
settlement, they agree that one of the spouses will buy the stock of the other or cause the
corporation to redeem all the stock of the other spouse – a distribution that should qualify
for § 302(b)(3) sale or exchange treatment. Often a promissory note is involved. This
would mean that the spouse whose shares are redeemed must pay income tax at capital
gain rates on the amount realized in excess of his basis. The incidence and amount of tax
liability would of course be a part of the settlement discussions.
After finalization of the divorce, the distributee spouse reneges and does not pay income
tax on a distribution in exchange for stock. The distributee spouse argues that the payment
fulfills the distributee-former spouse’s primary and unconditional obligation under the
property settlement. As in Sullivan, the corporation’s fulfillment of that obligation is a
taxable dividend to the one whose obligation the corporation fulfills. See, e.g., Read v.
Comm’r, 114 T.C. 14, 38 (2000), aff’d sub. nom. without opinion, Mulberry Motor Parts,
Inc. v. Comm’r, 273 F.3d 1120 (CA 11 2001) (§ 1041(a) applies to distributee spouse’s
transfer of stock; no gain or loss recognized); Arnes v. United States, 981 F.2d 456, 460
(CA9 1992) (§ 1041(a) applies to distributee spouse’s transfer of stock; no gain or loss
recognized).

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Note that after careful negotiation, there is a double-cross. In 2003, 75 Treasury
promulgated a regulation that provides more certainty. (It might not be in your edited
version of the Code and Regulations, so it is reprinted here):
§ 1.1041-2(a) Redemptions of stock. – (a) In general. – (1) Redemption of stock
not resulting in constructive distributions. – Notwithstanding Q&A-9 of Reg. §
1.1041-1T(c), if a corporation redeems stock owned by a spouse or former spouse
(transferor spouse), and the transferor spouse’s receipt of property in respect of
such redeemed stock is not treated, under applicable tax law, as resulting in a
constructive distribution to the other spouse or former spouse (non-transferor
spouse), then the form of the stock redemption shall be respected for Federal
income tax purposes. Therefore, the transferor spouse will be treated as having
received a distribution from the corporation in redemption of stock.
(2) Redemption of stock resulting in constructive distribution. – Notwithstanding
Q&A-9 of § 1.1041-1T(c), if a corporation redeems stock owned by a transferor
spouse, and the transferor spouse’s receipt of property in respect of such redeemed
stock is treated, under applicable tax law, as resulting in a constructive distribution
to the nontransferor spouse, then the redeemed stock shall be deemed first to be
transferred by the transferor spouse to the nontransferor spouse and then to be
transferred by the nontransferor spouse to the redeeming corporation. Any property
actually received by the transferor spouse from the redeeming corporation in
respect of the redeemed stock shall be deemed first to be transferred by the
corporation to the nontransferor spouse in redemption of such spouse’s stock and
then to be transferred by the nontransferor spouse to the transferor spouse.
(b) Tax consequences – (1) Transfers described in paragraph (a)(1) of this section.
– Section 1041 will not apply to any of the transfers described in paragraph (a)(1)
of this section. See § 302 for rules relating to the tax consequences of certain
redemptions; redemptions characterized as distributions under § 302(d) will be
subject to § 301 if received from a Subchapter C corporation or section 1368 if
received from a Subchapter S corporation.
(2) Transfers described in paragraph (a)(2) of this section. – The tax consequences
of each deemed transfer described in paragraph (a)(2) of this section are
determined under applicable provisions of the Internal Revenue Code as if the
spouses had actually made such transfers. Accordingly, § 1041 applies to any
deemed transfer of the stock and redemption proceeds between the transferor
spouse and the nontransferor spouse, provided the requirements of § 1041 are
otherwise satisfied with respect to such deemed transfer. Section 1041, however,
75 Department of the Treasury, Constructive Transfers and Transfers of Property to a Third Party on Behalf of a Spouse, 63

Fed. Reg. 1534 (Jan.13, 2003).

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will not apply to any deemed transfer of stock by the nontransferor spouse to the
redeeming corporation in exchange for the redemption proceeds. See § 302 for
rules relating to the tax consequences of certain redemptions; redemptions
characterized as distributions under § 302(d) will be subject to § 301 if received
from a Subchapter C corporation or § 1368 if received from a Subchapter S
corporation.
(c) Special rules in case of agreements between spouses or former spouses – (1)
Transferor spouse taxable. – Notwithstanding applicable tax law, a transferor
spouse’s receipt of property in respect of the redeemed stock shall be treated as a
distribution to the transferor spouse in redemption of such stock for purposes of
paragraph (a)(1) of this section, and shall not be treated as resulting in a
constructive distribution to the nontransferor spouse for purposes of paragraph
(a)(2) of this section, if a divorce or separation instrument, or a valid written
agreement between the transferor spouse and the nontransferor spouse, expressly
provides that –
(i) Both spouses or former spouses intend for the redemption to be treated,
for Federal income tax purposes, as a redemption distribution to the
transferor spouse; and
(ii) Such instrument or agreement supersedes any other instrument or
agreement concerning the purchase, sale, redemption, or other disposition
of the stock that is the subject of the redemption.
(2) Nontransferor spouse taxable. – Notwithstanding applicable tax law, a
transferor spouse’s receipt of property in respect of the redeemed stock shall be
treated as resulting in a constructive distribution to the nontransferor spouse for
purposes of paragraph (a)(2) of this section, and shall not be treated as a
distribution to the transferor spouse in redemption of such stock for purposes of
paragraph (a)(1) of this section, if a divorce or separation instrument, or a valid
written agreement between the transferor spouse and the nontransferor spouse,
expressly provides that –
(i) Both spouses or former spouses intend for the redemption to be
treated, for Federal income tax purposes, as resulting in a constructive
distribution to the nontransferor spouse; and
(ii) Such instrument or agreement supersedes any other instrument or
agreement concerning the purchase, sale, redemption, or other disposition
of the stock that is the subject of the redemption.
The parties are free to choose who will bear the tax burden resulting from a corporate
redemption of one of the party’s stock. The “default” rules of Reg. § 1.1041-2(a)(1 and 2)
refer to “applicable tax law.” Presumably this means determining whether the
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nontransferor spouse has a “primary and unconditional” obligation to purchase the stock
of the transferring spouse. The regulation contains two provisions that the parties must be
careful to include to obtain this predictable treatment.

5. Redemptions in the Context of an Acquisition
Can you imagine a situation where § 302(b)(3) might enable one to acquire control of a
corporation?

Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954)
GOURLEY, District Judge
The appeal relates to the interpretation of § [302(b)(1)] ... and poses the question –
Is a distribution of substantially all of the accumulated earnings and surplus of a
corporation, which are not necessary to the conduct of the business of the corporation, in
redemption of all outstanding shares of stock of said corporation owned by one person
essentially equivalent to the distribution of a taxable dividend under the Internal Revenue
Code?
The District Court answered in the affirmative and sustained a deficiency assessment by
the Commissioner of Internal Revenue.
... [W]e believe the judgment should be reversed.

The question stems from the following circumstances:
Appellant is the widow of the person who was the motivating spirit behind the closed
corporation which engaged in the business of excavating and laying of sewers. Through
death of her husband she became the owner of all shares of stock issued by the corporation.
She operated the business until remarriage, when her second husband assumed the
management. As a result of a marital rift, separation, and final divorce, taxpayer sought to
dispose of her company to a competitor who was anxious to eliminate competition.
Prospective buyer did not want to assume the tax liabilities which it was believed were
inherent in the accumulated earnings and profits of the corporation. To avoid said profits
and earnings as a source of future taxable dividends, buyer purchased part of taxpayer’s
stock for cash. Three weeks later, after corporate reorganization and corporate action, the
corporation redeemed the balance of taxpayer’s stock, purchasing the same as treasury
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stock which absorbed substantially all of the accumulated earnings and surplus of the
corporation.
Taxpayer, in her tax return, invoked [§ 302(b)(3)] ... as constituting a cancellation or
redemption by a corporation of all the stock of a particular shareholder, and therefore was
not subject to being treated as a distribution of a taxable dividend.
The District Court sustained the deficiency assessment of the Commissioner that the
amount received from accumulated earnings and profits was ordinary income since the
stock redeemed by the corporation was “at such time and in such manner as to make the
redemption thereof essentially equivalent to the distribution of a taxable dividend” under
[§ 302(b)(1)] ...
The District Court’s findings were premised upon the view that taxpayer employed a
circuitous approach in an attempt to avoid the tax consequences which would have
attended the outright distribution of the surplus to the taxpayer by the declaration of a
taxable dividend.
The rationale of the District Court is dedicated to piercing the external manifestations of
the taxpayer’s transactions in order to establish a subterfuge or sham.
Nevertheless, the general principle is well settled that a taxpayer has the legal right to
decrease the amount of what otherwise would be his taxes or altogether avoid them, by
means which the law permits. Gregory v. Helvering, 293 U.S. 465, 469; [citation omitted].
The taxpayer’s motive to avoid taxation will not establish liability if the transaction does
not do so without it. [citations omitted].
The question accordingly presented is not whether the overall transaction, admittedly
carried out for the purpose of avoiding taxes, actually avoided taxes which would have
been incurred if the transaction had taken a different form, but whether the sale constituted
a taxable dividend or the sale of a capital asset. [citation omitted].
It is a salutary fact that [§ 302(b)(3)] ... is an exception to [§ 301] ... that all distributions
of earning and profits are taxable as a dividend.
The basic precept underlying the capital gains theory of taxation as distinguished from
ordinary income tax is the concept that a person who has developed an enterprise in which
earnings have been accumulated over a period of years should not be required to expend
the ordinary income tax rate in the one year when he withdraws from his enterprise and
realizes his gain.

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Common logic dictates that a fair basis of measuring income is not determined upon the
profits on hand in the year of liquidation but is properly attributable to each year in which
the profits were gained.
We cannot concur with the legal proposition enunciated by the District Court that a
corporate distribution can be essentially equivalent to a taxable dividend even though that
distribution extinguishes the shareholder’s interest in the corporation. To the contrary, we
are satisfied that where the taxpayer effects a redemption which completely extinguishes
the taxpayer’s interest in the corporation, and does not retain any beneficial interest
whatever, that such transaction is not the equivalent of the distribution of a taxable
dividend as to him. Tiffany v. Commissioner of Internal Revenue, 16 T.C. 1443.
The statutory concept of dividend is a distribution out of earnings and profits, and normally
it is proportionate to shares and leaves the shareholder holding his shares as his capital
investment. Flinn v. Commissioner of Internal Revenue, 37 B.T.A. 1085.
Complete and partial liquidations are treated for the purpose of the statute, as sales with a
consequent measure of gain or loss, even though the proceeds may to some extent be
derived from earnings. Hellmich v. Hellman, 276 U.S. 233.
The use of corporate earnings or profits to purchase and make payment for all the shares
of a taxpayer’s holdings in a corporation is not controlling, and the question as to whether
the distribution in connection with the cancellation or the redemption of said stock is
essentially equivalent to the distribution of a taxable dividend under the Internal Revenue
Code and Treasury Regulation must depend upon the circumstances of each case.
Since the intent of the taxpayer was to bring about a complete liquidation of her holdings
and to become separated from all interest in the corporation, the conclusion is inevitable
that the distribution of the earnings and profits by the corporation in payment for said stock
was not made at such time and in such manner as to make the distribution and cancellation
or redemption thereof essentially equivalent to the distribution of a taxable dividend.
In view of the fact that the application of [§ 301] ... contemplates that the shareholder
receiving the distribution will remain in the corporation, the circumstances of this
proceeding militate against treating taxpayer’s sale as a distribution of a taxable dividend.
....
We conclude that under the facts and circumstances of the present case the District Court
was in error, and the taxpayer is not liable as a distributee of a taxable dividend under [§
301] ...
The decision and judgment of the District Court is reversed and the case remanded with
instructions to enter judgment in accordance with this opinion.
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Questions and comments:
1. Suppose that the corporation had redeemed most of taxpayer’s shares. Then taxpayer
sold her few remaining shares to the third-party competitor. Her plan all along was that
she would have no interest in the corporation and that the competitor would own all the
shares. Should the result have been different? Cf. Rev. Rul. 75-447, 1975-2 C.B. 113
(applying § 302(b)(2)).
2. Notice that redemption of Mrs. Zenz’s shares caused the ownership interest of the other
shareholder in the corporation to increase from a nominal amount to 100%. Shouldn’t the
value of this increase be treated as a distribution to which § 301 applies?

6. Redemptions from Corporate Shareholders; Increasing the Interest of
Remaining Shareholders
Suppose: X corporation has outstanding 200,000x shares of voting common stock, which
is widely held and publicly traded. On June 1 of the current year, X offered to purchase
shares of its common stock for $250 per share. On June 2 of the current year, Y
corporation, which owned no X common stock either directly or constructively under §
318 prior to X’s offer, purchased 4000 shares of X stock on the market for a total price of
$1,000,000, and immediately tendered 800 shares to X for redemption. (Why did Y
corporation tender exactly 800 shares?) On June 21 of the current year, Y sold the
remaining 3200 shares of X stock on the market for $800,000. Y claimed a $200,000
dividends-received deduction. Because Y no longer owned the 800 shares that it tendered
to X and because Y claimed dividend treatment, Y increased its basis in its remaining
shares and claimed a short-term capital loss of $200,000 that it will apply against capital
gains from other sources.
•Was the sequence of Y Corporation’s disposal of its X Corporation stock, i.e.,
redemption followed by sale, important? What result if it had sold shares prior to
the redemption?
•Should the corporate distribution and ensuing sale of shares on the open market
be considered in the aggregate as a sort of reverse Zenz case? See Rev. Rul. 77226, 1977-2 C.B. 90.
•If the redemption of a shareholder’s shares qualifies for sale or exchange treatment
under § 302(b), should a shareholder be allowed to elect dividend treatment instead
by sequencing transactions carefully?
Imagine we are corporate tax counsel for the parties in the following case and with the
benefit of hindsight can apply the learning of Zenz and Rev. Rul. 75-447.

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Holsey v. Commissioner, 258 F.2d 865 (3d Cir. 1958)
MARIS, Circuit Judge
This is a petition to review a decision of the Tax Court. ... [This] case involves
[petitioner’s] income tax liability for the year 1951. ... The facts as found by the Tax Court,
some of which were stipulated, may be summarized as follows:
J.R. Holsey Sales Company, a New Jersey corporation, was organized on April 28, 1936,
as an Oldsmobile dealership. Taxpayer has been president and a director of the company
since its organization. Only 20 shares were issued out of the 2,500 shares of no par value
stock authorized; these 20 shares were issued to Greenville Auto Sales Company, a
Chevrolet dealership, in exchange for all of the latter’s right, title, and interest to the
Oldsmobile franchise and other assets with respect to the franchise which had been owned
and operated by the Greenville Company. The 20 shares issued were assigned a value of
$11,000. Taxpayer’s father, Charles V. Holsey, in 1936, owned more than two-thirds of
the outstanding stock of the Greenville Company, and taxpayer was vice-president and a
director of that corporation.
On April 30, 1936, taxpayer acquired from the Greenville Company an option to purchase
50% of the outstanding shares of the Holsey Company for $11,000, and a further option
to purchase, within ten years after the exercise of the first option, all the remaining shares
for a sum to be agreed upon. The Greenville Company owned all of the outstanding stock
of the Holsey Company from its organization in 1936 until November, 1939, when
taxpayer exercised his first option and purchased 50% of the outstanding stock of the
Holsey Company for $11,000.
On June 28, 1946, the further option in favor of taxpayer was revised. Under the terms of
the revised option, taxpayer was granted the right to purchase the remaining outstanding
shares of the Holsey Company at any time up to and including June 28, 1951, for $80,000.
The revised option was in favor of taxpayer individually and was not assignable by him to
anyone other than a corporation in which he owned not less than 50% of the voting stock.
On the date of the revision of this option, taxpayer’s father owned 76% of the stock of the
Greenville Company and taxpayer was a vice-president and director of that corporation.
... On January 19, 1951, taxpayer assigned his revised option to the Holsey Company; on
the same date the Holsey Company exercised the option and paid the Greenville Company
$80,000 for the stock held by it. This transaction resulted in taxpayer becoming the owner
of 100% of the outstanding stock of the Holsey Company. In his income tax return for the
year 1951, taxpayer gave no effect to this transaction.
... On January 19, 1951, when the revised option was exercised, the earned surplus of the
Holsey Company was in excess of $300,000.

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The Oldsmobile franchise, under which the Holsey Company operated, was a yearly
contract entered into by the Corporation and the manufacturer in reliance upon the personal
qualifications and representations of taxpayer as an individual. It was the manufacturer’s
policy to have its dealers own all of the stock in dealership organizations.
The Commissioner determined that the effect of the transaction of January 19, 1951,
wherein the Holsey Company paid $80,000 to the Greenville Company for 50% of the
outstanding stock of the Holsey Company, constituted a dividend to taxpayer, the
remaining stockholder. The Commissioner therefore asserted a deficiency against taxpayer
in the sum of $41,385.34. The Tax Court sustained the Commissioner.
The question presented for decision in this case is whether the Tax Court erred in holding
that the payment by the Holsey Company of $80,000 to the Greenville Company for the
purchase from that company of its stock in the Holsey Company was essentially equivalent
to the distribution of a taxable dividend to the taxpayer, the remaining stockholder of the
Holsey Company. To determine that question we must begin with the applicable statute,
[§§ 301, 302(b)(3)] ...
It will be observed that [§ 301] defines a dividend as a distribution made by a corporation
“to its shareholders”. Accordingly unless a distribution which is sought to be taxed to a
stockholder as a dividend is made to him or for his benefit it may not be regarded as either
a dividend or the legal equivalent of a dividend. Here the distribution was made to the
Greenville Company, not to the taxpayer. This the Government, of course, concedes but
urges that it was made for the benefit of the taxpayer. It is true that it has been held that a
distribution by a corporation in redemption of stock which the taxpayer stockholder has a
contractual obligation to purchase is essentially the equivalent of a dividend to him since
it operates to discharge his obligation. Wall v. United States, 164 F.2d 462 (CA4 1947);
Ferro v. Commissioner of Internal Revenue, 242 F.2d 838 (CA3 1957); Zipp v.
Commissioner of Internal Revenue, 259 F.2d 119 (CA6 1958). But where, as here, the
taxpayer was never under any legal obligation to purchase the stock held by the other
stockholder, the Greenville Company, having merely an option to purchase which he did
not exercise but instead assigned to the Holsey Company, the distribution did not discharge
any obligation of his and did not benefit him in any direct sense.
It is, of course, true that the taxpayer was benefited indirectly by the distribution. The value
of his own stock was increased, since the redemption was for less than book value, and he
became sole stockholder. But these benefits operated only to increase the value of the
taxpayer’s stock holdings; they could not give rise to taxable income within the meaning
of the Sixteenth Amendment until the corporation makes a distribution to the taxpayer or
his stock is sold. Eisner v. Macomber, 252 U.S. 189 (1920); Schmitt v. Commissioner of
Internal Revenue, 208 F.2d 819 (CA3 1954). In the latter case in a somewhat similar
connection this court said ...:

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“During these years when Wolverine was buying its own shares it, of course, was
subject to income tax as a corporation. Mrs. Green was subject to tax on whatever
profit she made by the sale of these shares to the corporation. But what happened
to warrant imposing a tax upon Schmitt and Lehren?[76] If one owns a piece of real
estate and, because of its favorable location in a city, the land becomes increasingly
valuable over a period of years, the owner is not subject to income taxation upon
the annual increase in value. In the same way, if a man owns shares in a corporation
which gradually become more valuable through the years he is not taxed because
of the increase in value even though he is richer at the end of each year than he
was at the end of the year before. If he disposes of that which has increased, of
course he must pay tax upon his profit. All of this is hornbook law of taxation;
nobody denies it.”
We think that the principle thus stated is equally applicable here. Indeed the Tax Court
itself has so held in essentially similar cases. S.K. Ames, Inc., v. Commissioner, 46 B.T.A.
1020 (1942); Fred F. Fischer v. Commissioner, 6 T.C.M. 520 (1947).
The question whether payments made by a corporation in the acquisition and redemption
of its stock are essentially equivalent to the distribution of a taxable dividend has been
often before the courts and certain criteria have been enunciated. The most significant of
these is said to be whether the distribution leaves the proportionate interests of the
stockholders unchanged as occurs when a true dividend is paid. Ferro v. Commissioner of
Internal Revenue, 242 F.2d 838, 841 (CA3 1957). The application of that criterion to the
facts of this case compels the conclusion that in the absence of a direct pecuniary benefit
to the taxpayer the Tax Court erred in holding the distribution in question taxable to him.
For in his case prior to the distribution the taxpayer and the Greenville Company each had
a 50% interest in the Holsey Company whereas after it was over the taxpayer had 100%
of the outstanding stock and the Greenville Company none.
The Government urges the lack of a corporate purpose for the distribution and the taxpayer
seeks to establish one. But we do not consider this point for, as we have recently held, “[i]t
is the effect of the redemption, rather than the purpose which actuated it, which controls
the determination of dividend equivalence.” Kessner v. Commissioner of Internal Revenue,
248 F.2d 943, 944 (CA3 1957). Nor need we discuss the present position of the
Government that the transaction must be treated as a sham and the purchase of the stock
as having been made by the taxpayer through his alter ego, the Holsey Company. For the
Tax Court made no such finding, doubtless in view of the fact that at the time the taxpayer
owned only 50% of the stock and was in a minority on the board of directors. On the
contrary that court based its decision on the benefit which the distribution by the
76 [Schmitt and Lehren were the only two shareholders of Wolverine other than Mrs. Green, a widow who

inherited her shares from her late husband. Schmitt and Lehren did not have the means to buy Mrs. Green’s
shares. After several years, the corporation finally agreed to buy her shares.]

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corporation to the Greenville Company conferred upon the taxpayer, which it thought gave
rise to taxable income in his hands.
For the reasons stated we think that the Tax Court erred in its decision. The decision will
accordingly be reversed and the cause remanded for further proceedings not inconsistent
with this opinion.
McLAUGHLIN, Circuit Judge (dissenting).
I think that the net effect of the facile operation disclosed in this case amounts to the
distribution of a taxable dividend to the taxpayer. … I agree with the Tax Court that “[t]he
assignment of the option contract to J.R. Holsey Sales Co. was clearly for the purpose of
having that company pay the $80,000 in exercise of the option that was executed for
petitioner’s personal benefit. The payment was intended to secure and did secure for
petitioner exactly what it was always intended he should get if he made the payment
personally, namely, all of the stock in J.R. Holsey Sales Co.”
I would affirm the Tax Court decision.

Questions and comments:
1. Diagram the facts.
2. After the purchase (redemption?) of Greenville’s shares by the J.R. Holsey Company,
Greenville owned no more shares of J.R. Holsey Sales Company. How do you think
Greenville treated the payment it received from J.R. Holsey Sales Company?
•Moreover, how should we expect J.R. Holsey Sales Company to treat its receipt
of its own stock at what was evidently a bargain price?
3. What would have been the result if the Commissioner had brought its case against
Charles V. Holsey, arguing that he had received a taxable dividend?

IV. Partial Liquidations: § 302(b)(4)
The partial liquidation of a corporation through redemption of shares implies a contraction
of the corporation and so, a reduction of its capital. We expect a partial liquidation of a
corporation to involve a corporation’s distribution of some of its capital in exchange for a
pro rata portion of all shareholders’ shares. A distribution of the corporation’s capital in
such circumstances should be treated as a return of capital by shareholders. But to the
shareholder, such a pro rata distribution would “feel” exactly like what the Supreme Court
in Davis said is “always” essentially equivalent to a dividend. Because pro rata
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distributions characterized as partial liquidations can receive capital gain treatment, it
should not be surprising that corporations and their shareholders may find characterizing
their pro rata distributions as “partial liquidations” to be attractive.
Perhaps for that reason, whether a distribution in exchange for shares is a partial liquidation
is determined by viewing things from the perspective of the distributing corporation. Read
§§ 302(b)(4) and 302(e). Prior to 1982, § 346 governed the tax consequences of partial
liquidations. In the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), 77
Congress moved “partial liquidations” to § 302. However, the regulations governing
partial liquidations have never been renumbered. See, e.g., Reg. § 1.346-1. One court
outlined the conflicting considerations thus:
The only requirement of § 346(a)(2) which is in issue is whether the distributions
by the corporations were “not essentially equivalent to a dividend.” According to
the legislative history of the section, qualification under this subsection depends
primarily on the existence of a bona fide corporate contraction. Such a corporate
contraction qualifies to the same extent as under previous law. 3 1954 U.S. CODE
CONG. & AD. NEWS 4680, 4899.
From the stockholder’s point of view a pro rata distribution in partial liquidation
of a corporation is similar to an ordinary dividend. Distributions in partial
liquidation are “characterized by what happens solely at the corporate level ....” 3
1954 U.S. CODE CONG. & AD. NEWS 4680, although §§ 331 and 346 are concerned
with the tax treatment of the shareholder.
Because a distribution qualifying under § 346(a)(2) possesses many of the
characteristics of a dividend taxed at ordinary income rates, the sale or distribution
of assets claimed to constitute a corporate contraction must be a significant event
in the history of the corporation if sale or distribution of assets is not to become a
convenient pretext for bailout of earnings and profits at capital gain rates. 5
BITTKER & EUSTICE, FED. INCOME TAXATION OF CORPORATIONS &
SHAREHOLDERS, ¶ 9.52, 3d Ed.
Mains v. United States, 508 F.2d 1251, 1255 (CA6 1975) (footnote omitted).
Consider how well these conflicting considerations have been resolved.

77 P.L. 97-248, § 222(c)(1).

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Imler v. Commissioner, 11 T.C. 836 (1948), acq.
The Commissioner determined a deficiency of $2,410.27 in the petitioner’s income and
victory tax for the year 1943. The sole question is, was the retirement of certain shares of
its stock by the Imler Supply Co. in 1942 accomplished at such time and in such manner
as to make the distribution and cancellation and redemption essentially equivalent to a
taxable dividend? The question arises on the following facts:
FINDINGS OF FACT.
....
During the periods here involved, the petitioner was a stockholder of Imler Supply Co.,
hereinafter called the company, a Pennsylvania corporation organized in 1923, 654 shares
of which company, having a par value of $50 per share, were issued for cash at par. The
corporation has never paid a stock dividend.
....
Previous to December 1, 1941, the company was engaged in the business of retinning and
soldering metals and in the rental of excess space in buildings owned by the company. The
company owned 5 buildings, consisting of a 7-story brick building and 4 smaller buildings.
The main building was equipped with a large freight elevator capable of carrying
automobiles. The company rented space in its buildings to the Allegheny County Milk
Exchange at a fixed rental of $650 per month, the exchange being entitled to whatever
space it required for its operations. Prior to December 1, 1941, the exchange used all of
the sixth floor of the main building and one half of the seventh floor. The rental allocable
to this space was from $100 to $125 per floor. The portion of the seventh floor that was
not used in the actual operation by the exchange was rented for storing various items of
freight, including automobiles.
On December 1, 1941, a fire destroyed the two upper floors of the main building. This
building was covered by insurance and in April 1942, the company recovered $28,603 as
insurance proceeds on account of the fire.
After the insurance proceeds were received, the company obtained an estimate as to the
cost of rebuilding the 2 top floors of the main building, which had been destroyed by the
fire. It was estimated that the cost would run from $40,000 to $50,000. The company did
not have sufficient cash to rebuild at this cost at that time. Because of war conditions and
consequent scarcity of materials, building was difficult. The company decided to remove
the 2 top floors of the main building which had been burned out and to place a roof over
the fifth floor. It was estimated that the cost of this operation would be $15,340. The
company thereupon removed the remains of the 2 top floors and placed a roof over the
building at the fifth floor, making a 5-story out of what had been a 7-story building.

215

... [A]t a meeting of the directors of the company held April 6, 1942, a resolution was
adopted in which the following appeared:
Mr. Imler stated to the Meeting that the loss occasioned by the fire on December
1, 1941 had been settled with the insurance companies for the sum of $28,603.00;
that it had been deemed advisable to tear down the walls of the sixth and seventh
floors of the seven-story building damaged by fire and not rebuild that portion of
the building, so that we now have instead of a seven-story building a five-story
building. He further stated that after the payment of repairs and damages caused
by the fire that we would have about $15,000.00 more cash than was needed to
operate the Company. He stated that in his opinion he thought it advisable that the
stockholders of the Company sell to the Company and the Company buy from the
stockholders 300 shares of the Capital Stock of the Company at $50.00 a share
totaling $15,000.00.
....
On motion duly seconded it was unanimously
RESOLVED: That the Company offer to purchase from ... Stockholders [about
half of their shares] ... pay therefor the sum of $50.00 per share ... and that said
shares be cancelled.
....
The resolution of the board of directors of the company was duly carried out ...
Petitioner [was one of the shareholders who turned in some of the stock that he owned in
exchange for $50/share.] ...
....
The cash working capital of the company for some years prior to December 1, 1941, ranged
from $7,500 to $9,000. The cash balance of the company, exclusive of the estimated fire
proceeds left after reconstruction of the building, was $9,628.76. At that time
approximately $4,500 had been expended on the damaged building and it was estimated
that the total cost of repairing and reroofing the building would amount to $15,340. This
estimated cost proved to be excessive in the amount of $175.81.
Except for the remaining proceeds of fire insurance, the company could not have paid a
dividend in the amount of $15,000 on April 6, 1942, without borrowing money.
After the building was repaired and reduced in size, Imler Supply Co. discontinued its
retinning and soldering activities and has never resumed the same. This cessation of
activity was primarily due to the fact that the corporation lacked space for storage of
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articles required in its retinning and soldering operations, together with the fact that war
conditions and scarcity of materials made such operations unprofitable.
The purchase by the company from petitioner ... of ... shares of the corporation’s capital
stock ... constituted a partial liquidation of the corporation under ... the Internal Revenue
Code.
The acquisition and cancellation of the stock of the company ... were not made at such
time and in such manner as to be essentially equivalent to the distribution of a taxable
dividend ...
OPINION.
VAN FOSSAN, Judge: The issue here raised presents a question of fact depending on the
circumstances of the particular case. [citation omitted]. No sole or universally applicable
test can be laid down. [citation omitted ... Though decided cases are not controlling, they
are helpful as indicating what elements have been considered important, viz., the presence
or absence of a real business purpose, the motives of the corporation at the time of the
distribution, the size of the corporate surplus, the past dividend policy, and the presence
of any special circumstance relating to the distribution.
In our findings of fact we have indicated our conclusions of fact that the acquisition and
cancellation by Imler Supply Co. of certain shares of its capital stock in 1942 were not
made at such time and in such manner as to be essentially equivalent to a distribution of a
taxable dividend ...; or, as stated otherwise, that the transaction constituted a partial
liquidation ...
The principal building owned by the company had been damaged by fire in 1941. When
the company undertook to repair the building it was found that, because of war conditions,
the shortage of building materials, and high costs, it was advisable to abandon 2 damaged
floors and reduce the 7-story building to one of 5 stories. The consequence was that the
company found its facilities inadequate to carry on the retinning and soldering operations
formerly engaged in. Moreover, these operations had proven unprofitable in recent
experience because of war conditions and shortage of necessary materials. For these
reasons the company discontinued the retinning and soldering operations. This reduction
in operations likewise reduced the amount of capital necessary for carrying on the business
activities of the company. This was a bona fide contraction of business operations and
consequent reduction in capital used. The company thus had a real and legitimate purpose
for reducing its outstanding capital stock.
The motives of the corporation were all related to the above business purpose and were,
therefore, legitimate and properly conceived. If the excess of insurance proceeds be set to
one side, the surplus of the company had remained almost constant for 10 years. The
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company had followed a conservative dividend policy throughout its history and had not
paid a dividend since 1934. The original issuance of the stock had occurred many years
before and there was no connection between the issuance and the redemption of the same.
There was no special circumstance or condition relating to the distribution excepting the
fact that the company had in its hands the excess insurance proceeds which formed the
basis of the distribution. We are convinced that, except for the fire and the excess insurance
proceeds, there would have been no distribution.
Under the facts here present, the redemption of the company’s stock was not accomplished
at such time and in such manner as to be essentially equivalent to the distribution of a
taxable dividend.
Reviewed by the Court.

Questions and comments:
1. In Imler, there was a readily identifiable event (fire) as well as a visible manifestation
(removal of two floors from a building) that caused the corporation to contract its business.
The corporation discontinued two distinct business activities, i.e., soldering and retinning.
The corporation also had funds derived from the event (insurance proceeds) that did not
represent earnings and profits. It would not be difficult to conclude that payment of the
proceeds to shareholders represented a partial liquidation of the corporation. It was a
smaller corporation than before the fire, and the payment fairly accurately measured how
much smaller.
•Suppose that the corporation had distributed only half of the insurance proceeds
to shareholders. Should that qualify as a partial liquidation? How would you
determine the number of shares the corporation had redeemed? See Gordon v.
Comm’r, 424 F.2d 378, 386-87 (2d Cir. 1970).
2. Suppose that there are funds (assets) derived from the event that caused the contraction,
but the corporation distributes some of its other assets of equal value. A corporation
engaged in poultry processing accumulates securities. The corporation enters the chicken
farming business. The business was profitable for a time, but then it began losing money.
The corporation decided to sell the chicken farming business and accepted from the buyer
a note secured by a mortgage. Rather than distribute the note to shareholders in a
redemption of some of their shares, it distributed the appreciated securities.
•Partial liquidation? See Rev. Rul. 79-275, 1979-2 CB 137.
3. Consider: corporation does not pay dividends for many years and builds up a substantial
reserve of earnings and profits. It accumulated earnings rather than distribute them as
dividends because it planned to expand its facilities. When it abandoned those plans, it

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redeemed some of each shareholder’s shares pro rata. This substantially reduced the
corporation’s e&p.
•Partial liquidation?
•Rather than a contraction of the corporation, isn’t this simply the payment of a
dividend? See Reg. § 1.346-1(a) (second to last sentence).
•See McGuire v Comm’r, 84 F.2d 431, 432 (7th Cir. 1936), cert. denied, 299 U.S.
591 (1936); McCarthy v. Conley, 229 F. Supp. 517, 526-27 (D. Conn. 1964) aff’d,
341 F.2d 948 (2d Cir. 1965), cert. denied, 382 U.S. 838 (1965).
4. On the other hand, what if the source of the redemption funds is not the corporation’s
accumulated e&p? Suppose that its business required it to keep a bank account sufficient
to meet a bank’s requirements for the corporation to extend letters of credit for the benefit
of customers who purchased steel from a particular foreign manufacturer. When the
foreign manufacturer terminated its arrangement with the corporation, the corporation lost
95% of its gross income. There was no need to keep the bank account, and corporation
used the funds in that account to redeem pro rata a portion of shareholder’s shares.
•Partial liquidation? See Rev. Rul. 75-3, 1975-1 CB 108.
5. Suppose: a corporation that provides mass transit services enters into an arrangement
with a regional transit authority (Authority) whereby the Authority will subsidize the
operations of the corporation and purchase new busses when needed. The corporation
could therefore redeem some of each shareholder’s shares with funds it had accumulated
for the purpose of replacing busses. Otherwise, there was no significant change in the
corporation’s business activities.
•Partial liquidation? See Rev. Rul. 78-55, 1978-1 CB 88.
6. How can we distinguish between a genuine contraction and a payment that is essentially
equivalent to a dividend? What factors are relevant in making this determination?
•accumulating earnings & profits without paying a dividend?
•pro rata distributions?
•continued business operation?
•rapidly declining sales and the response thereto?
•a full-line department store facing competition from new shopping centers
changes to a discount apparel store and sells a different type of
merchandise. It eliminates 33 of its 40 departments. Its sales declined from
$4M to $600K. It reduces leased floor space by 85% and reduces the
number of employees from 270 to 20. It sold all assets associated with the
eliminated departments including inventory and distributed the proceeds
pro rata to shareholders in exchange for a portion of their outstanding stock.
•Partial liquidation? See Rev. Rul. 74-296, 1974-1 CB 80.
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•a corporation purchases raw skins and processes them into leather that it
markets to a certain segment of the leather market. Its profits decline
rapidly. In an effort to revitalize the business, it buys a different type of raw
skins, processes them into leather, and markets them to a different segment
of the leather trade. Things did not improve. The corporation decided to
liquidate inventory – a long process in view of poor market conditions. The
corporation “proposes to redeem a portion of its stock with cash from the
sale of United States Series G bonds and from the proceeds of the
inventories being liquidated in the ordinary course of business.”
•Partial liquidation? See Rev. Rul. 60-322, 1960-2 C.B. 118.
7. What facts (evidence) in Imler would support the conclusion that the payment was a
partial liquidation? What facts (evidence) would support the conclusion that the payment
was essentially equivalent to a dividend?
8. What are the conditions of the safe harbor of § 302(e)? When is a business separate
from another?
•Should it matter that what the business taxpayer retains generates a very small
portion of what was the corporation’s total income prior to the partial liquidation?
See Blaschka v. United States, 393 F.2d 983, 990-91 (Ct. Cl. 1968).
9. How does the safe harbor resemble or differ from a “corporate contraction?”
10. Note: § 302(b)(4) does not apply to corporate shareholders. This means that any
distribution to a corporation would be treated as a dividend. However, § 1059(e)(1)
provides that such dividends are extraordinary dividends irrespective of how long the
corporate shareholder has held the stock. This means that the amount of the dividend
reduces the basis that the corporate shareholder has in its stock. § 1059(a).

Do the CALI exercise:
Corporate Taxation: Redemptions: Redemptions in Partial Liquidations: Section
302(b)(4).

V. Section 302(b)(5)
Section 302(b)(1, 2, 3, and 4) did not provide any test to determine how to apply “the ‘not
essentially equivalent to a dividend’ test in the case of an open-end RIC [regulated
investment company] whose shareholders ‘sell’ their shares by having them redeemed by

220

the issuing RIC. Multiple redemptions by different shareholders may occur daily.” 78
Section 302(b)(5), by cross-referencing § 67(c)(2)(B), now provides that –
the redemption of stock of a publicly offered RIC is treated as an exchange if the
redemption is upon the demand of the shareholder and the company issues only
stock which is redeemable upon the demand of the shareholder. A publicly offered
RIC is a RIC the shares of which are (1) continuously offered pursuant to a public
offering, (2) regularly traded on an established securities market, or (3) held by no
fewer than 500 persons at all times during the taxable year.79

VI. Redemptions to Pay Death Taxes: § 303
Read IRC § 303.
Section 303 treats a distribution to a shareholder of a corporation whose shares are
included in determining the gross estate of a decedent as a payment in exchange for the
stock. § 303(a). The amount distributed cannot exceed the amount of estate, inheritance,
legacy, and succession taxes collected because of decedent’s death – including interest –
plus funeral and administrative expenses deductible under § 2053 (or § 2106 in the case
of a nonresident noncitizen). § 303(a). A basis step-up under § 1014 makes such a
redemption advantageous. The distribution is apt to generate very little, if any, taxable
gain. The purpose of § 303 is to facilitate the financing of such taxes and expenses when
an estate consists largely of (probably) illiquid shares of a closely-held family corporation.
The benefits of § 303 do not depend upon illiquidity or even that the proceeds of a
redemption be used to pay for the taxes and expenses named. See United States v. Lake,
406 F.2d 941, 948 (CA5 1969) (not required “that amounts received in redemption be used
to pay the taxes and expenses;” “stockholders may be able to redeem stock that is included
in the estate of the decedent even though they have no obligation to pay any of the death
taxes or expenses”). If the corporation distributes more than the amount of the taxes and
expenses named, the excess is tested under § 302 for exchange treatment and relevant
attribution rules under § 318 apply. See Rev. Rul. 71-261, 1971-1 C.B. 108 (excess of
redemption over amount needed to pay death taxes and administration and funeral
expenses tested under § 302 and found to be essentially equivalent to dividend and taxable
as such to estate).

78 Joint Committee Summary of P.L. 111-325, Regulated Investment Company Modernization Act of 2010.
79 Joint Committee Summary of P.L. 111-325 (Regulated Investment Company Modernization Act of 2010),

Explanation of Provision.

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Congress limited the benefits of § 303 to those occasions when the stock owned by the
estate is greater than 35% of the value of the decedent’s gross estate minus the sum of
amounts deductible under §§ 2053 and 2054. Notice that it is not necessary that the stock
be in a corporation that is closely held. In fact, the stock might be widely held and publicly
traded. The estate may count shares in any corporation in which decedent owned 20% or
more of the corporation’s outstanding stock to reach the 35% threshold. § 303(b)(2)(B).
The estate may also count shares that the surviving spouse holds as community property,
joint tenants, tenants by the entirety, or tenants in common. § 303(b)(2)(B). However, in
reaching the 35% threshold, the estate does not get the benefit of § 318 attribution. See
Estate of Byrd v. Comm’r, 388 F.2d 223, 232 (CA5 1967) (§ 318 inapplicable to § 303).
Section 303 also requires that the interest of a shareholder in the estate be directly reduced
by the obligation to pay any of the taxes or expenses named. § 303(b)(3). Thus, if decedent
provided in his will that such taxes and expenses should come out of the residue of the
estate and that the stock should pass to a specific legatee with no liability for such
payments, the opportunity to rely on § 303 to minimize taxes is lost.

Problem:
Decedent died and left a gross estate valued at $1M. Various estate, inheritance, and legacy
taxes came to $250,000 – which the executor paid from the residue of the estate.
Administrative expenses came to $50,000. Decedent made the following specific bequests
to his son:
All the stock of Family Corporation XYZ that decedent owned. Decedent owned
20% of the outstanding stock of Family Corporation XYZ (fmv = $40,000).
Decedent’s wife (i.e., decedent’s son’s mother) owns 45% of the outstanding stock
(fmv = $90,000), and decedent’s wife’s father owns the other 35% (fmv =
$70,000).
All the stock of Family Corporation ABC that decedent owned. Decedent owned
20% of the outstanding stock of Family Corporation ABC (fmv = $20,000).
Decedent’s wife owns 30% of the outstanding stock (fmv = $30,000), and
decedent’s wife’s father owns the other 50% (fmv = $50,000).
$400,000 worth of Mega Corporation stock that it has offered to redeem. Decedent
owned 0.05% of the shares of Mega Corporation’s outstanding stock.
How would a redemption of the stock of any of these corporations of Decedent’s son’s
shares be treated under § 303?

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Would it make any difference if Decedent’s son received these shares as the residuary
legatee of Decedent’s estate and the taxes and expenses were to come out of the residue of
the estate?

VII. Redemptions Through Related Corporations, § 304
Read IRC § 304.
The shareholders of closely-held corporations often own shares in more than one such
corporation. To get cash out of a corporation without dividend treatment, they might sell
stock that they personally own in one of the corporations to another corporation that they
control. If they remain in control of both corporations, the sale has not appreciably reduced
their interest in the corporation whose stock they sold, yet they appear to be entitled to sale
treatment on the transaction.
•Recall that in Hurst, the senior Hursts owned the stock of HMI and of RHI. All
their businesses had prospered. The Hursts sold their RHI stock to HMI. In form,
this would appear to be the sale of stock to a third person and so not subject to
scrutiny under § 302.
•Not so fast. The effect of a purchase by one corporation of the stock of another
corporation’s stock closely related to it too strongly resembles a distribution.
Hence, such a purchase should be further tested for exchange treatment under §
302 and § 303.
•Section 304 establishes an intricate scheme by which to determine whether such
related-party sales should be (1) treated as redemptions, and if so (2) should be
accorded sale or exchange treatment.
1. Common Control: When two corporations are subject to common control, § 304
subjects a shareholder’s sale of one corporation’s stock to the other corporation to the tests
of §§ 302 and 303 for exchange treatment. “Control” is thus a threshold determination
upon which applicability of § 304 depends. “Control” means ownership of stock
possessing at least 50% by either vote or value of all the corporations’ stock. § 304(c)(1).
Moreover, if a person(s) is in control (as just defined) of a corporation which in turns owns
at least 50% of another corporation by vote or by value, such person(s) is deemed to
control that other corporation. § 304(c)(1). For purposes of determining ownership of
stock, the attribution rules of § 318 apply, § 304(c)(3)(A), with certain modifications that
broaden the applicability of § 304.
•Proportional attribution from a corporation to a shareholder (§ 318(a)(2)(C)) is
made if the corporation owns at least 5% of the shares of the acquiring or issuing
corporation. § 304(c)(3)(B)(i).
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•Additionally, there is proportional attribution from a shareholder to a corporation
when the shareholder owns at least 5% but less than 50% of the stock of the
corporation. § 304(c)(3)(B)(ii).
•If the shareholder owns 50% of the stock of the corporation, there is
attribution of all the stock that the shareholder owns to such corporation. §
318(a)(3)(C).
•Read § 304(c)(2)(B). Two or more unrelated transferors between whom there
would otherwise be no attribution may nevertheless constitute a control group. “In
any case in which two or more persons, in the aggregate, control two corporations,
§ 304(a)(1) will apply to sales by such persons of stock in either corporation to the
other ... provided the sales by each of such persons are related to each other.” Reg.
§ 1.304-2(b). Thus § 304 can apply to unrelated shareholders who both sell stock
of one corporation to another when their combined holdings constitute “control”
of both corporations, and not merely to instances where “control” exists only
because of attribution. Coates Trust v. Commissioner, 480 F.2d 468, 473 (9th Cir.
1973), cert. denied, 414 U.S. 1045 (1973).
2. Sale or Exchange Treatment: Section 304 addresses two types of control relationships:
brother-sister corporations and parent-subsidiary corporations.
Brother-sister Sales/redemptions: Section 304(a)(1) provides that a corporation that
purchases stock (the acquiring corporation) of another corporation (the issuing
corporation) from a person(s) who controls both corporations will be treated as making a
distribution in redemption of its own (the acquiring corporation’s) stock. This triggers an
analysis under §§ 302 or 303. If the analysis leads to the conclusion that the distribution is
not payment in exchange for stock, then § 301 applies.
•Note that after a putative sale, the very shares that the shareholder sold will be
proportionally attributed back to him because of his control of the acquiring
corporation, thus making the applicability of § 304 more likely.
If § 301 applies when the acquiring corporation has acquired shares of the issuing
corporation, the acquiring corporation is treated as having issued its own shares and
exchanging them for the shares that it ostensibly purchased. The acquiring corporation is
treated as then redeeming the stock that it issued. § 304(a)(1) (carryout ¶); Reg. § 1.3042(a) (shareholder’s receipt of property “shall be treated as received in redemption of stock
of the acquiring corporation”).
•The stock of the “acquiring corporation” that the person(s) who controls the
issuing corporation is deemed to receive is included in determining whether such
person(s) controls the “acquiring corporation.” § 304(c)(2)(A). Moreover, the
“control” group includes those shareholders of the “issuing corporation” who
transferred shares of such stock to the acquiring corporation who, after such
transfer, are in control of the “acquiring corporation.” § 304(c)(2)(B).
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A § 302(b) analysis is made with reference to the “issuing corporation,” i.e., the
corporation whose shares were purchased. § 304(b)(1); Reg. § 1.304-2(a). If such analysis
leads to the conclusion that the distribution is a dividend and not an exchange, the
distribution comes first from the e&p of the acquiring corporation and then from the e&p
of the issuing corporation. § 304(b)(2). The shareholder increases his basis in his
remaining shares of the issuing corporation that he “contributed” by his basis in those
shares. Reg. § 1.304-2(a). If § 301 applies, then the stock that the acquiring corporation
“purchased” will be treated as a contribution to capital, and the corporation takes the
shareholder’s basis in it. Reg. § 1.304-2(a).
A controlling shareholder who receives property from a corporation in a transaction to
which both § 304 and § 351(a) apply must apply § 304. § 304(b)(3)(A). Moreover, §§ 357
and 358 do not apply – meaning that the shareholder must treat corporate assumption of a
shareholder liability as the receipt of cash. § 304(b)(3)(A).80
Parent-subsidiary Sales/redemptions: The same rules apply when a subsidiary corporation
purchases shares of the parent corporation from a shareholder. § 304(a)(2). The “issuing
corporation” (parent) must “control” the “acquiring” (subsidiary) corporation. § 304(a)(2).
The “property” that the subsidiary provides is treated as a distribution in redemption of the
stock of the “issuing corporation,” i.e., the parent. § 304(a)(2) (carryout ¶).
•Notice that in the case of a sale of a shareholder’s parent stock to the parent’s
subsidiary, the property distributed is treated as that of the parent (i.e., the issuing
corporation), not the subsidiary (i.e., the acquiring corporation).
Sales/redemptions that can be characterized as both brother-sister and parent-subsidiary
transactions: Application of attribution rules can make brother-sister relationships into
parent-subsidiary relationships – and vice versa. A four-word parenthetical in § 304(a)(1)
provides that § 304(a)(1) applies only when § 304(a)(2) (parent-subsidiary rules) does not
apply. The extensive attribution rules assure that most, if not all, brother-sister situations
can be recast as parent-subsidiary situations. However, in an example, the regulations
apply § 304(a)(1) without considering § 304(a)(2). Reg. § 1.304-2(c), Example 1. This
suggests that we can (safely) test under § 304(a)(1) before undertaking an analysis under
§ 304(a)(2).

80 There is an exception to this rule for a liability incurred by the transferor to acquire the stock or to acquire

stock subject to such a liability. § 302(b)(3)(B)(i). The exception only prevails if the transferor acquired the stock
from a person from whom no stock is attributed to the transferor under § 318 – except that owning an option
is not considered to be ownership of the stock – or whose interest is completely terminated and who waives
attribution under § 302(c)(2). § 304(b)(3)(B)(iii).

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Problems:
1. All the outstanding stock of X corporation (1000 shares of voting common stock) is
owned by individuals A (60 percent), B (20 percent), and C (20 percent). All the
outstanding stock of Y corporation (1000 shares of voting common stock) is owned by
individuals D (70 percent), E (20 percent), and F (10 percent). A and D are father and son.
A sold 200 shares of his X Corporation stock to Y Corporation. A’s basis in the 200 shares
is $500. A’s basis in the 600 shares that he owns is $1500. Y Corporation paid A $1100
for 200 shares of X Corporation stock. Y Corporation’s e&p is $800; X Corporation’s e&p
is $600.
•Has A received a dividend? How much?
•After Y Corporation’s purchase, what is Y Corporation’s e&p? – what is X
Corporation’s e&p?
•What is Y Corporation’s basis in the X Corporation stock that it purchased from
A?
•What is A’s basis in the X Corporation stock that he still owns?
1A. What if D owned 35% (rather than 70%) of the shares of Y Corporation when Y
Corporation purchased 200 of A’s shares of X Corporation?
2. “Decedent, who was an officer and director of X corporation and Y corporation, died
in [2009]. After decedent’s death, his estate owned 18% of the outstanding stock of X and
50% of the outstanding stock of Y. The remainder of the X and Y stock was owned equally
by A and B, the decedent’s two sons, who were the sole beneficiaries of decedent’s estate.
The stock of X accounted for approximately 20% of the value of the decedent’s gross
estate ... while the stock of Y accounted for approximately 40% of the value of the
decedent’s gross estate ... Estate and inheritance taxes and funeral and administration
expenses, as described in § 303 of the Code, were 250x dollars. In order to meet expenses,
the executors of decedent’s estate decided to sell all of the X stock to Y. Y purchased all
the shares of X stock from the estate for 100x dollars.”
•Describe the tax consequences of this purchase. See Rev. Rul. 71-527, 1971-2 CB
174.
3. Parent Corporation owns 100% of the 1000 shares of Subsidiary Corporation. H owns
60% of the shares of Parent. Subsidiary Corporation purchases 15% of the shares of Parent
Corporation, i.e., 150 shares, from H.
•Describe the tax consequences of this sale.

Do the CALI exercise:
Corporate Taxation: Redemptions: Redemption Through the Use of Related Corporations:
Section 304.
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VIII. Consequences of Redemptions to Corporation
A payment by a corporation to redeem its own shares from a shareholder comes initially
from its earnings and profits, but there are limits. Read § 312(n)(7). A payment to a
shareholder in redemption of the shareholder’s stock may reduce the corporation’s e&p
pro tanto or pro rata.
•A pro tanto reduction is a dollar-for-dollar reduction of the corporation’s e&p. For
every dollar the corporation pays to a shareholder in redemption of the
shareholder’s stock, the corporation’s e&p is reduced by one dollar.
•A pro rata reduction is a proportionate reduction. The corporation reduces its e&p
by the same proportion as the redemption reduces the outstanding shares.
•A corporate distribution in redemption of its stock reduces its e&p pro tanto up to
the amount of a pro rata distribution.
•The allocation of e&p among different classes of stock is made according to the
weighted dividend rights of each class of stock. H.R. REP. NO. 98-861, 840 (1984).
Thus, if a corporation has two classes of stock outstanding, class A and class B,
and class A has a 2:1 preference in dividend rights to class B, two-thirds of the
corporation’s e&p will be allocated to class A and one-third of the corporation’s
e&p will be allocated to class B.
“When both ordinary distributions under § 301 of the Code and redemption distributions
under § 302 are made during the same taxable year and the combined distributions exceed
earnings and profits for the year, the ordinary distributions take priority in determining
current earnings available for dividends. Only current earnings in excess of the ordinary
distributions are treated as available for redemption distributions.” Rev. Rul. 75-339,
1974-2 C.B. 103.
•A redemption for an amount that exceeds an allowable reduction in a corporation’s
e&p reduces the corporation’s capital account.

Problems:
Corporation X has 1000 shares of one class of stock outstanding. A, B, C, and D – all
unrelated to each other – each own 250 shares with a basis of $2000 (i.e., $8/share).
Corporation X’s accumulated e&p is $20,000.
1. Corporation X redeems 100 shares of its stock from shareholder A for $1750. What are
the tax consequences to A? What is Corporation X’s remaining e&p?
2. Same facts except that Corporation X redeems that shares for $2250. What are the tax
consequences to A? What is Corporation X’s remaining e&p?
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Chapter 5: Distributions of Stock

I. Concerns about Converting Ordinary Income into Capital Gain and
Changing a Shareholder’s Relative Interest in a Corporation: From Macomber
to §§ 305, 306 and 307
A fundamental principle embedded in the Code and of United States income tax law is that
a taxpayer may not convert the character of income from ordinary income to capital gain
income. Such a conversion would reduce the income tax burden that a taxpayer must bear.
We have seen that the Code may characterize a corporate distribution as an exchange
(capital gain) or as a dividend (ordinary income). The source of such distributions is likely
to be the same, i.e., corporate profits. In the case of an exchange, the distribution is actually
partly a distribution of after-tax profits and partly a return of taxpayer’s previously taxed
capital. However, a distribution is either given exchange treatment or dividend treatment –
not some pro-rated amount of each.
A corporation’s distribution of its stock with respect to a An analogy: We can view all of
shareholder’s stock has been from the beginning a means a corporation’s outstanding
by which shareholders and the corporations they own shares of stock as a pie.
endeavor to convert the character of income. In Eisner v. Shareholders own a slice of the
Macomber, 252 U.S. 189 (1920), the United States pie; the size of their slice
Supreme Court held that a shareholder of the Standard depends on the number of
Oil Company had not realized income when Standard shares that they own. A one-forone stock-on-stock distribution
Oil distributed one share of Standard Oil common stock
does not alter the overall size of
to all its shareholders for every share of common stock
the pie, nor any shareholder’s
that they owned, i.e., a “common on common” relative portion of it. The slice
distribution. Standard Oil’s stated purpose for the that they owned has been
distribution was to convert retained profits to capital. divided into two slices that
Shareholders’ interests in profits yet-to-be taxed as together, are equal in size to
ordinary income were converted to capital interests in their original slice. In this sense,
which gain upon disposition would be taxed as capital the shareholder gains nothing.
gain. Presumably, Standard Oil wanted to spend retained There is no gain to subject to an
profits on more capital goods to make still more money. income tax.
If Standard Oil had distributed profits to its individual
shareholders, the dividends would have been taxable as ordinary income to them. By
distributing stock instead of cash, Standard Oil made it possible for shareholders to sell
the shares Standard Oil distributed to them and realize capital gain/loss – while retaining
the shares that represented their original contribution to the corporation’s capital. Standard
Oil facilitated conversion of its shareholders’ untaxed ordinary income to capital gain.
This contravenes the policy that a taxpayer not be permitted to change the character of
income from ordinary income to capital gain.
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In Eisner v. Macomber, the Court observed that the distribution of stock in such a manner
“does not alter the preexisting proportionate interest of any stockholder or increase the
intrinsic value of his holding or of the aggregate holdings of the other stockholders as they
stood before. The new certificates simply increase the number of shares, with consequent
dilution of the value of each share.” Id. at 211. What the shareholder received was not
“income” within the meaning of the Sixteenth Amendment. Id.81
The holding in Eisner v. Macomber perforce reflects
the reality that the market will value a corporation –
and so also value its shares of stock – by taking account
of both its capital and retained profits. So long as there
is no effort to tax shareholders’ shares of corporate
profits at the time they are earned, it does not matter
whether the corporation traces its assets to the capital
contributions of investors or to its reinvestment of
profits. The pie neither expands nor shrinks contingent
on the label given to its constituent parts. And if the pie
neither expands nor shrinks, the number of slices into
which it is cut does not matter. A “common on
common” when there is only one class of common
outstanding, then, is not a taxable stock dividend.
Nevertheless, “the camel’s head is in the tent” insofar
as the conversion of the character of income from
dividend income into capital gain is concerned. A
shareholder who sells dividend stock realizes capital
gain, even though the stock (may have) represented
corporate earnings.

Review: Recall that the basic rights
of shareholders are to receive
dividends, to vote (i.e., control),
and to share proceeds upon
liquidation (i.e., to share in
corporate growth). It is possible to
sever one of these rights from the
others and then to subdivide the
severed interests, ad infinitum. The
owners of these severed interests
may own “stock,” but not all shares
of the corporation’s stock are the
same. For example, preferred
stock is preferred and limited as to
dividends,
but
holders
of
preferred stock do not share in the
corporation’s growth. Holders of
non-voting common shares share in
corporate growth and dividends,
but not in control. And so on.

Some distributions of stock on stock do change the relative interests of shareholders with
respect to their claims upon corporate profits or assets. The distribution of dividend-paying
stock to some shareholders but not to others gives the holders of the dividend stock a claim
to a greater share of corporate profits. The distribution of common stock to some holders
of common stock but not to others gives the holders of the dividend stock a greater power
of voting control, greater participation in corporate growth, and/or a greater claim upon
corporate assets in the event of a liquidation. Such a stock dividend should be subject to
income tax because the wealth of those shareholders has increased at the expense of those
who did not receive such dividends.

81 The Supreme Court extended the rule of Eisner v. Macomber by holding that extending the opportunity to all

existing shareholders to purchase additional shares of stock on a pro rata basis for less than fair market value
was not the distribution of a dividend that constitutes “income” within the Sixteenth Amendment. Miles v. Safe
Deposit & Trust Co., 259 U.S. 247, 252 (1922).

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A distribution of stock on stock may be a way of altering the individual slices of the pie
without changing the overall size of the pie – or the amount of pie each shareholder owns.
For example, a distribution to shareholders of a new class of non-convertible nonvoting
common reduces the dividends accruing to each share of common stock. However, the same
persons still own all the corporation’s dividend rights in the same proportion that they did
before the distribution. The sum of each shareholder’s interests has not changed. The mere
issuance of stock that alters the slices of the pie is not the occasion for taxing gain, for there
is no gain to tax.
•If a shareholder sells shares of such dividend
Use your tax intuition to answer
stock to others, any capital gain would be subject
these questions: When a
to income tax as such. The shareholder succeeds corporation
distributes
a
in subjecting income to income tax at only capital nontaxable stock dividend, e.g.,
gain rates and retains the same level of control of “common on common,” how
the corporation as well as interest in its assets.
should shareholders determine
•And if the corporation makes a distribution in their bases in the “old” and the
redemption of those shares, treatment of the “new” shares? See § 307(a);
distribution as made in exchange for the Beckers v. United States, 42 F.2d
shareholder’s dividend stock would have served 300, 303 (Ct. Cl.), cert. denied,
the end of converting dividend income into capital 282 U.S. 882 (1930); Chapman
gains through a redemption, i.e., of “bailing out” v. United States, 63 Ct. Cl. 106,
111, cert. denied, 275 U.S. 524
corporate earnings as capital gain.
•The Code does not permit this, but addresses the (1927). What should be the
matter with a “wait and see’ approach to effect of the distribution of a
determine whether to tax gains as capital gains nontaxable stock dividend on
upon disposition to a third party or as a the corporation’s earnings and
profits? See § 312(d)(1)(B).
distribution of dividends. See § 306; § III infra.
Congress has enacted rules that specifically govern the distribution of stock and stock rights.
Sections 305 and 306 reflect congressional concern with stock dividends that serve the
objectives of either converting the character of income or changing the relative interests of
shareholders vis-a-vis each other.82 Section 307 provides rules for allocating the basis of the
stock between that stock and untaxed dividend stock.

82 Earlier versions of the Code manifested clumsy congressional efforts not to contradict the holding of Eisner v.

Macomber while addressing concerns about enriching some shareholders at the expense of others or of “bailing
out” corporate earnings. To this point, the position that Congress may not tax a “common on common” stock
dividend remains on solid constitutional footing. In Helvering v. Griffiths, 318 U.S. 371 (1936), the Commissioner
asked the Supreme Court to overrule Eisner v. Macomber. The Standard Oil Company of New Jersey had declared
a common on common stock dividend. Justice Jackson observed:
The tax is asserted under the general provision ... of the ... Code that income includes “dividends,”
together with the specific provision of § 115(f)(1) that:
A distribution made by a corporation to its shareholders in its stock or in rights to acquire its
stock shall not be treated as a dividend to the extent that it does not constitute income to the

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Suppose that a distribution of stock does “alter the preexisting proportionate interest of
any stockholder or increase the intrinsic value of her holding or of the aggregate holdings
of the other stockholders as they stood before?” Suppose that the value of the interest of a
shareholder who receives stock does not change, but the nature of the shareholder’s
interest does change? Suppose that a corporation issues “common on preferred?”

Koshland v. Helvering, 298 U.S. 441 (1936)
Justice ROBERTS delivered the opinion of the Court.
The writ of certiorari was granted in this case to resolve a conflict between the decision
below [footnote omitted] and one by the Circuit Court of Appeals for the Sixth Circuit.
[footnote omitted].
The question is whether ... a taxpayer who purchases cumulative nonvoting preferred
shares of a corporation upon which a dividend is subsequently paid in common voting
shares must, upon a sale or other disposition of the preferred shares, apportion their cost
between preferred and common for the purpose of determining gain or loss.
The petitioner, in 1924 and 1926, purchased preferred stock of Columbia Steel
Corporation. The company’s articles of incorporation provided that holders of preferred
stock should receive annual dividends of $7 a share in cash or, at the company’s option,
one share of common stock for each share of preferred. Dividends on the preferred were
to be paid in full before any could be paid on the common; the common had voting rights,
the preferred none. The preferred was redeemable at $105 per share, plus accrued
dividends, and, upon dissolution or liquidation, was entitled to preferential payment of
$100 per share, plus accrued dividends, and no more. The common alone was entitled in
such event to the assets of the corporation remaining after payment of the preferred.
In each of the years 1925 to 1928, inclusive, the company had a surplus sufficient to pay
the preferred dividends in cash, but elected to pay them in common stock. The petitioner
received, in each of those years, shares of common stock as dividends on her preferred. In
shareholder within the meaning of the Sixteenth Amendment to the Constitution. [footnote
omitted].
Was Congress thereby saying that such a dividend as we have here is not being taxed, in view of the
Eisner v. Macomber decision, or was it saying that, regardless of that decision, it is being taxed?
Id. at 372-73. The Court held that the statute did not subject a “common on common” stock dividend to income
tax; it did not reach the contention that it should reconsider Eisner v. Macomber. Id. at 404. Justice Douglas
dissented, concluding that Eisner v. Macomber should be overruled. Id. at 409 (Douglas, dissenting). Justices Black
and Murphy joined in this dissent.

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1930, the corporation redeemed its preferred stock at $105 per share. In computing the
profit realized by the petitioner, the Commissioner allocated to the common stock so
received, in each instance, a proportionate amount of the cost of the preferred stock. He
thereby decreased the resulting cost basis per share and increased the gain. The Board of
Tax Appeals reversed, holding that the dividends were taxable income, were not stock
dividends within the meaning of the Revenue Acts,83 and their receipt did not reduce the
cost basis of the preferred stock. The Circuit Court of Appeals reversed the Board, and
approved the Commissioner’s action.
The petitioner contends, first, that the dividends she received were not stock dividends
exempted from taxation by the Revenue Acts; and, secondly, if exempted, they were
nonetheless income, and cannot be treated as returns of capital in computing capital gain
or loss. The respondent answers that the distributions were stock dividends because made
in the capital stock of the corporation and come within the plain meaning of the provisions
exempting stock dividends from income tax; accordingly, the Treasury regulations have
consistently and continuously treated them as returns of capital, and required the original
cost to be apportioned between the shares originally acquired and those distributed as
dividends to obtain the cost basis for the calculation of gain or loss. We hold that the
dividends were income, and may not be treated as returns of capital.
The Revenue Act of 1913 imposed an income tax on dividends. [footnote omitted]. In
Towne v. Eisner, 245 U.S. 418, it was held that, where a corporation declared a dividend
on its common stock, in the form of common stock, the dividend was not income within
the intendment of the act. The Revenue Act of 1916 provided that a stock dividend should
be considered income to the amount of its cash value. [footnote omitted]. In Eisner v.
Macomber, 252 U.S. 189, it was decided that a dividend in the corporation’s common
stock paid to the then common stockholders was not income within the meaning of the
Sixteenth Amendment, and therefore the effort to tax such dividends exceeded the power
granted by the Amendment. It was said that such a dividend was not income because, by
its payment, no severance of corporate assets was accomplished and the preexisting
proportionate interests of the stockholders remained unaltered. After the decision, the
Treasury revoked regulations to the effect that a dividend paid in the corporation’s stock
is income, and issued amended regulations, broadly phrased, to exempt all income in the
form of stock dividends, whether the dividend shares be of the same class as those
theretofore held by the stockholder or of a different class, and prescribing the method of
allocating the original cost as between the old and the new stock for purposes of calculating
gain or loss upon realization. Subsequently Congress adopted the Revenue Act of 1921

83 Revenue Act of 1928, § 115(f), c. 852, 45 Stat. 791, 822; Revenue Act of 1926, § 201(f), c. 27, 44 Stat. 9, 11:

“A stock dividend shall not be subject to tax.”

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which provided, in § 201(d): “A stock dividend shall not be subject to tax.”84 The reason
for the exemption was the decision in Eisner v. Macomber, supra. The reports of both the
House and the Senate Committees dealing with the bill state that the act
modifies the definition of dividends in existing law by exempting stock dividends
from the income tax, as required by the decision of the Supreme Court in Eisner v.
Macomber, 252 U.S. 189.85
Although Eisner v. Macomber affected only the taxation of dividends declared in the same
stock as that presently held by the taxpayer, the Treasury gave the decision a broader
interpretation which Congress followed in the Act of 1921. Soon after the passage of that
Act, this Court pointed out the distinction between a stock dividend which worked no
change in the corporate entity, the same interest in the same corporation being represented
after the distribution by more shares of precisely the same character, and such a dividend
where there had either been changes of corporate identity or a change in the nature of the
shares issued as dividends whereby the proportional interest of the stockholder after the
distribution was essentially different from his former interest. [footnote omitted].
Nevertheless, the successive statutes and Treasury regulations respecting taxation of stock
dividends remained unaltered. [footnote omitted]. We give great weight to an
administrative interpretation long and consistently followed, particularly when the
Congress, presumably with that construction in mind, has reenacted the statute without
change. [footnote omitted]. The question here, however, is not merely of our adopting the
administrative construction, but whether it should be adopted if, in effect, it converts an
income tax into a capital levy.
We are dealing solely with an income tax act. Under our decisions, the payment of a
dividend of new common shares, conferring no different rights or interests than did the
old, the new certificates, plus the old, representing the same proportionate interest in the
net assets of the corporation as did the old, does not constitute the receipt of income by the
stockholder. On the other hand, where a stock dividend gives the stockholder an interest
different from that which his former stockholding represented, he receives income. The
latter type of dividend is taxable as income under the Sixteenth Amendment. Whether
Congress has taxed it as of the time of its receipt is immaterial for present purposes.
The relevant capital gains provisions of the Revenue Act of 1928 are § 111(a):
The gain from the sale or other disposition of property shall be the excess of the
amount realized therefrom over the adjusted basis provided in § 113, [footnote
omitted].
84 Stat. 227, 228. The same provision was repeated in all subsequent Revenue Acts; Revenue Acts of 1924 and

1926, § 201(f); Revenue Acts of 1928 and 1932, § 115(f), 26 U.S.C. § 115(f) and note; Revenue Act 1934, § 115(f).
85 H.R. 350, 67th Cong., 1st Sess., p. 8. Senate Report No. 275, 67th Cong., 1st Sess., p. 9.

233

and Section 113:
The basis for determining the gain or loss from the sale or other disposition of
property acquired after February 28, 1913, shall be the cost of such property [with
exceptions having no relevancy here]. [footnote omitted].
The property disposed of was the petitioner’s preferred stock. In plain terms, the statute
directs the subtraction of its cost from the proceeds of its redemption, if the latter sum be
the greater. But we are told that Treasury regulations [footnote omitted] long in force
require an allocation of the original cost between the preferred stock purchased and the
common stock received as dividend. And it is said that, while no provision of the statute
authorizes a specific regulation respecting this matter, the general power conferred by the
law to make appropriate regulations comprehends the subject. Where the act uses
ambiguous terms or is of doubtful construction, a clarifying regulation or one indicating
the method of its application to specific cases not only is permissible, but is to be given
great weight by the courts. And the same principle governs where the statute merely
expresses a general rule and invests the Secretary of the Treasury with authority to
promulgate regulations appropriate to its enforcement. But where, as in this case, the
provisions of the act are unambiguous and its directions specific, there is no power to
amend it by regulation. [footnote omitted]. Congress having clearly and specifically
declared that, in taxing income arising from capital gain, the cost of the asset disposed of
shall be the measure of the income, the Secretary of the Treasury is without power by
regulatory amendment to add a provision that income derived from the capital asset shall
be used to reduce cost.
The judgment is
Reversed.
Justice STONE and Justice CARDOZO are of the opinion that the judgment should be
affirmed. ....

Questions and comments:
1. Exactly what is the impact of the last full paragraph of the Supreme Court’s opinion?
How do we determine the basis of the dividend stock when its receipt is taxable to the
shareholder? What does this tell us about what basis is?
•How did it benefit taxpayer to argue that the stock dividends were not exempted
from income taxation? Is she volunteering to pay more income tax?

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2. Was the Supreme Court right to reverse long-standing administrative construction of
the statute? On the other hand, does it really require a careful parsing of the holding and
dictum to conclude that Congress and the Treasury had read too much into the holding of
Macomber?
•Might the fact that Congress and the Treasury “got it wrong” affect subsequent
developments so that they might be less than satisfactory?
3. How does the distribution of “common on preferred” alter the relation among
shareholders and between preferred shareholders and corporation? See Commissioner v.
Tillotson Mfg. Co., 76 F.2d 189, 190-91 (6th Cir. 1935) (“Each preferred stockholder, in
consideration of relinquishing his rights to the accrued preferred dividends, secured new
voting rights, and additional property rights which might well afford him a different and
greater market with an increased money return.”).
4. The accumulated earnings tax (§ 531 to 537) might have been regarded as a substitute
for imposing an income tax on stock dividends. If a corporation could not accumulate
after-tax earnings and profits without paying an additional tax, there would be no need to
worry about shareholders getting such surplus out of the corporation without the Treasury
benefitting from someone’s payment of a tax – whether an accumulated earnings tax on
the corporation or an income tax on the shareholder.
5. Congress added § 305 when it enacted the 1954 Code. Section 305 assumed its current
form with passage of the Tax Reform Act of 1969.
6. When a shareholder owns all the shares of the only class of a corporation’s outstanding
stock, should a distribution of “preferred on common” be subject to income tax?
•No. Helvering v. Sprouse, 318 U.S. 604, 607 (1943) (“the distribution brought
about no change whatever in his interest in the corporation. Both before and after
the event, he owned exactly the same interest in the net value of the corporation as
before.”).

II. Section 305
Read § 305. The origins and evolution of § 305 are described at James A. Hime, The
Application of Section 305(b) and 305(c) to Redemptions, Recapitalizations, and
Acquisitions, 48 TAX LAW. 375 (1995).
We now consider cases where a corporation distributes stock or stock rights that alter the
relative interests of shareholders in the corporation. Section 305 governs such cases.
Notice the format of § 305. Section 305(a) provides that “[e]xcept as otherwise provided
in this section, gross income does not include the amount of any distribution of the stock
of a corporation made by such corporation to its shareholders with respect to its stock.”
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(emphasis added). Section 305(b) lists exceptions to the general rule of exclusion – i.e.,
distributions which are included in “gross income.” Those distributions are treated “as a
distribution to which § 301 applies ...” We generally expect a Code provision to include
everything except what is specifically excluded. Section 305 is counter to that intuition. It
results from judicial and congressional efforts to deal with what was believed to be the
rule of Eisner v. Macomber and with the assumption that it would be unconstitutional to
alter that rule.
•Is there any significance to a distribution being a dividend and being “treated” as
a dividend?
•What happens to the distributing corporation’s e&p when the distribution of its
stock is not technically a dividend but is “treated” as a dividend? See § 312(d);
Reg. § 1.312-1(d).
Notice also that § 305(a) – a rule of non-inclusion in gross income – applies only to a
“distribution of the stock of a corporation made by such corporation to stockholders with
respect to its stock.” Section 305(b) – a rule of inclusion in gross income – applies only
to a “distribution by a corporation of its stock.” Other provisions of the Code govern
transactions that are not a “distribution by a corporation of its stock,” e.g., an exchange, a
recapitalization. Cf. Reg. § 1.305-3(e), Example 12 (recapitalization accomplished through
“single and isolated [exchange];” such exchanges not “within the purview of § 305”).
Moreover, distributions that may alter the proportionate interests of some shareholders but
which do not fall within any of the transactions described in § 305(b) are not governed by
§ 305. Such is the effect of the phrase in § 305(a) “except as otherwise provided in this
section, gross income does not include the amount of any distribution of the stock of a
corporation made by such corporation to its shareholders with respect to its stock.”
By now, you should have some sense of the interests that shareholders have with respect
to each other and with respect to the corporation. When a distribution of stock alters either
or both of such relationships, we should expect such a distribution to be subject to the rules
governing income taxation of dividends. Eisner v. Macomber does not stand in the way.
Nevertheless, we must read § 305(b) very closely.
If a corporation has cash to distribute but its shareholders would prefer not to be taxed on
the receipt of a cash dividend, is there any way that the corporation can avail itself of §
305(a) to avoid such a consequence?

A. Section 305(b)(1)
Read § 305(b)(1), Reg. § 1.305-2(a), and Reg. § 1.305-2(b), Example 2. Consider these
questions:

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1. Suppose a corporation gives shareholder the option of receiving cash or shares.
All the shareholders elect to receive shares so that the relationships between
shareholders and each other, and between the shareholders and the corporation do
not change. Does this fall within the § 305(b)(1) exception?
2. Suppose that all shareholders receive shares and that the distribution appears to
fall within § 305(a). Shareholders are entitled to have the corporation redeem
shares immediately. Does this distribution fall within the § 305(b)(1) exception?
See note 3, following Rev. Rul. 78-375.
3. Suppose that all shareholders receive shares and that the distribution appears to
fall within § 305(a). Shareholders have the option to ask the corporation to redeem
shares immediately. The corporation may exercise its discretion to deny the
request, but it always accedes to a shareholder’s request. Does this fall within the
§ 305(b)(1) exception? See Frontier Savings Ass’n v. Commissioner, infra. Should
it matter that the distribution of shares is made for the very purpose of allowing
one shareholder in need of cash to obtain it from the corporation by requesting a
redemption while another shareholder retains her shares? See note 4, following
Frontier Savings.

Rev. Rul. 78-375, 1978-2 C.B. 130
Advice has been requested as to the treatment for federal income tax purposes of a
“dividend reinvestment plan” where the shareholder may not only elect to receive stock of
greater fair market value than the cash dividend such shareholder might have received
instead, but also the shareholder may, through the plan, purchase additional stock from the
corporation at a discount price which is less than the fair market value of the stock.
X is a corporation engaged in commercial banking whose shares of common stock are
widely held and are regularly traded in the over-the-counter market. In order to raise
additional equity capital for corporate expansion and to provide holders of X’s common
stock with a simple and convenient way of investing their cash dividends and optional
payments in additional shares of X common stock without payment of any brokerage
commission, X established an automatic dividend reinvestment plan. An independent
agent will administer the plan and will receive the stock from X in the manner described
below on behalf of a participating shareholder.
The plan provides the following:
1. Shareholders can elect to have all their cash dividends (less a quarterly service charge
of 3x dollars that is paid to an independent agent of the shareholder) otherwise payable on
common stock registered in the name of the shareholder automatically reinvested in shares
of X common stock. The service charge is paid to the agent for administering the plan and
237

maintaining the stock certificates for the shareholders. The shareholders who elect to
participate in the plan acquire X stock at a price equal to 95 percent of the fair market
value of such stock on the dividend payment date. The shareholder’s option to receive a
dividend in additional common stock in lieu of a cash dividend is not transferable apart
from a transfer of the common shares themselves.
2. A shareholder who participates in the dividend reinvestment aspect of the plan as
described in paragraph (1) above, in addition, has the option to invest additional amounts
to purchase shares of X common stock at a price equal to 95 percent of the fair market
value of such stock on the dividend payment date. Optional investments by a shareholder
in any quarterly dividend period must be at least 4x dollars and cannot exceed 100x dollars.
The shareholder’s right to invest additional amounts under the plan is not transferable apart
from a transfer of the common shares themselves.
There is no requirement to participate in the plan and shareholders who do not participate
receive their cash dividend payments in full. Certain shareholders have chosen not to
participate; therefore, they receive their regular quarterly cash dividend. While the plan
continues in effect, a participant’s dividends will continue to be invested without further
notice to X.
Prior to the dividend payment date no cash dividend is available to either X’s participating
or nonparticipating shareholders. On the dividend payment date the participant receives
written notification that X is acting to effectuate the participant’s option to receive stock
on that date. The crediting on the plan account and notification to the participant of the
exact number of shares acquired (including fractional shares) takes place shortly after the
dividend payment date.
A participant may withdraw from the plan at any time, upon written request. Upon
withdrawal, certificates for whole shares credited to the participant’s account under the
plan will be issued and a cash payment based upon the market value of the participant’s
fractional share interest will be paid by X, through the participant’s agent, to the
participant. As an alternative, the shareholder may request that all or part of the whole
shares credited to its account in the plan be sold for the shareholder’s account. The sale
will be made by an independent agent acting on behalf of such participant and the proceeds
of the sale (less any brokerage commission and transfer tax) will be forwarded to the
participant. With regard to the whole shares, X will neither purchase any shares of a
participant nor pay any expense attributable to the sale of such stock. Upon a request for
sale of a participant’s shares, a cash payment equal to the market value of the participant’s
fractional share interest will be paid by X, through the participant’s agent, to the
participant. The purpose of the payment of cash is to save X the trouble, expense, and
inconvenience of issuing and transferring fractional shares and is not designed to give any
particular group of shareholders an increased interest in the assets or earnings and profits
of X.
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Section 305(a) of the Code provides that, with certain exceptions, gross income does not
include the amount of any distribution of the stock of a corporation made by such
corporation to its shareholders with respect to its stock. Section 305(d)(1) provides that for
purposes of the foregoing the term “stock” includes rights to acquire such stock.
Section 305(b)(1) of the Code provides that § 305(a) will not apply, and the distribution
will be treated as a distribution to which § 301 applies, if the distribution is, at the election
of any shareholder (whether exercised before or after the declaration), payable either in
the stock of the distributing corporation or in property.
Section 305(b)(2) of the Code provides that § 305(a) will not apply, and the distribution
will be one to which § 301 applies, if the distribution (or a series of distributions of which
such a distribution is one) has the result of (a) the receipt of property by some shareholders,
and (b) an increase in the proportionate interest of other shareholders in the assets or
earnings and profits of the corporation.
Reg. § 1.305-3(b)(2) provides that in order for a distribution of stock to be considered as
one of a series of distributions, it is not necessary that such distribution be pursuant to a
plan to distribute cash or property to some shareholders and to increase the proportionate
interests of other shareholders. It is sufficient if there is an actual or deemed distribution
of stock and, as a result of such distribution, some shareholders receive cash or property
and other shareholders increase their proportionate interests. This is so whether the stock
distributions and the cash distributions are steps in an overall plan or are independent and
unrelated. In addition, § 1.305-3(b)(3) states that there is no requirement that both elements
of § 305(b)(2) of the Code (receipt of cash or property by some shareholders and an
increase in proportionate interests of other shareholders) occur in the form of a distribution
or series of distributions as long as the result of a distribution of stock is that some
shareholders’ proportionate interests increase and other shareholders in fact receive cash
or property.
Section 301 of the Code states that, except as otherwise provided, a distribution of property
made by a corporation to a shareholder with respect to its stock shall be included in the
gross income of the shareholder to the extent the amount distributed is a dividend as
defined in § 316.
Rev. Rul. 76-53, 1976-1 C.B. 87, concerns a situation where a widely held corporation
that regularly distributes its earnings and profits adopted a plan permitting the shareholders
to choose to have all of the cash dividends, otherwise payable on common shares owned
by the shareholder, automatically invested to purchase additional shares of the
corporation’s stock. The shareholders who elect to participate under this plan acquire the
company’s stock at a price equal to 95 percent of the fair market value of such stock on
the dividend payment date. That Revenue Ruling concludes that the distributions made by
239

the corporation while the plan is in effect are properly treated as payable either in stock or
in cash at the election of the shareholder within the meaning of § 305(b)(1) of the Code,
and, therefore, such participating shareholders will be treated as having received a
distribution to which § 301 applies by reason of § 305(b)(1).
Rev. Rul. 77-149, 1977-1 C.B. 82, concerns a situation where a corporation established a
dividend reinvestment plan administered by a local bank, acting as agent for the
shareholders. At a shareholder’s direction the shareholder’s cash dividends would be
received by the participating shareholders’ agent, the bank, who would then purchase the
corporation’s stock on the open market at 100 percent of fair market value. That Revenue
Ruling held that § 301 applies directly to the cash dividends without reference to §
305(b)(1) because the distribution is payable by the corporation only in cash, and the
shareholders of the corporation do not have the election of receiving their dividend
distribution from the corporation in either stock or cash.
In the present case, the distributions made by X while the plan is in effect are properly
treated as payable either in X’s stock or in cash at the election of X’s common shareholders
within the meaning of § 305(b)(1) of the Code. The acquisition of stock through the
dividend reinvestment aspect of the plan is identical to the situation in Rev. Rul. 76-53.
Further, the present case and Rev. Rul. 76-53 are distinguishable from Rev. Rul. 77-149
because the distribution described in Rev. Rul. 77-149 was payable by the corporation
only in cash, and the shareholder, through the agent, purchased the corporation’s stock on
the open market.
The optional investment aspect of the present case results in an increase in the
proportionate interests of the shareholders making the purchase at a 5 percent discount,
and this event increases their proportionate interests in the assets or earnings and profits
of X within the meaning of § 305(b)(2)(B) of the Code. Furthermore, the fact that X
shareholders who do not participate in the plan receive cash dividends constitutes a receipt
of property by those shareholders within the meaning of § 305(b)(2)(A).
Accordingly, under the circumstances described above, it is held as follows:
(a) A shareholder of X who participates in the dividend reinvestment aspect of the plan
will be treated as having received a distribution to which § 301 of the Code applies by
reason of the application of section 305(b)(1). Pursuant to Reg. § 1.305-1(b), the amount
of the distribution to a participating shareholder (including participating corporate
shareholder) will be the fair market value of the X stock received on the date of the
distribution (§ 1.301-1(b) and (d)), plus, pursuant to § 301, 3x dollars, the service charge
subtracted from the amount of the shareholder’s distribution.
(b) The basis of the shares credited to the account of a participating shareholder pursuant
to the dividend reinvestment aspect of the plan will equal the amount of the dividend
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distribution, as provided in § 301(c) of the Code, measured by the fair market value of the
X common stock as of the date of the distribution both as to noncorporate and corporate
shareholders, pursuant to § 301(d). Reg. § 1.301-1(h)(1) and (2)(i). The quarterly service
charge paid by a participant who is an individual for the production of income or for the
management, conservation, or maintenance of property held for the production of income,
is deductible in the year paid by such participant under § 212, provided the individual
itemizes deductions. See Rev. Rul. 70-627, 1970-2 C.B. 158, and Rev. Rul. 75-548, 19752
C.B. 331. The quarterly service charge, which is paid in carrying on a trade or business by
a participant who is an individual, is deductible in the year paid by such participant under
§ 162. A participant who is a corporation may deduct the service charge under § 162.
(c) A shareholder of X who participates in the optional payment aspect of the plan will be
treated as having received a distribution to which § 301 of the Code applies by reason of
the application of § 305(b)(2). Pursuant to Reg. § 1.305-3(a), the amount of the distribution
to a participating shareholder will be the difference between the fair market value on the
dividend payment date of the shares purchased with the optional payment and the amount
of the optional payment. § 1.305-3(b)(2).
(d) The basis to the shareholder who participates in the optional payment aspect of the
plan is the excess of fair market value of the shares purchased with the optional payment
over the optional payment (provided that this deemed distribution is taxable as a dividend
under § 301(c)(1) of the Code) pursuant to § 301(d) and Regs. §§ 1.301-1(h)(1) and 2(i),
plus the amount of the optional payment, pursuant to § 1012.
(e) A participant in the plan will not realize any taxable income upon receipt of certificates
for whole shares that were credited to the participant’s account pursuant to the plan. Rev.
Rul. 76-53. Any cash received by an X shareholder in lieu of a fractional share interest
will be treated as a redemption of that fractional share interest, subject to the provisions
and limitations of § 302 of the Code. See Rev. Rul. 66-365, 1966-2 C.B. 116.
(f) A participant will recognize gain or loss pursuant to § 1001 of the Code when shares
are sold or exchanged on behalf of the participant upon the participant’s withdrawal from
the plan, or when the participant sells the shares after its withdrawal from the plan. In
accordance with § 1001, the amount of such gain or loss will be the difference between
the amount that the participant receives for the whole shares and the participant’s tax basis.
Any cash received by the participants, who withdraw from the plan, in lieu of their
fractional share interests will be treated as a redemption of that fractional share interest,
subject to the provisions and limitations of § 302. See Rev. Rul. 66-365.
Rev. Rul. 77-149 is distinguished.

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Questions and comments:
1. The IRS noted that in Rev. Rul. 77-149, 1977-1 C.B. 82, a local bank administered a
DRIP for the shareholders of a corporation. Shareholders could direct the bank to use
dividend money to buy on the open market shares of the corporation’s stock at 100% of
fmv. The IRS determined that § 301 applies directly to such a plan, without reference to §
305(b)(1). Is there any significance to such a holding?
2. Examine paragraphs (a) through (e) of the IRS’s holding: account for the amounts on
which a shareholder pays income tax, the character of the income, and the amount that
becomes the shareholder’s basis in share that they acquired.
3. Corporation issues preferred stock pro rata to its common stock shareholders. Holders
of the preferred stock are entitled to have the preferred stock redeemed at any time –
including immediately.
Since the preferred stock is redeemable immediately after the distribution at the
option of a shareholder, a shareholder may either hold the preferred stock or have
it redeemed for money. Thus, the effect of the immediate redeemability feature of
the preferred stock is to give a shareholder an election to receive either stock or
property within the meaning of § 305(b)(1)(A) and (B) of the Code.
Accordingly, in the instant case, the distribution is treated as a distribution of
property to which § 301 of the Code applies.
Rev. Rul. 76-258, 1976-2 C.B. 95.
4. In Rev. Rul. 76-258, the corporation retained no discretion to refuse to redeem dividend
shares of a shareholder. Can we measure the amount of discretion a corporation must retain
for a distribution of stock not to fall within § 305(b)(1)? Consider the following case –

Frontier Savings Ass’n v. Commissioner, 87 T.C. 665, aff’d sub nom. Colonial Savings
Ass’n v. Commissioner, 854 F.2d 1001 (CA7 1988), cert. denied, 489 U.S. 1090 (1989)
In statutory notices of deficiency ..., respondent determined deficiencies in petitioner’s
Federal income tax liabilities ...
....
... [T]he issue .... is whether stock dividends received by petitioner in 1978 and 1979 from
the Federal Home Loan Bank of Chicago are taxable to petitioner under § 305(b)(1)
[footnote omitted]. The resolution of this issue will affect the taxability of stock dividends
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received by the other 496 stockholders of the Federal Home Loan Bank of Chicago which
also received stock dividends in 1978 and 1979.
FINDINGS OF FACT
....
Petitioner Frontier Savings Association (Frontier Savings) is a mutual savings and loan
association ... It operates as a mutual savings association pursuant to Wisconsin law. ...
Frontier Savings has been a member and stockholder of the Federal Home Loan Bank of
Chicago (the Chicago Bank) at all times since the organization of the Chicago Bank. The
Chicago Bank is one of 11 district banks (12 prior to 1946) established pursuant to the
Federal Home Loan Bank Act of 1932, 47 Stat. 725, 12 U.S.C. §§ 1421 et seq. The district
banks were capitalized with stock subscriptions from member institutions and the U.S.
Treasury. District banks operate under the supervision of the Federal Home Loan Bank
Board, an administrative agency in the Executive Branch of the Federal Government. The
Federal Home Loan Bank Board also is the chartering and regulatory authority for Federal
savings and loan associations and Federal mutual savings banks.
The Federal Home Loan Bank system was designed primarily as a reserve credit facility
for savings and loan associations and other home mortgage credit institutions. Savings and
loan associations (such as Frontier Savings) and mutual savings banks that are members
or stockholders in the district banks (hereinafter referred to as members or member banks)
are required by Federal law to maintain a certain capital stock ownership in the respective
district banks of which they are members. The stock ownership requirements are
determined at the end of each calendar year and are calculated with reference to each
member bank’s net home mortgage loans outstanding and total borrowings of each
member from the district bank.
Each member bank generally must maintain a capital stock ownership interest in the
district bank in an amount equal to at least 1 percent of the total outstanding balance of its
home mortgage loans [footnote omitted] and at least equal to one-twelfth [footnote
omitted] of total outstanding borrowings of the member bank from the district bank, as of
December 31 of each year. Each share of stock in the district banks is valued by statute at
its $100 par value. See 12 U.S.C. § 1426(b) and (c) (1978).
Based upon the above yearend calculations, member banks that are required to purchase
additional stock of district banks must do so by January 31 of the following year at the par
value of $100 per share. Member banks that own stock in district banks in excess of the
required number of shares (excess shares) may request that excess shares be redeemed by
the district banks.
….
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As of December 31, 1977, Frontier Savings owned 6,721 shares of stock in the Chicago
Bank, all of which it had purchased over many years from the Chicago Bank at $100 per
share. On that day, the principal amount of Frontier Savings’ outstanding mortgage loans
and borrowings from the Chicago Bank was such that, prior to January 31, 1978, Frontier
Savings was required to increase its stock interest in the Chicago Bank to 9,066 shares.
Accordingly, during January of 1978, Frontier Savings purchased 2,345 additional shares
of the common stock of the Chicago Bank for $234,500. ... [A]s of December 28, 1978,
Frontier Savings owned 9,066 shares of the common stock of the Chicago Bank.
As stockholders in district banks, member banks are entitled to receive dividends that are
declared by district banks. Prior to December 29, 1978, dividends were paid by the
Chicago Bank to its member banks in the form of cash. On December 29, 1978, dividends
were paid by the Chicago Bank to its member banks in the form of additional shares of
common stock. On December 31, 1979, dividends were paid by the Chicago Bank to its
member banks half in stock and half in cash.
DECEMBER 29, 1978, STOCK DIVIDEND
At a meeting held on November 20, 1978, the board of directors of the Chicago Bank
adopted a resolution to pay a 6.58-percent dividend to its stockholders of record as of
December 31, 1978. Subject to the approval of the Federal Home Loan Bank Board, the
resolution stated that the dividend would be paid in the form of shares of stock in the
Chicago Bank. On December 22, 1978, the Director of the Office of District Banks,
Federal Home Loan Bank Board, wrote a letter to the President of the Chicago Bank
approving the stock dividend.
On December 22, 1978, the Chicago Bank mailed a bulletin to its member banks,
informing them that a 6.58-percent stock dividend would be paid, with fractional shares to
be paid in cash. The explanation made in the bulletin for paying a stock dividend, rather
than a cash dividend, was as follows:
(1) Providing a stock rather than a cash dividend may enable your association to
defer the payment of income taxes on the value of the stock dividend. You may
wish to consult your tax adviser for the proper handling of a stock dividend.
(2) A stock dividend can be applied toward satisfying the stock investment
requirement for members that experienced a growth in assets during 1978 or that
will be required to purchase additional stock due to increased borrowings from the
Bank.

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The bulletin also explained that most member banks would be required to increase their
stock holdings in the Chicago Bank due to that year’s general increase in outstanding home
mortgage loans.
On December 29, 1978, [footnote omitted] the Chicago Bank distributed the 1978 stock
dividend by (1) crediting the appropriate number of whole shares of stock to the stock
account of each member bank, (2) crediting an appropriate amount of cash with respect to
fractional shares to the demand account of each member bank, and (3) issuing a new stock
certificate to each member bank. Each new stock certificate reflected the total number of
shares of stock held by each member bank before the stock dividend, the number of shares
of stock distributed pursuant to the dividend, and the total number of shares of stock owned
by each member bank after distribution of the dividend. ...
On December 29, 1978, a total of 234,620 shares of common stock was distributed by the
Chicago Bank as a stock dividend to its 497 member banks. On December 29, 1978,
Frontier Savings received 588 shares of common stock in the Chicago Bank (and cash
representing fractional shares in the amount of $51.07) as its share of the 1978 stock
dividend.
COMMON STOCK PURCHASES AND REDEMPTIONS
DECEMBER 31, 1978, STOCK OWNERSHIP REQUIREMENTS

RELATING

TO

Enclosed with the December 22, 1978, bulletin mailed by the Chicago Bank to its member
banks describing the 1978 stock dividend was a form entitled “Calculation of Bank Stock
Requirement as of December 31, 1978.” Using that form, each member bank could
calculate the number of shares of stock it was required, under 12 U.S.C. § 1426(c) (1978),
to own in the Chicago Bank as of December 31, 1978. If a member bank was required to
purchase additional shares of stock, it could submit the form (reflecting the number of
shares to be purchased) along with a check in payment therefore to the Chicago Bank. If
the member bank held more shares than it legally was required to own, it could use the
form to request the redemption of any excess shares. Although the Chicago Bank had no
legal obligation to redeem excess shares, in prior years it routinely had done so.
On January 16, 1979, Frontier Savings completed the form calculating the number of
shares of common stock in the Chicago Bank it was required to own based on its December
31, 1978, outstanding balance for home mortgage loans. That calculation indicated that
Frontier Savings was required to purchase 678 additional shares of common stock in the
Chicago Bank (after taking into account the shares received as part of the common stock
dividend on December 29, 1978). Frontier Savings, therefore, sent a check in the amount
of $67,800 to the Chicago Bank and 678 shares were credited to its stock account at the
Chicago Bank. A new stock certificate was issued reflecting the ownership by Frontier
Savings of a total of 10,332 shares of common stock in the Chicago Bank. During 1979,

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none of the shares of common stock in the Chicago Bank owned by Frontier Savings were
redeemed or otherwise transferred.
Exclusive of the December 29, 1978, stock dividend received, on December 31, 1978, 195
of the 497 member banks owned sufficient shares of common stock in the Chicago Bank
to meet their stock ownership requirements, and 302 member banks did not own sufficient
shares to meet their stock ownership requirements. After receipt of the 1978 stock
dividend, 69 member banks requested that the Chicago Bank redeem all or some of their
excess shares. All such redemption requests were agreed to by the Chicago Bank and [it
redeemed 94,320 shares of common stock from member banks from December 1978
through 1979.]
....
1979 CASH AND STOCK DIVIDENDS
At a meeting held on November 19, 1979, the board of directors of the Chicago Bank
adopted a resolution, subject to the approval of the Federal Home Loan Bank Board, to
pay a 10-percent dividend to its stockholders of record as of December 31, 1979, half of
which would be paid in cash and half of which would be paid in the form of common stock
of the Chicago Bank. On December 13, 1979, the Federal Home Loan Bank Board
approved payment by the Chicago Bank of the proposed cash and stock dividends. On
December 21, 1979, the Chicago Bank mailed a bulletin to its member banks, informing
them that the 10-percent dividend would be paid to the stockholders on December 31,
1979.
On December 31, 1979, the Chicago Bank distributed the 1979 dividends by (1) adding
the appropriate number of whole shares of stock to the stock account of each member, and
(2) adding to the demand account of each member the amount representing the cash portion
of the dividend as well as the amount of cash representing fractional shares of stock
distributed as part of the dividend. A total of 209,197 shares of stock was distributed by
the Chicago Bank as a stock dividend to its 497 member banks on December 31, 1979.
Frontier Savings received 514 shares of Chicago Bank common stock as its portion of the
1979 stock dividend and $51,567.87 in cash as its portion of the cash dividend.
COMMON STOCK PURCHASES, SALES, AND REDEMPTIONS RELATING TO
DECEMBER 31, 1979, STOCK OWNERSHIP REQUIREMENTS
The December 21, 1979, bulletin mailed to member banks concerning the 1979 dividends
explained that “to help preserve the non-taxable characteristics of the stock dividend” a
new procedure was being adopted for the purchase and disposition of excess shares of
stock in the Chicago Bank. Instead of having member banks purchase additional shares of
stock from the Chicago Bank and instead of having the Chicago Bank redeem excess
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shares from member banks, the new procedure called for member banks who had excess
shares they wished to dispose of to sell such excess shares to other member banks who
wished to buy additional shares.
Enclosed with the December 21, 1979, bulletin was a form entitled “Calculation of Bank
Stock Requirement” as of December 31, 1979, and a separate form that could be used by
the member banks to notify the Illinois and Wisconsin League Offices 86 of their desire to
sell excess shares of stock in the Chicago Bank to other member banks. Each member bank
was required to notify the Chicago Bank of any purchases of shares of stock in the Chicago
Bank so the changes in ownership of the stock could be reflected on its records.
Frontier Savings completed its form for the “Calculation of Bank Stock Requirement” on
January 29, 1980. Thereon, it was indicated that, based on its December 31, 1979, loan
balance figures, Frontier Savings was required to purchase 520 additional shares of
common stock in the Chicago Bank. Frontier Savings, therefore, mailed a $52,000 check
to the Chicago Bank, and the Chicago Bank credited Frontier Savings with 520 shares of
stock, increasing the total number of shares in petitioner’s stock account to 11,366.
Exclusive of the December 31, 1979, stock dividends, 282 of the Chicago Bank’s 497
member banks owned sufficient shares of stock in the Chicago Bank to meet their stock
ownership requirements on December 31, 1979, and 215 member banks did not own
sufficient shares. After receipt of their 1979 stock dividends from the Chicago Bank, 31
member banks sold some of their stock to other member banks, and 10 bought additional
stock from member banks. A total of 85,859 shares of stock in the Chicago Bank was
exchanged between member banks during December of 1979 and January of 1980.
Sales of excess shares between member banks occurred only in January of 1980. Excess
shares that member banks wished to dispose of after January of 1980 were redeemed by
the Chicago Bank. Between February 1, 1980, and December 31, 1980, 64 member banks
requested the Chicago Bank to redeem their excess shares. Sixty member banks redeemed
a number of shares that was equal to or that exceeded the number of shares they received
as their portion of the 1979 stock dividend. The Chicago Bank honored all redemption
requests received during that period of time and [redeemed a total of 281,840 shares in
1980].
None of the shares of stock in the Chicago Bank received by Frontier Savings with respect
to the 1978 and 1979 stock dividends were redeemed by the Chicago Bank or otherwise
disposed of by Frontier Savings prior to 1982. In January of 1982, the Chicago Bank, at

86 Although not explained in the record, apparently the Illinois and Wisconsin League offices were trade

associations of member banks which agreed to act as intermediaries to effect the sales of stock between member
banks in January of 1980.

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the request of Frontier Savings, redeemed 3,584 shares of its stock owned by Frontier
Savings.
OPINION
The receipt of common stock dividends generally is not taxable to stockholders. § 305(a).
Where, however, dividends from a corporation are payable, at the election of the
stockholders, in stock or property (such as cash), the receipt of dividends will be taxable
to the stockholders under the provisions of § 301. § 305(b)(1). [footnote omitted]. In that
circumstance, the receipt of stock dividends will be taxable under §§ 305(b)(1) and 301
regardless of whether the stockholders exercise their election to receive the dividends in
cash or other property. Reg. § 1.305-2(a). [footnote omitted].
Respondent argues that by redeeming all of the common stock it was requested to redeem
from its member banks in 1979 and 1980 (and apparently doing so in years before 1979),
the Chicago Bank established such a policy and practice of redeeming excess stock upon
request of the member banks that the member banks should be regarded as having had an
“election” to receive the 1978 and 1979 stock dividends in cash. Respondent therefore
argues that the stock dividends in question do not qualify for exemption from taxability
under § 305(a) and should be taxable to the member banks under §§ 305(b)(1) and 301.
For the reasons explained below, we disagree.
The Federal statute under which the Federal Home Loan Bank Board and the district banks
regulate certain activities of member banks addresses the authority of district banks to
redeem common stock from its member banks and explicitly describes that authority as
discretionary with each district bank. Section 1426(c) of the Federal Home Loan Bank Act
as amended in 1961 provides, in relevant part, as follows:
If the bank finds that the investment of any member in stock is greater than that
required under this subsection it may, unless prohibited by said Board [i.e., the
Federal Home Loan Bank Board] or by the provisions of paragraph (2) of this
subsection, in its discretion and upon application of such member retire the stock
of such member in excess of the amount so required. * * * [12 U.S.C. § 1426(c)
(1961), as amended by Act of Sept. 8, 1961, subsec. (c), Pub. L. 87-210, 75 Stat.
482. Emphasis supplied.]
A comparison of the language quoted above (reflecting the 1961 amendment to § 1426(c))
with the language of the predecessor statute to § 1426(c) (as originally enacted in 1932) is
particularly significant. As originally enacted, § 1426(c) of the Federal Home Loan Bank
Act of 1932, supra, provided as follows:
If the board finds that the investment of any member in stock is greater than that
required under this section, upon application of such member, the bank shall pay
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such member for each share of stock in excess of the amount so required an amount
equal to the value of such stock * * * [Federal Home Loan Bank Act of 1932,
supra, § 1426(c). Emphasis supplied.]
The language quoted immediately above suggests that member banks may have had the
right to require district banks to redeem excess shares before the 1961 amendment to 12
U.S.C. § 1426(c). That is suggested by use in the statutory language of the mandatory
“shall.” Nothing, however, in the Federal Home Loan Bank Act, in its present form,
suggests that since 1961 anyone other than the district banks and the Federal Home Loan
Bank Board have the authority to determine whether excess shares will be redeemed.
The policy of the Chicago Bank with respect to the redemption of excess shares … is
entirely consistent with the above statutory provisions. Also, the bulletins mailed in
December of 1978 and 1979 by the Chicago Bank to its members do not communicate any
contrary policy to member banks. Those bulletins acknowledged that although the
issuance of stock dividends was attributable, in part, to a perceived tax planning
opportunity, the distributions of stock dividends also were attributable to the recognized
need for a number of member banks to acquire additional shares of common stock in the
Chicago Bank. With respect to the holding of excess shares, the bulletin dated December
22, 1978, simply suggested that member banks “may want to retire” such stock. The
bulletin dated December 21, 1979, stated that it was “hoped that the majority of those
holding excess stock will choose to hold the stock to meet future needs and for investment
purposes,” but that if they chose to sell excess shares to another member bank the league
offices will “make every effort to bring you in contact with a member * * * willing to
purchase” the excess shares. Neither bulletin suggested that the Chicago Bank necessarily
would grant any or all redemption requests.
Congress vested in the district banks and in the Federal Home Loan Bank Board
discretionary authority to redeem excess shares of common stock held by member banks.
Our careful examination of the record herein satisfies us that the manner in which stock
dividends were paid and redeemed in 1978 and 1979 by the Chicago Bank was consistent
with that grant of discretionary authority and did not vest in the member banks the
unilateral right to elect or to require the Chicago Bank to redeem excess shares upon
request.
Respondent concedes that the Chicago Bank did not completely abdicate its discretionary
authority to redeem its stock but respondent argues that that authority was exercised so
consistently in favor of redemption that member banks, as a practical matter, had the option
or election to have excess shares redeemed at any time. Respondent contends that the
option arose “from the circumstances of the distribution,” citing Reg. § 1.305-2(a)(4). As
indicated, we have carefully examined the circumstances of the stock dividends in question
and conclude that the member banks, including Frontier Savings, did not have the option

249

or election to have the Chicago Bank redeem excess shares of common stock in the
Chicago Bank.
In addition to the factors explained above, we think it significant that the stock dividends
of the Chicago Bank were declared and distributed in late December of 1978 and 1979.
Member banks, however, normally would not be able to determine until early in the
following year (after actual distribution of the stock dividends) whether they would be
able even to request a redemption of some of their common stock in the Chicago Bank. In
other words, on the day of distribution of the stock dividends, member banks could not
know (other than through estimates and projections) whether they would be required to
retain the stock dividends they received as part of their required investments in the district
bank or whether the stock dividends would qualify as excess shares, in which case
redemption thereof, if requested, might occur depending on the decision of the Chicago
Bank. [footnote omitted].
....
We recognize that the issuance by the Chicago Bank in 1978 and 1979 of stock dividends
instead of or in addition to cash dividends was motivated in part by tax considerations. We
cannot conclude, however, on the facts before us that the stock dividends were a mere
subterfuge for cash distributions ... or that the Chicago Bank had relinquished its
discretionary authority to decline to grant stock redemption requests.
....
Decisions will be entered under Rule 155.
Reviewed by the Court.
STERRETT, GOFFE, CHABOT, NIMS, PARKER, WHITAKER, KRNER, SHIELDS,
HAMBLEN, COHEN, CLAPP, JACOBS, and PARR agree with the majority opinion.
SIMPSON, J., dissents.
GERBER, WRIGHT, and WILLIAMS, JJ., did not participate in the consideration of this
case.
HAMBLEN, J., concurring:
I concur in the conclusion of the majority based upon the limited factual circumstances
involved. If a discretionary act of the board of directors of a shareholder corporation to
redeem stock dividends becomes a routine matter, it might, in my opinion, develop into an
“option” that arises after the distribution or a distribution pursuant to a “plan.” See Regs.
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§§ 1.305-2(a) and 1.3053(b). In such a situation, it seems the redemptions might be
periodic rather than isolated. The broad rules of § 305 could invoke different
considerations under other circumstances.
STERRETT, COHEN, AND JACOBS, JJ., agree with this concurring opinion.

Questions and comments:
1. Who is affected by a determination that a case falls within § 305(b)(1)? The
shareholders whose shares are redeemed, the shareholders whose shares are not redeemed,
or both?
2. Did you like the tax advice that was given by the FHLB in this case? It seems that
members who did not have to purchase additional shares were able to “purchase”
protection with untaxed dividend shares.
3. Consider the facts of Rev. Rul. 87-132, 1987-2 C.B. 82:
X corporation had outstanding 300 shares of voting common stock that were
owned equally by an estate and by A ... The value of the X stock held by the estate
exceeded the amount specified in § 303(b)(2)(A). The estate wanted to effect a
redemption pursuant to § 303 to pay death taxes.
In order to maintain relative voting power and to preserve continuity of
management, X undertook the following two steps. First, X issued 10 shares of a
new class of nonvoting common stock on each share of common stock outstanding.
Thus, the estate and A each received 1,500 shares of this stock. Immediately
thereafter, 1,000 shares of the nonvoting common stock were redeemed by X from
the estate in exchange for cash. The overall result of these two steps was that the
estate obtained the cash it needed while giving up only nonvoting stock.
HELD:
The exclusion from gross income provision of § 305(a) of the Code, and the
carryover of basis provisions of § 307(a), apply to X’s distribution of its new
nonvoting common stock to A and the estate. Section 303(a) applies to X’s
distribution of cash to the estate in redemption of the 1,000 shares of its new
nonvoting common stock.

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Problems:
1. Corporation X declared a dividend payable in additional shares of its common stock to
the holders of its outstanding common stock. Individual shareholders could elect to receive
either –
•two shares of Corporation X common stock for each share held on the record date.
The fmv of the stock on the date of distribution was $10/share.
OR
•one share of Corporation X common stock plus a Corporation Y bond that
Corporation X owned. The bond had a $12 face amount. The bond’s fmv on the
date of distribution was $11. Corporation X’s basis in the Corporation Y bond was
$9.
A. In effect, each shareholder received two shares of Corporation X’s common stock, but
could exchange one of them for a bond of another corporation. What is the tax consequence
to each shareholder and to Corporation X of receiving the share that shareholders could
not exchange? If it is a distribution to which § 301 applies, what is the amount of the
distribution?
B. Each shareholder received a second share of Corporation X stock and could elect to
exchange it or not. What is the tax consequence to those shareholders who did not elect to
exchange that share for a Corporation Y bond? If it is a distribution to which § 301 applies,
what is the amount of the distribution?
C. What is the tax consequence to the shareholders of Corporation X who did elect to
exchange their second share of Corporation X common stock for a Corporation Y bond?
If it is a distribution to which § 301 applies, what is the amount of the distribution? What
is the shareholder’s basis in the bond?
These questions come from Reg. § 1.305-2(b), Example 1. You should try to answer these
questions yourself, but check your answers against Example 1.

B. Section 305(b)(2)
Read § 305(b)(2).
Notice that § 305(b)(2) focuses on a result rather than on different treatment of different
shareholders. The result must be a consequence of a distribution or a series of distributions
by a corporation of its stock. The heading of § 305(b) states that § 305(a) does not apply
to a distribution of stock that falls within any of five exceptions. Obviously, if a
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corporation distributes cash to one group of shareholders and stock to a different group of
shareholders, the result will be “the receipt of property by some shareholders,” and “an
increase in the proportionate interests of other shareholders in the assets or earnings and
profits of the corporation.” But, would the result be different if a corporation distributed
cash in redemption of the stock of one group of shareholders and distributed nothing to
the remaining shareholders? Read Reg. § 1.305-3(b)(3).
•Should it make any difference if the distribution of cash (or other property) were
not a dividend under § 301? See id. Is the rule of the regulation theoretically sound
– or merely practically sound?
•Reg. § 1.305-3(b)(3) states in part that “a distribution of property incident
to an isolated redemption of stock ... will not cause § 305(b)(2) to apply even
though the redemption distribution is treated as a distribution of property to
which § 301 ... applies.”
Section 305(c) empowers the Secretary of the Treasury to prescribe regulations that
provide that certain occasions are themselves to be treated as distributions, i.e., “deemed
distributions,” Reg. § 1.305-3(b)(1). Section 305(c) requires the Secretary to prescribe
regulations to deem as distributions of stock transactions that have the effect of increasing
the proportionate interest of any shareholder in the earnings and profits of the corporation
or increasing the proportionate interest of any shareholder in the assets of the corporation.
See Reg. § 1.305-7(a). Section 305(c) works “hand-in-glove” with § 305(b)(2) (as well as
§ 305(b)(3, 4, and 5)). See Reg. § 1.305-7(a)(2). One of the occasions of a deemed
distribution is a distribution to some shareholders that is subject to § 301.

Rev. Rul. 78-60, 1978-1 C.B. 81
Advice has been requested whether under § 302(a) the stock redemptions described below
qualified for exchange treatment, and whether under § 305(b)(2) and (c) the shareholders
who experienced increases in their proportionate interests in the redeeming corporation as
a result of the stock redemptions will be treated as having received distributions of property
to which § 301 applies.
Corporation Z has only one class of stock outstanding. The Z common stock is held by 24
shareholders, all of whom are descendants, or spouses of descendants, of the founder of Z.
In 1975, when Z had 6,000 shares of common stock outstanding, the board of directors of
Z adopted a plan of annual redemption to provide a means for its shareholders to sell their
stock. The plan provides that Z will annually redeem up to 40 shares of its outstanding
stock at a price established annually by the Z board of directors. Each shareholder of Z is
entitled to cause Z to redeem two-thirds of one percent of the shareholder’s stock each
year. If some shareholders choose not to participate fully in the plan during any year, the

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other shareholders can cause Z to redeem more than two-thirds of one percent of their
stock, up to the maximum of 40 shares.
Pursuant to the plan of annual redemption, Z redeemed 40 shares of its stock in 1976. Eight
shareholders participated in the redemptions. ...
Issue 1
[The distributions did not qualify for exchange treatment under § 302(b)(1, 2, or 3).]
Issue 2
Section 305(b)(2) of the Code provides that § 301 will apply to a distribution by a
corporation of its stock if the distribution, or a series of distributions that includes the
distribution, has the result of the receipt of property by some shareholders, and increases
in the proportionate interests of other shareholders in the assets or earnings and profits of
the corporation.
Section 305(c) of the Code authorizes regulations under which a redemption treated as a §
301 distribution will be treated as a § 301 distribution to any shareholder whose
proportionate interest in the earnings and profits or assets of the corporation is increased
by the redemption.
Reg. § 1.305-7(a) provides that a redemption treated as a § 301 distribution will generally
be treated as a distribution to which §§ 305(b)(2) and 301 of the Code apply if the
proportionate interest of any shareholder in the earnings and profits or assets of the
corporation deemed to have made the stock distribution is increased by the redemption,
and the distribution has the result described in § 305(b)(2). The distribution is to be deemed
made to any shareholder whose interest in the earnings and profits or assets of the
distributing corporation is increased by the redemption.
Reg. § 1.305-3(b)(3) provides that for a distribution of property to meet the requirements
of § 305(b)(2) of the Code, the distribution must be made to a shareholder in the capacity
as a shareholder and must be a distribution to which § 301 [or one of several other specified
sections] applies. A distribution of property incident to an isolated redemption will not
cause § 305(b)(2) to apply even though the redemption distribution is treated as a § 301
distribution.
Section 305 of the Code does not make the constructive stock ownership rules of § 318(a)
applicable to its provisions.
The 16 shareholders of Z who did not tender any stock for redemption in 1976 experienced
increases in their proportionate interests of the earnings and profits and assets of Z (without
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taking into account constructive stock ownership under § 318 of the Code) as a result of
the redemptions. … The 1976 redemptions were not isolated but were undertaken pursuant
to an ongoing plan of annual stock redemptions. Finally, the 1976 redemptions are to be
treated as distributions of property to which § 301 of the Code applies.
Accordingly, … 16 shareholders of Z who did not participate in the 1976 redemptions are
deemed to have received stock distributions to which §§ 305(b)(2) and 301 of the Code
apply. See Reg. § 1.305-3(e), examples (8) and (9) for a method of computing the amounts
of the deemed distributions.

Questions and comments:
1. Notice: 40 is ⅔ of one percent of 6000. None of the shareholders of Corporation Z
actually received any stock.
2. “Deemed distributions:” Notice that the transactions described in § 305(c) – “a change
in conversion ratio, a change in redemption price, a difference between redemption price
and issue price,87 a redemption which is treated as a distribution to which § 301 applies”
– do not necessarily involve a distribution of stock – yet such transactions may have the
result described in § 305(b)(2), i.e., receipt of property by some shareholders and increase
in proportionate interest in the assets or earnings and profit by other shareholders. These
and other transactions that the Secretary of the Treasury may prescribe in regulations are
“deemed distributions” subject to treatment under § 305(b)(2, 3, 4, or 5).
3. If we deem that a distribution has occurred when it in fact has not occurred, how do we
determine the number of shares the distributee received?
•Read Reg. § 1.305-3(e), Example 8. Methodology: Determine the increase in
percentage ownership of the corporation to the non-tendering shareholder resulting
from the distribution of cash to other shareholders that is subject to § 301.
Hypothesize that percentage of ownership prior to the distribution to other
shareholders. Determine the number of additional shares the non-tendering
shareholder would have to own in order to own that percentage of the corporation.
Add that number to the non-tendering shareholder’s shares. Divide that total into
the fair market value of the corporation’s outstanding shares after the actual
distribution. The quotient is the non-tendering shareholder’s dividend under § 301.
4. We have already studied redemptions and know that a corporation may intend a
redemption to be an exchange, but fail to execute the redemption in a manner that permits

87 A “de minimis” difference between redemption price and issue price is treated as a difference of zero. Reg. §

1.305-3-5(b)(1) (by cross-reference to § 1273(a)(3); ¼ of 1% multiplied by the number of years).

255

the shareholder to treat her receipt of property as an exchange for her stock. Rev. Rul. 7860 involved periodic distributions, i.e., annual. What should happen to a non-tendering
shareholder if the failed redemption is a one-time event? After all, every redemption of the
shares of less than all shareholder(s) will necessarily increase the proportionate interests
of the other shareholders.
Read Reg. § 1.305-3(e), Example 10. It seems that the non-tendering shareholders are
“safe.” On the other hand, Reg. § 1.305-3(b) provides definitions and rules that make §
305(b)(2) broadly applicable. Reg. § 1.305-3(b)(4) creates a 36-month presumption:
distributions that are not part of a plan separated by 36 months presumptively do not result
in receipt of cash or property by some shareholders and an increase in proportionate
interest by other shareholders.
5. Conversion Ratios: A corporation with convertible stock or convertible securities must,
upon distribution of dividend stock, adjust its conversion ratio. Regs. §§ 1.305-3(d)(1)(i);
1.305-7(b)(1).
•A change in the conversion ratio may be a deemed distribution, but “a change in
the conversion ratio of convertible preferred stock made pursuant to a bona fide,
reasonable, adjustment formula that has the effect of preventing dilution of the
interest of the holders of such stock will not be considered to result in a deemed
distribution of stock.” Rev. Rul. 77-37, 1977-1 C.B. 85, citing Reg. § 1.3057(b)(1).

Problems:
1. Corporation had outstanding 4000 shares of A common and 24,000 shares of B
common, a ratio of 1 A share to 6 B shares. These were the only classes of stock
outstanding. All the voting power was held by the A stock before distribution and remained
in the A stock following the dividend. Under a dividend resolution shares of A and B stock
of the Company were issued pro rata among the stockholders so that for each share of A
stock held, a dividend of ½ share of A was allotted, and for each share of B, ½ share of B.
Appropriate amounts were transferred from the Company’s surplus account to its capital
account. No change was worked in the qualifications and preferences of the two classes of
stock. Do some math. Is this a taxable dividend? See Reg. § 1.305-3(b)(6); Wiegand v
Commissioner, 194 F.2d 479 (3d Cir. 1952).
2. Same facts plus the following: Class A common stock and Class B common stock share
equally in any liquidating distributions. The Corporation pays a cash dividend to holders
of A common and one share of B common for each share of B common. Have the holders
of class B common received a distribution subject to § 301?
3. Same facts: Corporation pays one share of Class B common on each share of Class A
common and one share of Class A common on each share of Class B common. Have the
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holders of class A common and/or class B common received a distribution subject to §
301?
4. Corporation Y is organized with two classes of stock, class A common, and class B,
which is nonconvertible and limited and preferred as to dividends. A dividend is declared
upon the class A stock payable in additional shares of class A stock and a dividend is
declared on the class B stock payable in cash. What is the tax consequence of Corporation
Y’s distribution of one share class A common to each shareholder of class A common?
•Work this problem for yourself. Then check your answer at Reg. § 1.305-3(e),
Example 2.
5. Corporation K is organized with two classes of stock, class A common, and class B,
which is nonconvertible preferred stock. A dividend is declared upon the class A stock
payable in shares of class B stock and a dividend is declared on the class B stock payable
in cash. What are the tax consequences of the distribution of class B shares to the holders
of class A common?
5A. Suppose instead that Corporation K declared a dividend upon the class A stock payable
in a new class of preferred stock that is subordinated in all respects to the class B stock.
What would be the tax consequences on the distribution to the holders of class A common,
each of whom received a share of this new class of preferred stock?
•Work this problem for yourself. Then check your answer at Reg. § 1.305-3(e),
Example 3.
6. Corporation W has one class of stock outstanding, class A common. The corporation
also has outstanding convertible preferred stock, whose rights to dividends are limited and
preferred. The preferred stock is convertible at a fixed conversion ratio that is not subject
to full adjustment in the event stock dividends or rights are distributed to the class A
shareholders. Corporation W distributes to the class A shareholders rights to acquire
additional shares of class A stock. During the year, a cash dividend is paid on the
convertible preferred stock. See § 305(d)(1). What are the tax consequences to the class A
shareholders?
•Work this problem for yourself. Then check your answer at Reg. § 1.305-3(e),
Example 4.
7. For the mathematically-inclined: Corporation O has a stock redemption program under
which, instead of paying out earnings and profits to its shareholders in the form of
dividends, it redeems the stock of its shareholders up to a stated amount which is
determined by the earnings and profits of the corporation. If the stock tendered for
redemption exceeds the stated amount, the corporation redeems the stock on a pro rata
basis up to the stated amount. During the year corporation O offers to distribute $10,000
in redemption of its stock. At the time of the offering, corporation O has 1000 shares
outstanding of which E and F each owns 150 shares and G and H each owns 350 shares.
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The corporation redeems 15 shares from E and 35 shares from G. F and H continue to hold
all of their stock. Assume that the cash E and G receive is taxable under § 301. What are
the tax consequences to F and H? If you find this to be a distribution to which § 301
applies, how would you determine the value of that distribution?
•Work this problem for yourself. Then check your answer at Reg. § 1.305-3(e),
Example 9. You may have to look this Example up by going to Westlaw, Lexis,
Bloomberg Law, or another source.

C. Section 305(b)(3)
A distribution or series of distributions of stock that result in receipt of preferred stock by
some common shareholders and receipt of common stock by other common shareholders
is subject to § 301. Such distributions obviously increase the interest of some shareholders
in the earnings and profits of the corporation and increase the interest of others in the assets
of the corporation. Both groups of recipients are subject to income tax, irrespective of
whether the preferred stock is convertible. Reg. § 1.305-4(a).
A distribution that facially appears not to fall within § 305(b)(3) may in fact fall within §
305(b)(3) if it “can reasonably be expected to result in the receipt of preferred stock by
some common shareholders and the receipt of common stock by other common
shareholders.” Reg. § 1.305-4(b), Example 2.
•Suppose that a corporation has only one class of common stock outstanding and it
distributes newly issued preferred on that common. The preferred stock is
convertible within 6 months at a price slightly higher than the price of common on
the date of distribution. Taking all factors into account, it is reasonable to anticipate
that some shareholders will exercise their conversion rights, and others will not.
The distribution is one to which § 301 applies. Id.

Problem:
Corporation X is organized with two classes of common stock, class A and class B.
Dividends may be paid in stock or in cash on either class of stock without regard to the
medium of payment of dividends on the other class. A dividend is declared on the class A
stock payable in additional shares of class A stock and a dividend is declared on class B
stock payable in newly authorized class C stock which is nonconvertible and limited and
preferred as to dividends. What are the tax consequences of these distributions?
•Work this problem for yourself. Then check your answers at Reg. § 1.305-4(b),
Example 1.

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D. Section 305(b)(4)
Any distribution of stock with respect to preferred stock is one to which § 301 applies. The
only exception to this is an increase in the conversion ratio of convertible preferred stock
to take account of a stock dividend or stock split of the stock into which the preferred stock
is convertible.
An adjustment of the conversion ratio is apparently the only means of protecting preferred
shareholders from dilution resulting from the distribution of common on common.
Protecting the holders of convertible preferred from having their interests in the assets of
the corporation diluted through distribution of a common on common dividend by issuing
a proportionate amount of common on preferred is subject to § 301. Rev. Rul. 83-42, 19831 C.B. 76.
Protecting the cumulative preferred shareholder’s interest in dividends to which she is
entitled may not be accomplished through the distribution of common stock to such a
shareholder. “The holder of cumulative preferred stock which, by its terms, gives the
holder the right to elect to receive common stock of equivalent value to the accrued
dividend account if cash dividends are not paid for two successive quarters, will
constructively receive a distribution of common stock with respect to preferred stock
taxable under § 301 of the Code by reason of § 305(b)(4) upon the passage of two
successive quarters without the payment of cash dividends.” Rev. Rul. 84-141, 1984-2
C.B. 80.

Problem:
Corporation was in arrears in paying dividends on the only class of preferred stock that it
had issued. It declared a cash dividend on each share, payable only in shares of common
stock of the corporation. Shareholder owned only preferred stock. After receipt of the
common stock, shareholder sold all her preferred stock. How would you compute the basis
of the preferred stock for purposes of determining shareholder’s gain on the sale of the
preferred stock? Commissioner v Tillotson Mfg. Co., 76 F.2d 189 (6th Cir. 1935); see
Koshland, supra.

E. Section 305(b)(5)
A distribution of convertible preferred stock is subject to § 301, unless the taxpayer can
establish that such a distribution will not result in the receipt of property by some
shareholders and an increase in the proportionate interests in the corporation’s assets or
earnings and profits by other shareholders.
With any distribution of convertible preferred stock, there is some level of probability that
259

some holders of the preferred
stock will exercise their
conversion rights and others
will not. Such a result would
fall within § 305(b)(3) (some
common shareholders receive
common stock and some
receive preferred stock). If that
probability is sufficiently high,
the distribution falls within §
305(b)(5).
The regulations offer
following guidance:

the

The distribution of
convertible preferred
stock is likely to result
in a disproportionate
distribution when both
of
the
following
conditions exist:
(a) the conversion right
expires
“within
a
relatively short period
of time” after the
distribution, and
(b) taking into account
such factors as dividend
rights,
redemption
provisions,
marketability,
and
conversion price, it may
be anticipated that some
shareholders
will
exercise
their
conversion rights and
others will not.
Reg. § 1.305-6(a)(2). On the
other hand:

Stripped Preferred Stock, § 305(e): Section 305(e)
prescribes the tax treatment of dispositions of socalled “stripped preferred stock.”
•“Stripped stock” is stock whose ownership
interests of the stock itself and the right to
receive dividends that have not become
payable
have
been
separated.
§
305(e)(5)(A). For it to be “stripped stock” the
stock must be limited and preferred as to
dividends, may not participate in corporate
growth to any significant extent, and must
have a fixed redemption price. § 305(e)(5)(B).
Purchaser of Stripped Stock: A taxpayer who
purchases “stripped preferred stock” must treat the
“stripped preferred stock” as a bond and recognize
the difference between the redemption price and the
price paid for such stock as original issue discount. §
305(e)(1). The same is true of anyone who receives
such stock if the basis of the stock is determined by
reference to the basis of the stock in the hands of the
seller, e.g., by gift. § 305(e)(1, 6).
•Treatment of the stock as a bond with original
issue discount has the consequence of requiring
recognition of periodic payments as they
accrue. Section 305(e)(4) provides that the
purchaser must treat any amount included in
“gross income” as “ordinary income.” Because
it is “ordinary income,” an individual taxpayer
may not treat such income as qualified
dividend income under § 1(h)(11) or as interest
income. Such recognition of income will require
periodic (upward) adjustments to the
taxpayer’s basis in the “stripped preferred
stock.” § 305(e)(2).
Seller of Stripped Stock: The person who “strips” the
preferred stock and then sells the “stripped stock,”
must treat the difference between the redemption
price and her adjusted basis in the stock as original
issue discount. § 305(e)(3). Congress intended no
inference concerning the allocation of basis by the
creator of stripped stock, (See H.R. REPT. NO. 103-213,
at 578 (1993)) but logically the seller should allocate
basis between the interests into which the stock has
been divided according to their relative fair market
values.
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[W]here the conversion right may be exercised over a period of many years and
the dividend rate is consistent with market conditions at the time of distribution of
the stock, there is no basis for predicting at what time and the extent to which the
stock will be converted and it is unlikely that a disproportionate distribution will
result.
Id.
The regulations offer two contrasting examples. In one example, the conversion right
expires after 20 years. In the other example, the conversion right expires after four months
and there is a willing buyer of the preferred stock. In the first example, it was “impossible
to predict the extent to which the” preferred stock will be converted into common stock.
In the second example, it was anticipated that the holders of the preferred stock would
either sell to the willing buyer or convert. The second case falls within § 305(b)(5), and
the first does not. This is not very useful guidance. Perhaps it does not need to be precise
because §§ 305(b)(3 and 5) essentially cover the same ground. Compare Reg. § 1.3054(b), Example (2) (applying § 305(b)(3); six-month deadline for conversion; facts fall
within § 305(b)(3)) and Reg. § 1.3056(b), Example 2 (applying § 305(b)(5); four-month
deadline for conversion; facts fall within § 305(b)(5)).

F. Section§ 305(c): Deemed Stock Distributions
There are transactions that do not involve the distribution of any stock yet produce results
that one of more of § 305(b)’s subsections describe, i.e., an increase in a shareholder’s
proportionate interest in the corporation’s assets or earnings and profits. Section 305(c)
deems such transactions to be distributions to which § 301 applies. Section 305(c) provides
in part:
For purposes of this section and § 301, the Secretary shall prescribe regulations
under which a change in conversion ratio, a change in redemption price, a
difference between redemption price and issue price, a redemption which is treated
as a distribution to which § 301 applies, or any transaction (including a
recapitalization) having a similar effect on the interest of any shareholders shall be
treated as a distribution with respect to any shareholder whose proportionate
interest in the earnings and profits or assets of the corporation is increased by such
change, difference, redemption or similar transaction.
Section 305(c) names events or situations that may increase the proportionate interest of a
shareholder in the corporation’s earnings and profits or assets. If such an increase in
proportionate interest results, the event or situation is deemed to be (i.e., “shall be treated
as”) a distribution. The distribution would be subject to the rules of § 305(b).
261

The statute also requires that regulations governing redemption premiums treat them as a
distribution if the premium is not “reasonable.” “Reasonable” is defined as “less than” ¼
of 1% multiplied by the number of years until redemption. Section 305(c)(1), crossreferencing § 1273(a). The regulations require that premiums be accounted for under the
original issue discount (OID) principles of § 1272(a). § 305(c)(3). The threshold of a
redemption premium that is not “reasonable” is also the threshold of a de minimis
exception to application of the principles of § 305(b). The following examples illustrate
some of these points:
Reg. § 1.305-3(e), Example 6. (i) Corporation M is organized with two classes of
stock outstanding, class A and class B. Each class B share may be converted, at the
option of the holder, into class A shares. During the first year, the conversion ratio
is one share of class A stock for each share of class B stock. At the beginning of
each subsequent year, the conversion ratio is increased by 0.05 share of class A
stock for each share of class B stock. Thus, during the second year, the conversion
ratio would be 1.05 shares of class A stock for each share of class B stock, during
the third year, the ratio would be 1.10 shares, etc.
(ii) M pays an annual cash dividend on the class A stock. At the beginning of the
second year, when the conversion ratio is increased to 1.05 shares of class A stock
for each share of class B stock, a distribution of 0.05 shares of class A stock is
deemed made under section 305(c) with respect to each share of class B stock, since
the proportionate interests of the class B shareholders in the assets or earnings and
profits of M are increased and the transaction has the effect described in section
305(b)(2). Accordingly, sections 305(b)(2) and 301 apply to the transaction.
Reg. § 1.305-3(e), Example 15. (i) Facts. Corporation V is organized with two
classes of stock, class A common and class B convertible preferred. The class B
stock is issued for $100 per share and is convertible at the holder's option into class
A at a fixed ratio that is not subject to full adjustment in the event stock dividends
or rights are distributed to the class A shareholders. The class B stock pays no
dividends but it is mandatorily redeemable in 10 years for $200. Under sections
305(c) and 305(b)(4), the entire redemption premium (i.e., the excess of the
redemption price over the issue price) is deemed to be a distribution of preferred
stock on preferred stock which is taxable as a distribution of property under section
301. This amount is considered to be distributed over the 10–year period under
principles similar to the principles of section 1272(a). During the year, the
corporation declares a dividend on the class A stock payable in additional shares of
class A stock.
(ii) Analysis. The distribution on the class A stock is a distribution to which sections
305(b)(2) and 301 apply since it increases the proportionate interests of the class A
262

shareholders in the assets and earnings and profits of the corporation and the class
B shareholders have received property (i.e., the constructive distribution described
above). If, however, the conversion ratio of the class B stock were subject to full
adjustment to reflect the distribution of stock to class A shareholders, the
distribution of stock dividends on the class A stock would not increase the
proportionate interest of the class A shareholders in the assets and earnings and
profits of the corporation and such distribution would not be a distribution to which
section 301 applies.

Do the CALI exercise:
Corporate Taxation: Distributions: Distributions of Interests by C Corporations.

III. Section 307: Basis in Dividend Stock
A basic principle – not universally applicable – is that all income (i.e., accessions to
wealth) is subject to income tax in the hands of a taxpayer once – and only once. We assure
that we do not tax income more than once by assigning “basis” to any item on which
taxpayer spends her already-taxed income. “Basis” is money not to be subject to income
tax (again).
Right to Acquire Stock: Section
When a stock dividend is not included in gross 305(d)(1) provides that the term
income, the dividend stock presumptively does “stock” includes rights to acquire
not increase or decrease the value of the such stock. Thus, the basis of such
corporation. Hence, if non-taxed dividend stock rights should be included in the
has value, it must have taken that value dollar-for- determination of the relative fair
dollar from the stock with respect to which the market values of stock. This rule
stock was distributed. The sum of the fair market only applies if the stock rights are
value of the dividend stock and the fair market exercised or sold. Reg. § 1.307value of the stock with respect to which the 1(a) (last sentence). The holding
dividend stock was distributed must equal the fair period of stock acquired through
the exercise of rights to acquire it
market value of the stock with respect to which
begins on the date taxpayer
the dividend stock was distributed immediately
exercises that right. § 1223(5).
prior to the distribution. The distribution itself
Moreover, if the fair market value
cannot create basis. Since we are not taxing the of such rights is less than 15% of the
receipt of stock, we must allocate existing basis fair market value of the old stock,
among the “old” stock and the “new” stock. We the fair market value of such rights
allocate existing basis among old and new stock does not have to be included in such
according to the relative fair market value of each. a determination, § 307(b)(1), unless
See Chapman v. United States, 63 Ct. Cl. 106, the taxpayer elects otherwise, §
111, cert. denied, 275 U.S. 524 (1927) (basis of 307(b)(2).
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original 1800 shares was $48/share; after non-taxable stock dividend of 3600 shares, basis
was $16/share). Early on, the Commissioner applied this method of allocating basis with
approval of courts. See, e.g., Appeal of S. Thomas Fuller, 4 B.T.A. 992, 993, 1926 WL
559 (1926). The Commissioner tried to apply this principle in Koshland, supra. Now it is
the rule of § 307(a). The holding period of the “old” stock is tacked to the holding period
of the “new” stock. § 1223(4).
Of course, if a stock dividend is subject to income tax, taxpayer pays income tax on the
fair market value of the stock received – and acquires a tax basis in that stock equal to the
value on which taxpayer paid income tax. Reg. § 1.301-1(h)(1 and 2(i)); cf. Koshland.,
supra. There is no tacking of the holding period of the “old” stock. Cf. § 1223(4) (basis
not determined under § 307).

Problems:
1. LaTonya owns 500 shares of Class A voting common of Pelham Corporation. Pelham
Corporation has 100,000 shares of Class A voting common outstanding, and this is its only
class of stock outstanding. LaTonya’s basis in her 500 shares is $10,000. Its fair market
value is $15,000. In a nontaxable distribution, Pelham distributes one share of newly
issued Class A common shares for each share of Class A common shares that a shareholder
owns. LaTonya received 500 shares in this distribution.
•What is the basis of each of her shares of Class A voting stock?
2. Same facts, except that Pelham Corporation distributed a non-taxable stock dividend
of one share of newly issued Class B non-voting common for each share of Class A
common share that a shareholder owns. LaTonya received 500 shares of Class B nonvoting
common in Pelham Corporation. The total value of LaTonya’s 500 shares of Class B nonvoting common is $6000.
•What is the basis of each of her shares of Class A stock and of each of her shares
of Class B stock?
3. A taxpayer in 1947 purchased 100 shares of common stock at $100 per share and in
1954, by reason of the ownership of such stock acquired 100 rights entitling her to
subscribe to 100 additional shares of such stock at $90 a share. Immediately after the
issuance of the rights, each of the shares of stock in respect of which the rights were
acquired had a fair market value, ex-rights, of $110 and the rights had a fair market value
of $19 each.
•What is the basis of the rights to acquire more stock and of the common stock?
•Suppose taxpayer exercises her right to acquire 100 more shares of stock for
$90/share. What is her basis in each share of stock that she purchases? What is her
basis in each of her shares of “old” stock, i.e., the stock with respect to which the
subscription rights were distributed?
264

•Work this problem. Then check your answer at Reg. § 1.307-1(b), Example.

IV. Section 306 Stock
Ownership of stock gives a shareholder certain interests in the corporation, e.g., right to
vote, right to share in dividends, right to share in proceeds upon liquidation. A corporation
might split a shareholder’s interest into its constituent parts by issuing different classes of
shares. For example, a corporation might exchange one share of class B voting common
stock, one share of class C non-voting common stock, and one share of class D non-voting
preferred for each share of class A common stock – its only class of stock outstanding.
Such a splintering of a shareholder’s interest would not change the shareholder’s total
interest in the corporation – either by value or by control. It also would not alter the assets
or earnings and profits of the corporation. If the corporation’s distribution of such stock to
its shareholders altered the total interests of none of them, the distributions should not be
subject to income tax. Indeed, the United States Supreme Court held that a corporation’s
distribution of “preferred on common” to its only shareholder of its only class of stock did
not constitute the distribution of a taxable dividend. Helvering v. Sprouse, 318 U.S. 604,
607 (1943) (“the distribution brought about no change whatever in his interest in the
corporation. Both before and after the event, he owned exactly the same interest in the net
value of the corporation as before.”).
•BUT: The splitting of common stock into common stock plus preferred stock
gives shareholders something they can sell at a capital gain (i.e., preferred stock)
without giving up any control rights. Shareholders of a corporation that has
substantial accumulated earnings and profits can essentially “bail out” those
earnings and profits at capital gain rates by selling the preferred stock. If the
purchaser of the preferred stock happened to be a corporation, the issuing
corporation could distribute dividends to it that would be subject to very little
income tax. Cf. § 243(a) (dividends-received deduction).
In Chamberlin v. Commissioner, 207 F.2d 462 (6th Cir. 1953), cert. denied, 347 U.S. 918
(1954), taxpayers owned stock in a closely-held corporation with substantial earnings and
profits and executed such a “preferred stock” bail out. The corporation distributed a
preferred on common stock dividend. The Commissioner argued facts-and-circumstances
to claim that the proceeds of the subsequent sale of the shares of preferred stock were
dividends taxable as ordinary income. This argument prevailed in Tax Court, but the
United States Court of Appeals for the Sixth Circuit reversed. The issuance of the preferred
stock dividend was legal, and whether it furthered a corporate purpose was irrelevant. Id.
at 469. A purpose to avoid income tax did not change a nontaxable legal stock dividend
into a taxable one. Id. The sale of dividend stock by the recipient does not transform the
stock dividend from nontaxable to taxable. Id.
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Congressional reaction to Chamberlin was swift. Its response was to enact § 306. There is
now something called “section 306 stock.” A corporation distributes “section 306 stock”
by distributing stock at a time when it could have distributed cash instead. Indeed, if a
corporation could not have paid a cash dividend at the time of distributing stock because
it has no earnings and profits at the time of its distribution, the stock it distributes is not
“section 306 stock.” § 306(c)(3). The tax consequences associated with the distribution of
such stock are determined only upon disposition of the “section 306 stock,” not upon its
distribution. The distribution of “section 306 stock” is a nontaxable event. The tax
consequences turn on how the shareholder disposes of the “section 306 stock.”

A. Dispositions of Section 306 Stock: Tax Consequences
“Dispositions other than redemptions”: A “disposition other than a redemption” must
necessarily be a disposition to a third party, e.g., disposition by sale or exchange. The
consideration for the disposition therefore does not come from the corporation. Section
306(a)(1)(A) treats the amount realized as ordinary income to the extent the stock
distribution would have been a dividend if the corporation had distributed money equal to
the fair market value of the stock at the time of distribution. The amount of this
hypothetical dividend is limited to the shareholder’s ratable share of the corporation’s
earnings and profits on the date of distribution. Section 306(a)(1)(A) does not call the
taxable income “dividend income,” but rather “ordinary income.” Section 306(a)(1)(D)
provides that individuals may treat such “ordinary income” as a “dividend” for purposes
of applying § 1(h)(11). A corporation may not avail itself of the dividends-received
deduction of § 243.
•While the amount that would have been a dividend to an individual is taxed as if
it were a qualified dividend under § 1(h)(11), it is not actually a dividend. The
corporation’s earnings and profits do not decrease as the result of a disposition of
§ 306 stock other than by redemption. Reg. § 1.312-1(e).
•The “amount realized” is treated as gain – to the extent that it exceeds the amount
treated as a dividend plus the adjusted basis of the stock. § 306(a)(1)(B).
•The shareholder may not claim a loss on such a sale, § 306(a)(1)(C), but excess
basis is added to the basis of the common stock with respect to which the stock
dividend was distributed. Reg. § 1.306-1(b)(2), Example 2. This is true even if
taxpayer sold only a portion of her “section 306 stock” and retained some to which
the excess basis might have been assigned. Reg. § 1.306-1(b)(2), Example 3.
•The examples cited provide that excess basis is assigned to the common stock
“with respect to which the preferred stock was distributed.” The seller of the § 306
stock might not own the common stock at the time of sale. Nevertheless, the
generalized language of the examples leads to the conclusion that the basis is
assigned to the stock, no matter who owns it.

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Dispositions by redemption: A disposition of “section 306 stock” by redemption is treated
as a distribution of property to which § 301 applies. § 306(a)(2). The extent to which the
distribution is a dividend (or a return of capital or capital gain) depends on the earnings
and profits of the corporation on the date of the redemption. Essentially, a disposition by
redemption is treated as if the preferred stock had never been issued and the corporation
made a distribution on the date of the redemption – except no provision is made for the
application of § 302. Thus, the distribution is a dividend to the full extent of the
corporation’s earnings and profits without being subject to the limitation of § 312(n)(7)
(ratable share of earnings and profits in redemptions governed by § 302(a) or § 303). Only
to the extent the distribution is included in the shareholder’s taxable income is there a
reduction in the corporation’s earnings and profits. Reg. § 1.312-1(d). The dividendsreceived deduction would be available to a corporate shareholder.

B. Definition of Section 306 Stock
In enacting § 306, Congress addressed a particular abuse, i.e., using a nontaxable
distribution of preferred stock to bail out corporate earnings at capital gain rates without
shareholder surrender of ownership or control rights in the corporation. If the receipt of
stock facilitates such bailing out, it should be considered section 306 stock. If the receipt
of stock does not facilitate such a bailing out, we expect it not to be section 306 stock – or
at least the stock should be subject to an exception to the applicability of § 306.
Section 306(c) does not leave matters to the participants to characterize stock as
“preferred.” A key concept in § 306(c) is “stock other than common stock.” The following
revenue rulings give an idea of the considerations that control.

Rev. Rul. 75-236, 1975-1 C.B. 106
X corporation had outstanding 1,000 shares of common stock all of which were held by
five related individuals. X issued two new classes of stock, class A and class B, and
distributed both classes pro rata to each individual shareholder in exchange for his X
common stock in a transaction that qualified as a [nontaxable reorganization]. No gain or
loss was recognized to the X shareholders upon the exchange of their common stock solely
for class A and class B stock … X had earnings and profits at the time of the exchange.
The class A stock has a par value of $10 per share, is nonredeemable, is voting stock, is
entitled to noncumulative preferred dividends of five percent of par value prior to the
payment of any dividends on the class B stock and is entitled to share equally with the
class B stock upon liquidation in proportion to but not in excess of its par value. The class
B stock has a par value of $10 per share, is nonredeemable, is nonvoting, has unlimited
rights to dividends, subject to the prior rights of the class A stock, and on liquidation is
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entitled to all of the assets remaining after the required distributions to the holders of the
class A stock. Neither class of stock has a fixed or determinable redemption price.
The transaction was undertaken in order to make growth stock (class B) available to key
employees of the corporation and, at the same time, restrict managerial control of the
corporation to the present shareholders through their ownership of class A stock. By
restricting the growth of the class A stock, upon the death or retirement of any of the
present shareholders, the remaining shareholders will be able to purchase the class A stock
for a sum within their means and control of the company will, therefore, not fall into the
hands of inexperienced persons. At the same time the heirs of the deceased shareholders
will share in the growth of the company through their ownership of the class B stock.
Section 306(c) of the Code defines “section 306 stock,” in part, as stock which is not
common stock and which was received in a reorganization within the meaning of § 368(a)
where no gain or loss was recognized upon its receipt, but only to the extent that the effect
of the transaction was substantially the same as the receipt of a stock dividend. Reg. §
1.306-3(d) provides, in part, that ordinarily “section 306 stock” includes stock which is
not common stock received in pursuance of a plan of reorganization if cash received in
lieu of such stock would have been treated as a dividend under § 356(a)(2) or as a
distribution to which § 301 applies by reason of § 356(b) or § 302(d).
Section 306(a) of the Code provides generally that if a shareholder sells or otherwise
disposes of “section 306 stock” and (1) if the disposition is a redemption, the amount
realized shall be treated as a distribution of property to which § 301 applies, or (2) if the
disposition is not a redemption, the amount realized shall be treated as gain from the sale
of property which is not a capital asset and no loss shall be recognized.
In the instant case, the class A stock distributed in the reorganization is limited and
preferred as to dividends, has limited rights upon liquidation, does not participate in
corporate growth to any significant extent and was distributed pro rata to the shareholders
of X. Therefore, even though the class A stock is the only voting stock of X outstanding,
it is stock other than common stock. See Reg. § 1.305-5(a). Had cash been distributed in
lieu of the class A stock in the recapitalization, this distribution would have been treated
as a dividend under § 356(a)(2) of the Code. Therefore, the distribution of the class A stock
has substantially the same effect as the receipt of a dividend on the class B stock.
Accordingly, the class A stock issued in the instant case is “section 306 stock” within the
meaning of section 306(c) of the Code.

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Questions and comments:
1. Class A shareholders had voting control of the corporation, yet their stock was “section
306 stock.” What are the determinative points that made class A shares “section 306
stock?”
2. In Rev. Rul. 81-91, 1981-1 C.B. 123, the IRS considered these facts:
A corporation had outstanding a single class of common stock held by 10
individuals, each of whom owned 20 shares. ... [T]he corporation entered into a
plan of [nontaxable] recapitalization under which each outstanding share of
common stock was surrendered to the corporation in exchange for one share of
new class A stock plus one share of new class B stock of the corporation.
Each share of the class A and class B stock had a par value of 10x dollars. The
class B shares were entitled to an annual cumulative dividend of 6 percent of par
value payable before any dividend was payable on the class A shares, and a prior
right to repayment up to par value in the event of liquidation. After the satisfaction
of the class B stock’s preferences, each share of class A and class B stock shared
equally as to dividends and on liquidation. Each class of shares carried equal voting
rights and neither class was by its terms redeemable.
The IRS determined that the class B stock would not be section 306 stock because it
enjoys voting rights on an equal basis with the class A stock, the only other class
of stock outstanding. After satisfaction of its preference as to dividends and as to
assets in the event of liquidation, the class B stock shares equally with the class A
stock. These rights in the class B stock to participate in corporate growth are
significant. Thus, a sale of the class B stock cannot occur without a loss of voting
control and interest in the unrestricted growth of the corporation. Therefore, the
bailout abuse that Congress sought to prevent by the enactment of section 306
cannot be effected through a sale of the class B stock.
The IRS offered the following as determinative considerations:
The potential for a preferred stock bailout exists if the shareholders receive a pro
rata distribution of two classes of stock in a recapitalization when the corporation
has earnings and profits, and the stock of one class, because of its terms, can be
disposed of without a surrender by the shareholders of significant interests in
corporate growth. Thus, stock is “other than common stock” for purposes of § 306
not because of its preferred position as such, but because the preferred position is
limited and the stock does not participate in corporate growth to any significant
extent.
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3. Common stock that can be converted into stock other than common stock is not
common stock. § 306(e)(2).

Rev. Rul. 81-186, 1981-2 C.B. 85
ISSUE
Is preferred stock received by the sole shareholder of a company in exchange for a portion
of such shareholder’s common stock “section 306 stock” within the meaning of § 306(c)
of the ... Code, when, as part of an integrated plan, the shareholder thereafter disposes of
the remaining common stock by gift?
FACTS
A domestic corporation, X, had outstanding solely 100 shares of common stock, all of
which stock had been owned by A for many years. The officers of X were B, C, and D,
who were, respectively, president and board chairperson, secretary, and treasurer.
Operations of X were managed mainly by B and C. In addition, A, B, and C were friends
of long standing, although B and C were in no way related to A. D was married to A’s
brother. A had no spouse or children. At the time of the transaction, A desired to be
completely removed from all active business interests and to give the growth potential of
X to B, C, and D. Accordingly, pursuant to an integrated plan, the following three steps
were taken. First, X was authorized to issue new shares of nine percent cumulative,
nonconvertible, nonvoting preferred stock. Second, A surrendered to X 97 shares of X
common stock in exchange for X preferred stock of an equal fair market value. Third,
immediately thereafter A gave the three remaining shares of X common stock, one share
each, to B, C, and D. The transfers of these three shares were subject to the gift tax
provisions of ... the Code. The transfers did not result in any increase in the amount
includible in the income of B, C, or D, since the transfers were motivated solely by A’s
donative intent and were not in consideration of either past or future services.
The total of X’s accumulated and current earnings and profits (within the meaning of §
316(a)(1) and (2) of the Code) applicable to a distribution made at the time A received the
X preferred stock exceeded the fair market value of this preferred stock. None of the 100
shares of X common stock held by A was “section 306 stock” within the meaning of §
306(c) of the Code. A had no plan or intent to sell or otherwise dispose of any of the X
preferred stock received. Nor was there any plan or intent for A (or for any person related
to A within the meaning of § 318 of the Code) to receive any X common stock.
LAW AND ANALYSIS

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Section 368(a)(1)(E) of the Code defines the term “reorganization” to include a
recapitalization. Reg. § 1.368-2(e)(3) states that a recapitalization takes place if a
corporation issues preferred stock for outstanding common stock.
Under § 354 of the Code, a shareholder exchanging stock for stock in a recapitalization
will not recognize gain or loss on the transaction.
Section 306(c)(1)(B) of the Code, in part, defines “section 306 stock” as stock received in
a reorganization that is not common stock and with respect to the receipt of which gain or
loss to the shareholder was to any extent not recognized by reason of part III of subchapter
C of chapter 1, but only to the extent that the effect of the transaction was substantially the
same as the receipt of a stock dividend.
Under Reg. § 1.306-3(d), ordinarily, section 306 stock includes stock, which is not
common stock, received in pursuance of a plan of reorganization (within the meaning of
§ 368(a) of the Code) if cash received in lieu of such stock would have been treated as a
distribution to which § 301 applies by reason of § 302(d).
Under § 302(d) of the Code, if a corporation redeems its stock and if § 302(a) does not
apply, such redemption shall be treated as a distribution of property to which § 301 applies.
Section 302(a) provides that if a corporation redeems its stock and if § 302(b)(1), (2), (3),
or (4) applies, such redemption shall be treated as a distribution in part or full payment in
exchange for the stock. Section 302(b)(3) provides that § 302(a) shall apply if the
redemption is in complete redemption of all of the stock of the corporation owned by the
shareholder.
In the present situation, A’s receipt of X preferred stock in exchange for X common stock
constituted a recapitalization and a reorganization within the meaning of § 368(a)(1)(E) of
the Code. No gain or loss was recognized to A in accord with § 354. Thus, under Reg. §
1.306-3(d), the preferred stock received by A will be section 306 stock if cash received in
lieu of such stock would have been treated as a distribution to which § 301 of the Code
applied by reason of § 302(d).
For purposes of this cash-in-lieu test, it is proper to apply the rationale of Zenz v. Quinlivan,
213 F.2d 914 (6th Cir. 1954). Under the Zenz rationale, there is a complete termination of
shareholder interest for purposes of § 302(b)(3) of the Code when a shareholder disposes
of his or her entire stock interest in a company partly through redemption and partly
through a sale or gift pursuant to an integrated plan. Rev. Rul. 79-273, 1979-2 C.B. 125;
Rev. Rul. 77-226, 1977-2 C.B. 90; Rev. Rul. 55-745, 1955-2 C.B. 23. See also, Estate of
Lukens v. Commissioner, 246 F.2d 403 (3rd Cir. 1957); and Rev. Rul. 77-293, 1977-2 C.B.
91. Moreover, the sequence of events (whether the redemption comes before or after the
sale or gift) is irrelevant for section 302(b)(3) purposes, as long as both events are part of
an integrated plan. Rev. Rul. 77-226. See Rev. Rul. 75-447, 1975-2 C.B. 113.
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In applying the cash-in-lieu test and the Zenz rationale, X’s hypothetical redemption for
cash of 97 shares of A’s X stock, together with A’s disposition of the remaining three
shares of A’s X stock by gift, would result in a complete termination of A’s stock interest
in X within the meaning of § 302(b)(3) of the Code. Thus, the cash received by A would
be treated in accord with § 302(a) as a distribution by X in exchange for its stock, and not
as a distribution of property to which § 301 applies by reason of § 302(d). Accordingly,
the receipt of the preferred stock is not substantially the same as the receipt of a stock
dividend within the meaning of § 306(c)(1)(B) of the Code.
HOLDING
The X preferred stock received by A in exchange for a portion of the X common stock
owned by A is not “section 306 stock” within the meaning of § 306(c) of the Code, when,
as part of an integrated plan, A thereafter disposed of A’s remaining common stock by
gift.

Questions and comments:
1. Is a bailout of earnings and profits possible in the facts of this revenue ruling?
2. The section 306 “taint” is not lost simply by disposing of the stock other than by
redemption, sale, or exchange. If the basis of any stock is determined by reference to the
basis of the section 306 stock, i.e., carryover or substituted basis, it is (or remains) section
306 stock. Thus, the recipient of a gift of section 306 stock owns section 306 stock.
Similarly, the common stock that the owner of section 306 stock receives in a tax-deferred
exchange is section 306 stock. § 306(c)(1)(C). See Reg. § 1.306-3(e) (“common stock can
be section 306 stock”).
•Notice that the basis of inherited section 306 stock is determined by the stock’s
fair market value at the time of death, § 1014, not by reference to its basis in anyone
else’s hands. Thus, death beats the section 306 taint. See Reg. § 1.306-3(e) (last
sentence).
•And of course, the purchaser of section 306 stock takes a cost basis, § 1012, and
so the purchase cuts off the section 306 taint.
3. In a transaction to which § 351 applies, the section 306 taint attaches to any stock that
is not common stock that would have been a dividend if cash had been received instead of
such stock. § 306(c)(3). In Rev. Rul. 79-274, 1979-2 C.B. 31, the IRS considered the
following set of facts: “Corporation X had outstanding 3000x shares of common stock
which were owned 1500x each by individuals A and B. Corporation X is engaged in an
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ongoing business. For good business purposes A and B organized corporation Z and
transferred all the stock of X to it. In exchange therefor A and B each received 500x shares
of Z voting preferred stock and 1,000x shares of Z voting common stock.” The IRS
determined that the Z voting preferred stock was section 306 stock.
In the Tax Equity and Fiscal Responsibility Act of 1982,88 Congress added § 306(c)(3) to
the Code to reach the same result, and to apply rules “similar to” those of § 304(b)(2) in
determining whether the distribution of cash would have been a dividend. That provision
makes available the earnings and profits of both X corporation and Z corporation to
determine whether the payment of cash would have been a dividend. Moreover, the more
expansive attribution rules of § 304(c)(3)(B) apply. § 306(c)(4).

C. Exceptions
Section 306 by its terms contains certain exceptions to its treatment of dispositions of
section 306 stock. Such statutory exceptions identify occasions where there is no risk of a
bailing out of a corporation’s earnings and profits as capital gains. These exceptions come
in two forms: (1) § 306(b) identifies transactions where § 306(a) does not apply; however,
the stock involved in such transactions may remain § 306 stock; (2) §§ 306(c)(2) and
306(e)(1) identify stock that is not section 306 stock.
No bailout risk: Section 306(a) does not apply to a disposition that terminates the
shareholder’s entire interest – including an interest owned by attribution under § 318(a) –
in the corporation. § 306(b)(1). Section 306(a) does not apply to a redemption in complete
liquidation of the corporation. § 306(b)(2). Section 306(a) does not apply to situations
where gain or loss is not recognized on the disposition of the section 306 stock. §
306(b)(3). When taxpayer establishes to the satisfaction of the Secretary of the Treasury
that tax avoidance was not a “principal” purpose of the distribution, disposition, or
redemption of section 306 stock, whether or not simultaneously with the disposition or
redemption of the common stock with respect to which the section 306 stock was
distributed, § 306(a) does not apply. § 306(b)(4).
•A shareholder’s disposition of some but not all her common stock does not
necessarily establish that tax avoidance was a “principal” purpose of the issuance
and disposition. See Rev. Rul. 75-274, 1975-1 C.B. 104.
Stock that is not section 306 stock: If a corporation has no earnings and profits and
distributes stock other than common stock, it is not section 306 stock. § 306(c)(2). Section
306 is aimed at bailing out actual earnings and profits. There can hardly be a bailout of
earnings and profits if there are no earnings and profits to bail out. Reg. § 1.306-3(a).

88 P.L. 97-248, § 226(b).

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•If a shareholder exchanges section 306 stock distributed with respect to common
stock of a corporation for common stock in the same corporation, the common
stock so received is not section 306 stock. § 306(e)(1). In such a case, it seems that
the shareholder has surrendered the possibility of a bailout.

Problems:
1. The Sole City Corporation’s business is manufacturing shoes. It has eight shareholders
(A, B, C, D, E, F, G, and H), each owning 100 shares of the corporation’s class A common
stock. Each has a basis of $200/share in her stock (total basis of each = $20,000). This is
the only outstanding Sole City stock. The corporation was very profitable, and by year 6
its value had grown to $1M. At that time its earnings and profits was $800,000. In year 6,
the corporation issued one share of nonvoting, 6% nonconvertible preferred stock on each
share of common. The preferred stock had a liquidation preference and a fair market value
of $400/share.
A. Is the preferred stock section 306 stock? If so, is receipt of it by the eight shareholders
subject to income tax?
B. What would be the fair market value of each share of common stock just prior to the
distribution of the preferred stock dividend? What would be the fair market value of each
share of common stock immediately after the distribution of the preferred stock? What
would be the basis of each share of common stock and each share of preferred stock
immediately after the distribution?
2. Same as #1. By year 10, Sole City’s earnings and profits had grown to $1M. The value
of the corporation had grown to $1.6M. The value of each share of common stock was
$1200/share. The value of each share of preferred stock was $800/share. In year 10 –
A. Shareholder A caused Sole City Corporation to redeem all her preferred stock for
$80,000. What are the tax consequences to shareholder A and to Sole City Corporation?
B. Shareholder B sold all her Sole City Corporation preferred to I, an unrelated investor
for $80,000. What are the tax consequences to shareholder B and to Sole City Corporation?
Does I now own section 306 stock? What is I’s basis in her Sole City Corporation preferred
stock?
C. Shareholder C died and left all her stock to her son J. What are the income tax
consequences to C’s estate? What is J’s basis in his common and preferred stock?
D. Shareholder D, together with other investors, formed the Broken Heel Corporation in
a § 351 transaction. Broken Heel has no earnings and profits. Shareholder D transferred
all her preferred stock to the Broken Heel Corporation in exchange for 200 shares of
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Broken Heel Corporation common stock. What is D’s basis in the Broken Heel common
stock? Is it section 306 stock? Suppose that D received nonqualified preferred stock of
Broken Heel Corporation rather than common stock. What are the tax consequences to D?
What is D’s basis in the Broken Heel Corporation preferred stock?
E. Shareholder E gifted all his preferred to stock to his favorite charity – the National
Organization for the Preservation of High Corporate Tax Rates (assume that there’s a
charitable purpose there somewhere). May E claim a charitable contribution deduction?
For how much? See Rev. Rul. 57-328, 1957-2 C.B. 229.
•The charity, assuming it’s a § 501(c)(3) organization, will pay no income tax upon
sale of the stock.
3. Sole City Corporation was caught importing shoes from Mexico and the nation’s
president slapped a 35% tariff on those shoes. Sole City’s sales have slumped badly. In
year 12, the value of the corporation dipped to $800,000. The value of each share of its
common stock is $600/share, and the value of each share of its preferred stock is
$400/share. The corporation’s earnings and profits in year 12 are $200,000. In year 12 –
A. Shareholder F caused Sole City Corporation to redeem all her preferred stock for
$40,000. What are the tax consequences to F and to Sole City Corporation?
B. Shareholder G caused Sole City Corporation to redeem all her common and preferred
stock for $100,000. What are the tax consequences to G and to Sole City Corporation?
C. H gifted all her preferred stock to her son K in year 10. K sold the preferred stock to L
in year 12 for $40,000. What are the tax consequences to K, L, and Sole City Corporation?
•Suppose K had sold the preferred stock to L for $5000. What are the tax
consequences to H, K, L, and Sole City Corporation?

For review:
Do the CALI exercise:
Corporate Taxation: Distributions: Defining Section 306 Stock.

Do the CALI exercise:
Corporate Taxation: Distributions: Section 306 Exceptions.

Do the CALI exercise:
Corporate Taxation: Consequences on the Disposition of Section 306 Stock.
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Chapter 6: Liquidations

I. Introduction
Read § 346(a). Skim § 336, 331, 337, 332, 334.
Section 346(a) provides that “a distribution shall be treated as in complete liquidation of a
corporation if the distribution is one of series of distributions in redemption of all of the
stock of the corporation pursuant to a plan.” Read § 346(a) carefully, and you realize that
it does not actually provide a definition of “complete liquidation” – but rather an example
of a complete liquidation, i.e., distribution in redemption of all of a corporation’s stock
pursuant to a plan. Nevertheless, § 346(a) is helpful in that it provides the critical elements
of a liquidation, i.e., a distribution from the corporation to shareholders in redemption of
all their stock, a plan.
What is important is that the corporation distributes all its assets in exchange for all its
stock. The corporation pays for its stock with money or with appreciated or depreciated
assets, and we may choose to recognize gain/loss or defer recognition of gain/loss. The
shareholders in turn exchange appreciated or depreciated stock for money or assets, and
we may choose to recognize gain/loss or defer recognition of gain/loss. The shareholders
wind up with all the corporation’s assets and none of its stock. The corporation winds up
with all its stock and none of its assets.
Liquidation may be the natural result of a business failure and a precursor to a complete
dissolution. It may also be one of a series of transactions undertaken to achieve a certain
result.
•For example: an asset purchase followed by a liquidation is one means of
accomplishing a business acquisition.
•Or: an acquiring corporation purchases the assets of a target corporation so that
shareholders of the target corporation own shares in a corporation that owns only
the consideration given for the assets. The target corporation then liquidates. In this
manner, the acquiring corporation has taken over the business and assets of the
liquidating corporation without purchasing the stock of the liquidating corporation.
The acquiring corporation has not assumed the liabilities of the target corporation,
and the shareholders of the target corporation do not retain any ongoing interest in
the corporation. A liquidation was critical to accomplishing this acquisition.
•Or: a liquidation may facilitate an adjustment within a group of commonly owned
corporations. For example, the subsidiary of a parent may transfer all its assets to
its parent and then liquidate.

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Transactions such as these demonstrate that a variety of purposes may be served with the
liquidation of a corporation. We begin here with an examination of the statutory
framework governing the tax consequences of liquidations.
Tax treatment of liquidating distribution: The Code provides two quite different tax
treatments of liquidations, both of the liquidating corporation and of the shareholders who
receive the corporation’s assets in exchange for their stock. The appropriate tax treatment
turns on whether the liquidating corporation is held as a subsidiary by another corporation.
A subsidiary is a corporation that is at least 80% owned, by vote and value, by another
corporation. § 332(b)(1), cross-referencing § 1504(a)(2).
Begin with § 336(a). Section 336(a) is a residual or default provision, i.e., it applies when
no other provision in § 336 or § 337 is applicable. That is the effect of the language
“[e]xcept as otherwise provided in … section 337[.]”
•Section 336(a) provides that a liquidating corporation recognizes gain or loss upon
its complete liquidation and distribution of its property.
•Section 331(a) provides that a shareholder treats amounts received in a distribution
in complete liquidation of a corporation as payment for his stock.
•Section 332(a) provides that a corporation that receives a distribution of property
in complete liquidation of another corporation in which it has an 80% ownership
interest by vote and value recognizes no gain or loss.
•Section 337(a) provides that a subsidiary corporation recognizes no gain or loss
when § 332 applies to its liquidating distribution of property to its corporate parent.
•Section 334(a) states basis rules applicable to non-subsidiary liquidations.
•Section 334(b) states basis rules applicable to subsidiary liquidations.
“Distribution of property in complete liquidation”: The tax treatments of §§ 331/336 and
§§ 332/337 are accorded only to a “distribution of property in complete liquidation” of a
corporation.”

II. Nonsubsidiary Liquidation
Read §§ 331, 336, 334(a).
The liquidation of a nonsubsidiary can be viewed as the final tax reckoning of the
corporation’s profits and losses. The liquidating corporation ceases to be a taxable entity,
and liquidation will be the last opportunity to collect income tax on its realized but
unrecognized income. Both shareholders and the distributing corporation must recognize
gain or loss on the distribution. §§ 331(a)/336(a). Section 336(a) spells this out for the
liquidating corporation, i.e., “as if such property were sold to the distributee at its fair
market value.” Section 331(b) provides that § 301 is not applicable to distributions in
complete liquidation. The earnings and profits of the liquidating corporation simply
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disappear. Thus, the income that earnings and profits represent to shareholders on which
there should have eventually been a tax (i.e., upon distribution(s) to shareholders)
disappears. The distribution is treated as an exchange, not as a distribution of (taxable)
profits. If there are losses, they will probably be capital losses – which can be offset only
by capital gains. § 1211. Because gains and losses are subject to income tax at the
shareholder level, the shareholder takes a fair market value basis in the assets received –
not a carryover basis. § 334(a). There is of course no tacking of any holding period when
the shareholder takes a fair market value basis in assets rather than a carryover basis.
If a shareholder takes property subject to a liability, the shareholder’s “amount realized”
is reduced by the amount of the liability. Why should the shareholder get a fair market
value basis when the shareholder’s “amount realized” does not include the liability that
the shareholder assumes? What should be the result if the liability is contingent,
speculative, or unknown?
The corporation will measure its gain by the fair market value of property that it distributes
less the adjusted basis of the property. The corporation that distributes property subject to
more liability than the property’s fair market value must treat the fair market value as not
less than the liability. § 336(b). A liquidating corporation that is unprofitable but owns
property can find liquidation to be particularly expensive. What strategies does the
following case suggest? When should a corporation consider adopting such strategies?

Norwalk v. Commissioner, T.C. Memo 1998-279
MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE, Judge: These consolidated cases involve transferee liability [and] deficiencies ...
....
After concessions by the parties, the issues for decision are: (1) Whether DeMarta &
Norwalk, CPA’s, Inc. (the corporation), realized a gain of $588,297 on the distribution of
its intangible assets to its shareholders in a liquidation; ... (3) whether Robert and Patricia
DeMarta realized a capital gain of $505,935 on the receipt of property from the corporation
in a liquidating distribution in 1992; (4) whether William R. Norwalk realized a capital
gain of $165,940 on the receipt of property from the corporation in a liquidating
distribution in 1992; ...
FINDINGS OF FACT
....

278

In 1985, Messrs. DeMarta and Norwalk organized DeMarta & Norwalk, CPA’s, Inc.,
which was incorporated in California on August 14, 1985. The business of the corporation
was the practice of public accounting. At all times during the corporation’s existence,
Messrs. DeMarta and Norwalk have been its only shareholders.
On September 3, 1985, Messrs. DeMarta and Norwalk signed separate agreements with
the corporation regarding their respective ownership interests in, and rights and duties
regarding, the corporation. Each agreement is entitled “Employment Agreement.” The
effective date set forth on these agreements was October 1, 1985, and each provides,
among other things, the following:
TERM
5. The term of employment shall be five years from the date specified in Schedule
A attached to this Agreement …
….
RESTRICTIVE COVENANT
6. Employee agrees that during the term of this Agreement he will not engage in
any other business duties or pursuits whatsoever, directly or indirectly, except
activities approved in writing by the Board of Directors, directorships in
companies not in competition with the Corporation, and passive personal
investments. Furthermore, Employee will not, directly or indirectly, acquire, hold,
or retain any interest in any business competing with or similar in nature to the
business of the Corporation, and will not own or hold to any substantial degree any
securities in any company competing with the Corporation.
*******
DISCLOSURE OF INFORMATION
8. Employee recognizes and acknowledges that the list of the Corporation’s clients,
as it may exist from time to time, is a unique asset of the Corporation’s business.
Employee will not, during or after the term of employment, disclose the list of the
Corporation’s clients or any part of it to any person, firm, corporation, association,
or other entity for any reason or purpose whatsoever. …
*****
RECORDS
11. On the termination of this Agreement, Employee shall not be entitled to keep
or preserve records or charts of the Corporation as to any client unless a client
279

specifically requests a different disposition of those records, and in no event shall
Employee be entitled to the records of clients not served by him.
Subsequent to the term of the shareholders’ respective agreements with the corporation,
no other agreements between the shareholders and the corporation were entered into.
Accordingly, Messrs. DeMarta and Norwalk were not bound by any covenant not to
compete on June 30, 1992.
As of June 30, 1992, in addition to the shareholders, the corporation had eight employees,
four of whom were accountants. No other employee of the corporation signed any
employment agreement with the corporation.
On June 30, 1992, the corporation’s assets were distributed to its shareholders. On that
date, Mr. DeMarta held 75 percent of the corporation’s stock, while Mr. Norwalk held the
remaining 25 percent. Only a nominal amount of assets was left in the corporation after
this distribution. This distribution constituted a complete liquidation of the corporation in
1992. The corporation did not continue to provide accounting services after June 30, 1992,
and the business of the corporation did not continue. The corporation has never been
dissolved.
....
On January 3, 1992, as reflected in the corporation’s minutes, the board of directors
(Messrs. DeMarta and Norwalk) authorized the distribution of the corporation’s assets and
liabilities to the shareholders. These corporate minutes provided the following reason for
this distribution:
Due to lack of profitability, it was decided to stop practice as Certified Public
Accountants within the structure of DeMarta & Norwalk. It was further decided to
distribute all available assets and liabilities to the shareholders. Each shareholder
would then be able to pursue a professional practice on their own or as partners
with other CPA(s).
On July 1, 1992, following the distribution of the corporation’s assets, Messrs. DeMarta
and Norwalk became partners of the accounting firm Ireland, San Filippo (the partnership),
and transferred assets, distributed to them by the corporation, to the partnership. The
partnership did not use the corporation’s name. The tangible assets distributed to the
shareholders included all the corporation’s furniture and equipment, which the corporation
reported on its 1992 Federal income tax return at a value of $59,455. These assets were
contributed to the partnership at an agreed value of $59,455. The shareholders also
transferred their share of the corporation’s receivables to the partnership. These assets
were contributed to the partnership (less liabilities assumed by the partnership) in
exchange for the opening balances of the respective partnership capital accounts of Messrs.
280

DeMarta and Norwalk. The partnership did not assume tax obligations of the corporation,
nor did it assume the debts owed by the corporation to the shareholders. The opening
capital account balances in the partnership for Messrs. DeMarta and Norwalk were
$39,202 and $28,041, respectively.
Messrs. DeMarta and Norwalk each executed a partnership agreement when they joined
the partnership. Under the terms of the partnership agreement, Messrs. DeMarta and
Norwalk were treated as equal partners and subject to the same formula for allocation of
compensation. This partnership agreement also contained certain provisions restricting the
partners’ ability to compete with the partnership.
….
As of June 30, 1992, other than the shareholders, the corporation employed the following
persons: Barbara Bailey; Karin Laster; Beverly Hagan, C.P.A.; Thomas Tang, C.P.A.; Don
Christman, C.P.A.; Jeanette Joyce, accountant; Judy Cunningham, administrator; and Joan
Long, secretary. After the liquidation of the corporation, many of its former employees
were subsequently employed by the partnership. By the end of October 1992, both Beverly
Hagan and Thomas Tang left the partnership to set up their own separate accounting
practices. When Mr. Tang left, Barbara Bailey, a computer consultant, and Karin Laster,
a bookkeeper, also left the partnership to work for Mr. Tang.
When Ms. Hagan and Mr. Tang left to set up their individual practices, they each sent
announcements to former clients of the corporation and to clients of the partnership
informing them of their move. The partnership received at least 92 requests from former
clients to have the information contained in their files made available to either Ms. Hagan
or Mr. Tang. Pursuant to these client authorizations, the partnership permitted Ms. Hagan
and Mr. Tang to copy the files of clients that left the partnership. Neither Messrs. DeMarta
and Norwalk nor the partnership requested any compensation for any clients lost to either
Ms. Hagan or Mr. Tang. Five years following the liquidation of the corporation, only about
10 percent of the accounts serviced by the corporation remained with the partnership.
OPINION
The principal issue underlying all these consolidated cases is the fair market value of the
corporation’s assets on the date of distribution.
Customer-Based Intangibles
Respondent contends that when the corporation was liquidated, it distributed to its
shareholders “customer-based intangibles” in addition to tangible assets. Respondent
describes the intangible assets at issue to include the corporation’s client base, client
records and workpapers, and goodwill (including going-concern-value). Respondent’s
281

position is that these intangibles were assets of the corporation that had a specific value
and that when distributed to the shareholders in the liquidation, triggered taxable gain to
the corporation. Liability in respect of a deficiency in the corporation’s tax and penalty
was then asserted by respondent against the shareholders of the corporation as transferees.
Respondent also determined that the transfer of the customer-based intangibles received
by the shareholders generated taxable gain to the shareholders.
Petitioners maintain that the corporation did not own the intangibles in question. Rather,
petitioners argue that the accountants themselves owned the intangibles, and, thus, there
was no transfer nor any corresponding taxable gain attributable to these intangibles.
Generally, gain or loss must be recognized by a liquidating corporation “on the distribution
of property in complete liquidation as if such property were sold to the distributee at its
fair market value.” § 336(a). Petitioners do not contend that the provisions of § 336(a)
should not apply here. The corporation must recognize gain calculated as the difference
between the fair market value of the distributed property and the corporation’s basis in that
property.
Moreover, amounts received by the shareholders in a distribution in complete liquidation
of the corporation must be treated as in full payment in exchange for the corporation’s
stock. § 331(a). The shareholders must recognize any gain on the receipt of the property
in the liquidating distribution. The gain to the shareholder is computed by subtracting the
shareholder’s adjusted basis in the stock from the amount realized. § 1001(a); Reg. §
1.331-1(b). The amount realized is the sum of any money received on the distribution plus
the fair market value of the property received (other than money).89 § 1001(b). This gain
is reduced by the outstanding corporate liabilities assumed by the shareholders, if any.
Here, the loans payable to the shareholders totaled $96,678 as of June 30, 1992.
We have recognized that goodwill is a vendible asset which can be sold with a professional
practice. LaRue v. Commissioner, 37 T.C. 39, 44 (1961); Watson v. Commissioner, 35 T.C.
203, 209 (1960). Goodwill is often defined as the expectation of continued patronage.
Newark Morning Ledger Co. v. United States 507 U.S. 546 (1993). …
In determining the value of goodwill, there is no specific rule, and each case must be
considered and decided in light of its own particular facts. MacDonald v. Commissioner,
3 T.C. 720, 726 (1944). Moreover, in determining such value it is well established that the
earning power of the business is an important factor. Estate of Krafft v. Commissioner,
T.C. Memo. 1961-305. In Staab v. Commissioner, 20 T.C. 834, 840 (1953), we stated:

89 Reg. § 1.331-1(e) provides that a shareholder’s gain or loss on a liquidating distribution be calculated on a per-

share basis. [The regulation now makes this point by way of example.] ...

282

Goodwill, then, is an intangible consisting of the excess earning power of a
business. A normal earning power is expected of the business assets, and if the
business has greater earnings, then the business may be said to have goodwill. This
excess in earning power may be due to any one or more of several reasons, and
usually this extra value exists only because the business is a going concern, being
successful and profitable. Goodwill may arise from: (1) the mere assembly of the
various elements of a business, workers, customers, etc., (2) good reputation,
customers’ buying habits, (3) list of customers and their needs, (4) brand name, (5)
secret processes, and (6) other intangibles affecting earnings.
Both parties presented testimony from expert witnesses regarding the value of the
corporation’s intangible assets. In appraising the value of the corporation’s intangibles,
petitioners’ expert stated: “Intangible value within a company (or goodwill value) is based
upon the existence of excess earnings.” After examining financial information from the
corporation’s Federal income tax returns, the pay history of Messrs. DeMarta and
Norwalk, and Federal Government guidelines for an accountant’s pay, he found that the
corporation did not have excess earnings or earnings over and above a return on tangible
assets. Consequently, petitioners’ expert concluded that the corporation was worth the
value of its tangible assets [footnote omitted] and that there was no intangible or goodwill
value at the time of the distribution to the shareholders. He then addressed the valuation
of the corporation’s client list. Recognizing that in a service-related business the client
relationship is normally between the client and the professional who services that client,
petitioners’ expert concluded that “Without an effective non-competition agreement, the
clients have no meaningful value.” Recognizing that there was no restriction on the ability
of the individual accountants to compete with the corporation, he concluded that the client
related goodwill and intangibles belonged to the professional accountants (individually)
who serviced the clients and that a list of these clients had no material value.
We have held that there is no salable goodwill where, as here, the business of a corporation
is dependent upon its key employees, unless they enter into a covenant not to compete
with the corporation or other agreement whereby their personal relationships with clients
become property of the corporation. Martin Ice Cream Co. v. Commissioner, 110 T.C.
189, 207 (1998) (“personal relationships of a shareholder-employee are not corporate
assets when the employee has no employment contract with the corporation”); Estate of
Taracido v. Commissioner, 72 T.C. 1014, 1023-1024 (1979); Cullen v. Commissioner, 14
T.C. 368, 372 (1950); MacDonald v. Commissioner, supra at 727; ...
We have no doubt that most, if not all, of the clients of the corporation would have
“followed” the accountant who serviced that client if the accountant would have left the
corporation. For instance, when Mr. Tang and Ms. Hagan left the partnership shortly after
the corporation was liquidated, at least 92 clients engaged these former employees to
provide future services. On the record here, it is reasonable to assume that the personal
ability, personality, and reputation of the individual accountants are what the clients
283

sought. These characteristics did not belong to the corporation as intangible assets, since
the accountants had no contractual obligation to continue their connection with it. …
[The court reviewed the facts and holding of MacDonald v. Commissioner, supra, a case
holding that in the absence of a corporation’s right to the future services of an individual,
the individual’s personal ability is not part of the assets that an acquiring corporation
receives by acquisition of the corporation’s assets.]
….
Therefore, … we hold that at the time of the corporation’s liquidation it had no goodwill,
either in terms of a client list or in any other form, which could be distributed to the
individual shareholders or sold to a third party.
We have carefully considered the testimony of respondent’s experts who testified that in
their opinion a fair value of the corporation would be $870,000, of which $266,000 would
represent the value of the client list and $369,000 would represent goodwill. [footnote
omitted]. However, we conclude that their opinion regarding the intangible assets of the
corporation is of no probative force in light of other evidence of record and existing case
law.
….
… [R]espondent’s experts valued the corporation’s client list and goodwill as if a covenant
not to compete was in effect on the date of distribution. Respondent’s expert, Mr. Kettell,
testified that such a restriction is a very important factor in valuing the intangibles of the
corporation. However, we have found that there were no restrictions on the corporation’s
employees to compete with it on the date of distribution. Nevertheless, in determining the
corporation’s value, respondent’s experts relied upon the restrictions expressed in the
partnership agreement executed by Messrs. DeMarta and Norwalk after the distribution of
the corporation’s assets. The parties to the partnership agreement are Messrs. DeMarta and
Norwalk and the existing partners of the partnership, not the corporation. This agreement
was not enforceable by the corporation and should have no bearing on the valuation of the
corporation on the date that it distributed its assets.
In view of the foregoing, we conclude that there were no transferable “customer-based
intangibles” belonging to the corporation independent of the abilities, skills, and reputation
of the individual accountants. “Ability, skill, experience, acquaintanceship, or other
personal characteristics or qualifications do not constitute goodwill as an item of property,
nor do they exist in such form that they could be the subject of transfer.” Providence Mill
Supply Co. v. Commissioner, 2 B.T.A. 791, 793 (1925). In O’Rear v. Commissioner, 28
B.T.A. 698, 700 (1933), aff’d. 80 F.2d 473 (6th Cir. 1935), we stated that “it is at least
doubtful whether a professional man can sell or dispose of any goodwill which may attach
284

to his practice except perhaps by contracting to refrain from practicing.” Because there
was no enforceable contract which restricted the practice of any of the accountants at the
time of the distribution, their personal goodwill did not attach to the corporation. Any
goodwill transferred to the partnership was that of the individual accountants, not the
corporation. Under these circumstances, we conclude that the value of any “customer
based intangibles” that the corporation may have had was nominal. We hold that
petitioners have met their burden of establishing that value is not allocable to the customer
based intangibles as determined by respondent.
....
Decisions will be entered under Rule 155.

Questions and comments:
1. This case demonstrates the significance of covenants not to compete. What would the
result in this case have been if the employment contract of 1985 had still been in effect
and/or the other employees had been bound by the same covenants?
2. The excerpt from Staab v. Commissioner that the court quoted provided in part:
“Goodwill … is an intangible consisting of the excess earning power of a business. A normal
earning power is expected of the business assets, and if the business has greater earnings,
then the business may be said to have goodwill.”
•Does this excerpt imply a method of determining the value of goodwill? What did
the court do in Norwalk?
3. Characterization of shareholder gains/losses: Suppose: corporation liquidates. Both
the shareholders and the corporation recognize their respective gains and losses. Four years
later, the shareholders must pay a tort liability of the dissolved corporation. A corporation
that pays a tort liability may deduct the expenditure as an ordinary loss. Can the
shareholders of a liquidated corporation deduct such payments as ordinary loss?
•No. If the corporation had made such payments, it would have had less money to
distribute to its shareholders on the liquidation. They would have realized less on
the exchange of their stock. Their capital gain would have been less, or their capital
loss would have been greater. They must claim a capital loss – at a time when they
no longer own stock in the corporation. Matching such losses with capital gains
might be a problem, to say nothing of the fact that long-term capital gain rates are
lower for individuals than ordinary income rates. See Arrowsmith v.
Commissioner, 344 U.S. 6 (1952).
4. Liquidations/Reincorporations: When the rule of General Utilities prevailed –
specifically that a corporation could distribute property to shareholders without itself

285

recognizing gain or loss while shareholders took a carryover basis of the assets – the rules
of §§ 331/336 could be exploited to avoid future tax liabilities.
Shareholders could liquidate a corporation and form another corporation that looked a lot
like the old one. Shareholders could make adjustments in the property that they transferred
to the corporation, perhaps retaining some of it and not transferring it to the new
corporation. Similarly, they might add or subtract shareholders. Such a distribution would
escape the generally unfavorable treatment of dividend distributions.
•If the value of what shareholders received was less than their bases in their stock,
they could recognize capital losses. If the value of what shareholders received was
more than their bases in their stock, they recognized capital gain.
•They could step up the basis of the property that they received to its fmv.
•The new corporation that they formed and to which they transferred property
might look a lot like the old one insofar as the nature of the business that it carried
on and the assets that it owned was concerned, but the new corporation would have
shed the old corporation’s earnings and profits, thereby reducing the amount of
future distributions that might be taxed as dividends. The new corporation would
also have a stepped-up basis in its assets, the price of which was the shareholders’
income tax liability on the increase in their stock’s value.
•The value of such schemes depended on the tax consequences of more (or
different) recognition events.
The Commissioner – through application of the step transaction doctrine – successfully
argued that these schemes were simply F reorganizations, infra at chapter 9:V:B. Hence,
all the tax attributes of the old corporation carried over, including earnings and profits
history, bases in assets, and depreciation schedules. The repeal of the General Utilities
doctrine coupled with a lower tax rate on dividend income that individual shareholders
receive have altered the cost/benefit calculus of such schemes.
5. A judicial exception to § 331/336: The purchaser of all a corporation’s stock may desire
the corporation’s assets rather than its stock. In Sniveley v. CIR, 19 T.C. 850, 859 (1953),
aff’d, 219 F.2d 266 (5th Cir. 1955), the Tax Court held that the purchase of stock for the
purpose of acquiring the corporation’s assets and the liquidation of the corporation were
to be treated as one transaction, i.e., the purchase of the corporation’s assets. This rule will
sometimes work to taxpayer’s advantage and sometimes to taxpayer’s disadvantage. See
also Kimbell-Diamond Milling Co. v. Comm’r, 14 T.C. 74 (1950), aff’d 187 F.2d 718 (5th
Cir.), cert. denied, 342 U.S. 827 (1951), infra, chapter 9

286

Rev. Rul. 85-48, 1985-1 C.B. 126
ISSUE
What is the proper federal income tax treatment of amounts received by a shareholder
pursuant to a series of distributions in complete liquidation of a multiple-shareholder
corporation under the circumstances described below?
FACTS
Corporation X adopted a plan of complete liquidation on January 31, 1981, pursuant to
which it intended to distribute all its assets (other than those required to meet claims) to
its shareholders within a 12-month period beginning on the date of adoption of the plan.
A, a calendar year taxpayer, had acquired 10 of the 100 outstanding shares of X stock (first
block) at a cost of 10x dollars (1x dollar per share) on January 1, 1975. A had acquired an
additional 20 of the 100 outstanding shares (second block) at a cost of 40x dollars (2x
dollars per share) on January 1, 1980. The remaining 70 outstanding shares of X stock
were owned by persons other than A.
On February 15, 1981, X sold all its assets for 600x dollars. On June 1, 1981, X distributed
150x dollars to its shareholders including 45x dollars to A pursuant to its plan of
liquidation. At that time, A’s adjusted basis in each block of shares was equal to A’s cost.
On January 1, 1982, X distributed the remaining 450x dollars to its shareholders including
135x dollars to A in its final liquidating distribution pursuant to the plan.
LAW AND ANALYSIS
Section 346(a) of the Internal Revenue Code provides that a distribution will be treated as
in complete liquidation of a corporation if the distribution is one of a series of distributions
in redemption of all the stock of the corporation pursuant to a plan.
Rev. Rul. 68-348, 1968-2 C.B. 141, provides that where a sole shareholder owns more
than one block of shares of a corporation and receives a series of distributions in complete
liquidation of the corporation, each distribution must be allocated ratably among the
several blocks of shares in the proportion that the number of shares in a particular block
bears to the total number of shares outstanding. Where a corporation has multiple
shareholders, liquidation distributions must be allocated among blocks of shares held by
different shareholders as well as among different blocks of shares owned by a particular
shareholder. Rev. Rul. 79-10, 1979-1 C.B. 140, holds that distributions under a plan of
complete liquidation made by a corporation having a single class of stock will be treated
as pro-rata distributions among the outstanding shares of the corporation. Consistent with
Rev. Rul. 68-348, the liquidation distributions allocated to a particular shareholder must
be allocated among the several blocks of shares owned by the shareholder in the proportion
that the number of shares in a particular block bears to the total number of shares owned
by that shareholder.

287

HOLDING
Applying this principle to the situation described above, of the 45x dollars distributed to
A on June 1, 1981, 15x dollars (10/30 x 45) is allocated to the first block of shares, which
has an adjusted basis of 10x dollars, producing a gain of 5x dollars, and 30x dollars (20/30
x 45) is allocated to the second block of shares, which has an adjusted basis of 40x dollars,
producing no recognition of gain. Hence, A’s federal income tax return for the year ended
December 31, 1981, should show gain of 5x dollars resulting from the distribution on June
1, 1981. After the June 1, 1981, distribution, A’s adjusted basis for the shares of X stock
is zero for the first block and 10x dollars for the second block.
Of the 135x dollars distributed to A on January 1, 1982, 45x dollars (10/30 x 135) is
allocated to the first block of shares, producing a gain of 45x dollars, and 90x dollars
(20/30 x 135) is allocated to the second block of shares, producing a gain of 80x dollars.
Thus, A’s return for the taxable year ended December 31, 1982, should show gains of 45x
dollars and 80x dollars resulting from the January 1, 1982, distribution.

Questions and comments:
1. This revenue ruling “amplified” Rev. Rul. 68-348, 1968-2 C.B. 141. That revenue
ruling also stated: “Any losses resulting from a complete liquidation will be recognized
only after the corporation has made its final distribution.” [citations omitted].
2. We can infer the following from these revenue rulings: a shareholder’s gain or loss is
computed on each share individually.90
•Each distribution is allocated ratably to each block of stock according to the
number of shares in the block relative to the total number of shares outstanding.
3. We can also infer that a shareholder applies a “basis first” approach, i.e., shareholder
recovers all basis before recognizing any gain.
4. It seems that if a corporate distribution to shareholders is to escape § 301, there should
be some concrete indication such treatment is deserved. Perhaps that is some justification
for requiring a plan. Neither § 331 nor 336 specifically requires such a plan.

90 We take the fragmented view of stock ownership rather than the unitary view of Fink v. Commissioner, 483 U.S.

89 (1987); see chapter 2: VIII, supra.

288

Rendina v. Commissioner, T.C. Memo. 1996-392
MEMORANDUM FINDINGS OF FACT AND OPINION
BEGHE, Judge
Respondent determined a deficiency of $35,934 in petitioners’ 1988 Federal income tax ...
[footnote omitted]. The deficiency arose from respondent’s determination that the
distribution to petitioner [husband and wife; footnote omitted] of two condominium units
by Wood Street Apartments, Inc. (WSAI) was a dividend.
We hold that petitioner received the condominium units as a distribution in de facto
liquidation of his shares of WSAI, thereby reducing his realized gain by the amount of his
basis in the shares and by the amount of certain liabilities to third parties that he assumed
....
FINDINGS OF FACT
....
Wood Street Apartments, Inc.
In 1986, petitioner[, a CPA,] and Thomas J. Ackerman (Ackerman), a construction
contractor, formed WSAI as a general business corporation under Ohio law, for the
purposes of constructing and selling 18 condominium units in Willoughby, Ohio. WSAI
was operated as a C corporation. Petitioner and Ackerman each paid WSAI approximately
$250 for an equal number of common shares of WSAI.
In 1987 and 1988, WSAI constructed the 18 condominium units, known as “South Wood
Condominiums” (South Wood). South Wood consists of two-story townhouses, built in
clusters of six units in each of three buildings.
WSAI financed the construction of South Wood primarily with borrowed funds. The funds
used by WSAI consisted of a loan from Security Federal Savings and Loan of
approximately $740,000, petitioner’s deposits in WSAI’s checking account of
approximately $41,200, [footnote omitted] and approximately $68,000 in loans from three
of petitioner’s accounting clients: William and Mary Foss (the Fosses), Vito and Adella
Navar (the Navars), and Frank and Benette Posa (the Posas). The principal amounts of the
loans from the Fosses, Navars, and Posas were $53,000, $10,000, and $5,000, respectively.
The loan checks were made to WSAI, and deposited in WSAI’s checking account at
National City Bank. WSAI issued promissory notes to the lenders, providing that interest
would be paid at a rate of 12 percent per year. The maturity date of each of the notes was
approximately 1 year after issuance.

289

....
[WSAI issued new notes to the Fosses, Navars, and Posas.] With the exception of one of
the Foss notes, each new note reflected a rollover of the obligation on the prior note. For
the months of January, February, March, and April 1989, all interest payments due on the
notes to the Fosses, Navars, and Posas were made in the name of WSAI. [footnote
omitted].
In 1988, 16 of the 18 units were sold, two of which were purchased by Ackerman. ...
....
Toward the end of 1988, two of the 18 units remained unsold. Petitioner and Ackerman
orally agreed that WSAI would transfer title to the two remaining condominium units to
petitioner in consideration of petitioner’s assumption of the Foss, Navar, and Posa notes,
and petitioner’s discharge of WSAI’s “debt” owed to him.
In December 1988, WSAI transferred South Wood’s two remaining condominium units to
petitioner. Petitioner did not report any income or gain from the receipt of the two
condominium units on his 1988 Federal income tax return ... WSAI filed no U.S.
corporation income tax return for 1988, the tax year in which all the condominium units
were sold or transferred.
With the transfer of the last two condominium units to petitioner in 1988, WSAI no longer
held business assets, and ceased to be a going concern. Upon transfer of all 18
condominium units in 1988, WSAI ceased doing business, but did not formally dissolve.
Its charter was revoked in 1990 for nonpayment and nonfiling of Ohio franchise tax
returns.
In April 1989, petitioner sold one of the units for $67,900.
Transfer of notes from WSAI to Canterbury Construction Co.
....
The loans to the Posas and Navars, in the principal amounts of $15,000 and $10,000,
respectively, have been paid. As of the date of filing of the petition, the Fosses still held a
note ...
....

290

Corporation tax and transferee issues
On or around March 1, 1994, respondent sent petitioner, as transferee of WSAI, a 30-day
letter, with a report of income tax examination and explanation of items, asserting for the
taxable year 1988 that WSAI had taxable income of $272,320, resulting from gross
receipts of $1,068,000 from the sale of the South Wood condominium units,91 based on
the retail sales prices as determined by the transfer taxes paid, less costs and expenses of
$795,680. [footnote omitted]. The report took the position that WSAI owed 1988 U.S.
corporation income tax of $89,455, and an addition of $22,364 for failure to file its
corporation income tax return. WSAI’s liability for 1988 U.S. corporation income tax and
the failure to file addition remains unresolved; respondent had issued no statutory notice
of deficiency to WSAI (or to petitioner as transferee) as of the date of issuance of this
report.
OPINION
....
The substantive tax question before us is whether petitioner’s receipt of two condominium
units, during the taxable year 1988, was a taxable distribution from WSAI. Respondent
determined that petitioner’s receipt of the last two units was a dividend in the amount of
$135,800 during the taxable year 1988. Petitioner contended that his receipt of the units
was not taxable to him because it was offset by discharge of WSAI’s debt to him, and his
assumption of the Foss, Navar, and Posa notes. Petitioner also maintained that his receipt
of the two units could not be a dividend because WSAI had no earnings and profits.
Petitioner, in his reply brief, raised the alternative argument that he received the
condominium units in de facto liquidation of WSAI, which would entitle him to use the
basis of his WSAI stock to compute his gain on the distribution, if we should determine
that his payments into WSAI represented equity rather than debt. Because it appeared to
us that this position might have greater merit than the primary position of either of the
parties, we had them address this newly raised issue in supplemental briefs.
I. Lack of Prejudice to Respondent in Addressing Liquidation
....
II. De Facto Liquidation
Applying the three-pronged test of Estate of Maguire v. Commissioner, 50 T.C. 130, 140
(1968):

91 Respondent excluded the two units transferred to petitioner from the calculation of gross receipts.

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(1) Whether there is a manifest intention to liquidate; (2) whether there is a continuing
purpose to terminate corporate affairs; and (3) whether the activities of the corporation and
its shareholders are directed toward that objective, we are convinced that WSAI and its
shareholders displayed a manifest intention to liquidate and continuing purpose to
terminate corporate affairs, and that the activities of WSAI and its shareholders were
directed to that end. See Olmsted v. Commissioner, T.C. Memo. 1984-381.
Neither the Code nor the regulations to § 331 define the term “complete liquidation.”
However, as we noted in Olmsted v. Commissioner, T.C. Memo. 1984-381, the regulations
under § 332 (governing subsidiary liquidations) contain a definition of “complete
liquidation” under § 332 that applies equally to § 331:
A status of liquidation exists when the corporation ceases to be a going concern
and its activities are merely for the purpose of winding up its affairs, paying its
debts and distributing any remaining balance to its shareholders. A liquidation may
be completed prior to the actual dissolution of the liquidating corporation.
However, legal dissolution of the corporation is not required. Nor will the mere
retention of a nominal amount of assets for the sole purpose of preserving the
corporation’s legal existence disqualify the transaction. [Reg. § 1.332-2(c).]
Respondent maintains that petitioner never liquidated WSAI. In support of her position,
respondent relies on Haley Bros. Constr. Corp. v. Commissioner, 87 T.C. 498, 515–516
(1986). In Haley Bros. Construction Corp., the corporation at issue, Marywood Corp., was
not dissolved formally in accordance with State law, and continued to maintain a checking
account. We held that there was no liquidation because there was a business purpose for
the continued existence of Marywood, which continued to be operated in accordance with
that business purpose, holding and selling real property, maintaining a checking account,
paying expenses, and filing tax returns. Moreover, the continued corporate existence of
Marywood served the purpose of insulating its parent corporation from liabilities on a
mortgage and in pending litigation.
In the case at hand, there was no business purpose for WSAI to continue operating. WSAI
did not file a corporate tax return for 1988, and, with the sale or distribution of all of the
condominium units, WSAI had no further assets of any consequence.
We are unpersuaded by respondent’s assertion that, because WSAI continued some
activities through the beginning of 1989, it did not liquidate. Complete liquidation can
occur despite an extended liquidation process, and several earlier opinions of this court
have upheld liquidations despite protracted time frames. See, e.g., Estate of Maguire v.
Commissioner, supra; T.T. Word Supply Co. v. Commissioner, 41 B.T.A. 965 (1940);
Olmsted v. Commissioner, supra. In order for complete liquidation treatment to apply, it
is not essential that a formal plan of liquidation be adopted or that the corporation dissolve,
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as long as there is a manifest intention to liquidate that is carried out. Genecov v. United
States, 412 F.2d 556 (5th Cir. 1969); Stamler v. Commissioner, 145 F.2d 37 (3d Cir. 1944),
aff’g. 45 B.T.A. 37 (1941); Kennemer v. Commissioner, 96 F.2d 177, 178 (5th Cir. 1938),
aff’g. 35 B.T.A. 415 (1937); Olmsted v. Commissioner, supra; Silverman v. Commissioner,
T.C. Memo. 1971-143; see BITTKER & EUSTICE, FEDERAL INCOME TAXATION OF
CORPORATIONS & SHAREHOLDERS, ¶ 10.02, at 10-9 (6th ed. 1994); 11 MERTENS, LAW OF
FEDERAL INCOME TAXATION, § 42.06, at 53 (1992 rev.).
... The intentions of petitioner and Ackerman to liquidate WSAI at the end of 1988 were
apparent from the sales of WSAI’s assets, its cessation of business, and the agreement of
petitioner and Ackerman that WSAI would distribute the last two condominium units to
petitioner, in consideration of petitioner’s assumption of the corporation’s liabilities to its
lenders and his recovery of his investment out of the balance. With that final distribution,
WSAI held title to no further assets of any substantial consequence. With the exception of
interest payments made through the beginning of 1989, [footnote omitted] WSAI engaged
in no further activities.
Finally, respondent argues that petitioners made no disclosure of any kind on their 1988
individual income tax return regarding the receipt of the two condominium units as a
liquidating distribution, as required by Reg. § 1.331-1(d), which states:
In every case in which a shareholder transfers stock in exchange for property to the
corporation which issued such stock, the facts and circumstances shall be reported
on his return unless the property is part of a distribution made pursuant to a
corporate resolution reciting that the distribution is made in liquidation of the
corporation and the corporation is completely liquidated and dissolved within one
year after the distribution. See § 6043 for requirements relating to returns by
corporations.
Reg. § 1.331-1(d) does not impair our ultimate conclusion that a de facto liquidation did
occur during the taxable year 1988 in the case at hand. Although Reg. § 1.331-1(d) appears
to complement § 6043 and Reg. § 1.6043-1, thereunder, providing for the filing of Form
966 (Corporate Dissolution or Liquidation) by a corporation that adopts any resolution or
plan of liquidation, the filing of Form 966 is not a condition of liquidation treatment under
any provision of the Internal Revenue Code. Maguire v. Commissioner, 222 F.2d 472, 478
(7th Cir. 1955), rev’g, 21 T.C. 853 (1954); Murphy v. Commissioner, T.C. Memo. 199659;
see also Fowler Hosiery Co. v. Commissioner, 36 T.C. 201 (1961), aff’d, 301 F.2d 394
(7th Cir. 1962). We are satisfied that Reg. § 1.331-1(d), like the regulation under § 6043,
is directory only. While compliance with these regulations serves the evidentiary function
of supporting the conclusion that a distribution was received in a corporate liquidation,
and helps to avoid controversies of the sort we now deal with, we regard them as playing
only a facilitating role. Petitioner’s compliance with Reg. § 1.331-1(d), is not a condition

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precedent to our treating the distribution of the condominium units to petitioner as a
liquidating distribution. [footnote omitted].
We are convinced that the agreement of the WSAI shareholders, petitioner and Ackerman,
for the distribution of the last two condominium units to petitioner, in consideration of his
taking care of the corporate liabilities and recovering his own investment, manifested
WSAI’s intention to liquidate, and that that intention was carried out in the informal
winding-up of WSAI’s affairs that followed.
III. Computation of Gain
Having found that WSAI was liquidated in 1988, we turn to the tax treatment of
petitioner’s receipt of the condominium units. Section 331(a) provides that amounts
received by a shareholder in complete liquidation of a corporation shall be treated as “full
payment in exchange for the stock”, considering a liquidating distribution, in effect, as a
sale by the shareholder of his stock to the corporation. BITTKER & EUSTICE, FEDERAL
INCOME TAXATION OF CORPORATIONS & SHAREHOLDERS, at 10-4, 10-5 (6th ed. 1994); S.
REPT. 398, 68th Cong., 1st Sess. 11 (1924), 1939-1 C.B. (pt. 2) 266, 274. As a result, the
shareholder computes gain or loss under § 1001(a) by subtracting the adjusted basis of his
stock from the amount realized (the fair market value of the distribution), and reports the
difference as capital gain or loss if the stock is a capital asset in his hands.
To compute petitioner’s gain, we first look at the value of the condominium units
distributed to determine the amount realized. We then look at whether petitioner’s deposits
into the WSAI checking account were loans or equity investments; concluding that they
are equity rather than debt, we add them to petitioner’s basis in his WSAI stock, rather
than treating them as liability offsets to the amount realized. We also look at whether
petitioner assumed, or took subject to, WSAI liabilities, because the amount realized under
§ 1001 on the liquidation exchange is the net value of the distribution, and that amount
must be reduced by the amount of liabilities assumed or taken subject to. See Ford v.
United States, 311 F.2d 951 (1963). We then subtract the basis of petitioner’s shares from
the amount realized on the distribution to compute his gain.
A. Value of Condominium Units Distributed
...
... The average selling price of the other [footnote omitted] condominium units was
$66,915.14. Four months after the distribution, petitioner sold one of his condominium
units for $67,900.
Petitioner has not convinced us that the fair market value of his condominium units should
be less than the average selling price of the other units sold, or $66,915. Thus, we find the
fair market value of the condominiums transferred to petitioner to be $133,830.
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B. Basis of WSAI Shares: Debt v. Equity
Respondent maintains that no loan or other value was given by petitioner to WSAI.
However, the deposit records of National City Bank, where WSAI maintained a checking
account, indicate that petitioner deposited $41,200 into WSAI’s account. ... We are
satisfied that petitioner’s deposits into the WSAI account constitute value that resulted in
cost to be taken into account in determining petitioner’s gain on the receipt of the
condominium units.
While the analysis would vary, depending on whether the investment in the corporation
were debt or equity, the net tax effect to petitioner would be the same. If petitioner’s
investment in the corporation were a loan, WSAI’s transfer of property to petitioner in
satisfaction of the loan would not be governed by § 331 to that extent. This is because the
transfer would not be “in payment for” petitioner’s stock. In such a case, the corporation
merely would be repaying the loan, receiving equal value in exchange for the transfer,
resulting in no taxable event for the transferee. See Citizens Bank & Trust Co. v. United
States, 580 F.2d 442 (Ct. Cl. 1978); J. Hofert Co. v. United States, 69-1 USTC ¶ 9220
(CCH) (C.D. Cal.1969).
If petitioner’s investment were equity, petitioner would be entitled to increase his basis in
his WSAI shares by the amount of the investment. Under this scenario, petitioner would
subtract his basis from the amount of the distribution; if the distribution should exceed
petitioner’s basis, the excess would be treated as capital gain from sale of the stock.
....
In the case at hand, none of the factors are [sic is] present that would tend to show that
petitioner reasonably expected WSAI to repay the “loan” in accordance with terms in line
with those generally prevailing in the business community. See Nassau Lens Co. v.
Commissioner, 308 F.2d 39 (2d Cir. 1962), remanding 35 T.C. 268 (1960). Moreover, no
interest payments to petitioner were made or provided for. See Texas Farm Bureau v.
United States, 725 F.2d 307, 313-314 (5th Cir. 1984). If petitioner had been a true lender,
he would have provided for interest payments. Curry v. United States, 396 F.2d 630, 634
(5th Cir. 1968).
We find that petitioner’s $41,200 of deposits into the WSAI checking account was a
contribution to the capital of WSAI. Because petitioner was a shareholder of WSAI, his
$41,200 of contributions to capital is reflected in an increased basis for his WSAI stock.
Reg. § 1.118-1. Thus, petitioner’s basis in his WSAI stock was $41,450. [footnote
omitted].
Petitioner’s amount realized from the distribution of the condominium units should be
reduced by the amount of the corporation’s liabilities to the Posas, Fosses, and Navars that
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petitioner agreed to assume, and for whose discharge he made the necessary arrangements.
Thus, after subtracting the assumed liabilities of $68,000 from the $92,380 gain ($133,830
amount realized minus $41,450 adjusted basis), petitioner’s realized capital gain is
$24,380.
....
Decision will be entered under Rule 155.

Questions and comments:
1. As this case demonstrates, failure to execute a complete liquidation can result in
taxation of distributions as dividends under § 301. Furthermore, the corporation has not
been liquidated for tax purposes – and remains a taxpayer.
2. There are some limitations on § 336 treatment of distributing corporations in
nonsubsidiary liquidations. Recall that in a § 351 transaction, one level of gain or loss can
be transformed into two levels of gain or loss. The shareholder who transferred property
to a corporation has built-in gain or loss in shares. The corporation who received property
from a shareholder has built-in gain or loss in assets. A transferor of property might
transfer loss property to a corporation shortly before the corporation is to liquidate, i.e.,
the transferor might “stuff” the corporation with loss property. Upon liquidation, the
corporation recognizes a loss on disposition of assets. The shareholder who receives the
property that he transferred to the corporation recognizes loss on the disposition of his
shares, loss that had merely been built-in loss. Section 267(a)(1), which prevents loss
recognition in transactions between related parties, by its terms does not apply to a
distribution in complete liquidation of a corporation. Instead, § 336(d) addresses such
manipulations.
3. Section 336(d)(1): A corporation may not recognize loss on a distribution to a related
party as defined in § 267 if –
•the distribution is not pro rata, § 336(d)(1)(A)(i), OR
•it acquired the property within 5 years of the date of distribution in a § 351
transaction or as a contribution to its capital. §§ 336(d)(1)(A)(ii) and 336(d)(1)(B).
Moreover, the corporation may not recognize loss on the distribution of property
whose basis is determined by reference to such property (e.g., property acquired in
a like-kind exchange that the corporation exchanged for the property it acquired
within 5 years of the distribution in a § 351 transaction or as a contribution to its
capital). § 336(d)(1)(B).
•The loss property distributed does not have to be loss property when the
shareholder transfers it to the corporation.
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4. Section 336(d)(2): When the basis of property is greater than its fair market value, a
corporation in computing its loss on the sale, exchange, or distribution of the property,
must reduce the basis of the property to its fair market value (§ 336(d)(2)(A)) immediately
after acquisition if –
•the corporation acquired the property in a § 351 transaction or as a contribution to
its capital as part of a plan whose “principal purpose” was for the corporation to
recognize loss in connection with the liquidation. § 336(d)(2)(B).
•If the corporation acquires the property within 2 years prior to the adoption
of a plan of complete liquidation, the property is treated as acquired for the
principal purpose of recognizing loss in connection with the liquidation.
§ 336(d)(2)(B)(ii).
4A. Since the necessity of basis adjustment is made immediately after the acquisition, loss
in value occurring after that time is not subject to the loss limitation rules of § 336(d)(2).
This is different than the approach taken in § 336(d)(1), which only applies to distributions
made to “related persons.”
4B. The American Jobs Creation Act of 2004, P.L. 108-357, added § 362(e)(2) to the
Code. That provision of course requires a corporation that receives one or more properties
from a transferor in a § 351 transaction or as a contribution to capital to reduce its bases
in loss properties so that the aggregate bases of the properties that it receives from a
transferor is not greater than the aggregate fair market value of the properties that it
receives. Evidently, Congress gave no thought to the interplay of § 362(e)(2) and § 336(d).
Recall also that when § 362(e)(2) applies, the parties may agree to have the
shareholder/transferor reduce his basis in his shares rather than the corporation reduce its
basis in its assets. The corporation would take the properties with built-in losses. The
subsequent application of §336(d) would then deny both the shareholder and the
corporation the benefit of a built-in loss upon the occurrence of a recognition event.

Problems:
1. Maury purchased all the common stock of Zeltsin Corporation seven years ago for
$1000. This was (and is) all Zeltsin’s outstanding stock. Zeltsin owns assets, total basis =
$500, fmv = $2000. What are the tax results of the following events?
a. Zeltsin sells its assets to third parties for fmv, pays income tax on the gain, and
distributes the balance of its cash to Maury, and liquidates.
b. Zeltsin distributes its assets to Maury, retaining enough cash to pay any resulting tax
liabilities, and liquidates. What would be Maury’s basis in the assets?

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c. Nelson has contacted you because he is interested in acquiring the assets of Zeltsin. He
may continue to operate the business of Zeltsin or he may put those assets to use in another
business. He wants to know how much he should be willing to pay – and to whom – to
gain control of Zeltsin’s assets. What information would you want to acquire and how
would you use that information in advising Nelson?
d. Same as b, supra, except that Zeltsin’s assets are encumbered by a $250 liability. How
would that change your answer to question b?
2. Oliver and Penelope are the only shareholders of Dabble Corporation. Oliver owns 750
shares, and Penelope owns 250 shares. They formed the corporation seven years ago. At
that time, Oliver transferred Blackacre to the corporation, ab = $500, fmv = $750. Penelope
transferred Whiteacre, ab = $400, fmv = $250. The corporation still owns these properties,
but the fmv of Blackacre has decreased to $400, and the fmv of Whiteacre has increased
to $400. What are the tax consequences to each of the parties if Dabble Corporation –
a. sells Blackacre and Whiteacre to third parties, pays taxes, and distributes the proceeds
to Oliver and Penelope in a ratio of 3:1 in a liquidating distribution?
b. distributes Blackacre and a ½ interest in Whiteacre to Oliver in a liquidating
distribution. Dabble Corporation also distributes a ½ interest in Whiteacre to Penelope.
Tax consequences to each of the parties?
c. Would it make any difference if the corporation was formed three years ago?
d. Would it make any difference if the corporation was formed thirteen months ago?

Do the CALI exercise:
Corporate Taxation: Liquidations: Corporate Liquidations: Effects on Shareholders:
Sections 331 & 334(a).

Do the CALI exercise:
Corporate Taxation: Liquidations: Distributions of Property in Complete Liquidations:
Section 336.

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III. Liquidation of Subsidiary
Read §§ 332, 337, 334(b).
When a subsidiary liquidates, the corporate shareholder (i.e., parent) receives all the
liquidating subsidiary’s assets without recognition of gain or loss. § 332(a). The
liquidating subsidiary also does not recognize gain or loss. § 337(a). The liquidation of a
subsidiary liquidation is treated for tax purposes as if nothing happened – similar to a
person’s transfer of assets from the right hand to the left hand. The assets have a carryover
basis to the parent corporation that receives them. § 334(b)(1). The subsidiary’s built-in
gain/loss on its assets is thus preserved. The parent tacks the subsidiary’s holding period
to its own. § 1223(2). The parent’s basis in its shares of the liquidating subsidiary
disappears, so the parent’s built-in gain or loss on its stock disappears. If the subsidiary is
not insolvent and is indebted to the parent, a distribution to the parent is treated as made
in satisfaction of the debt. § 337(b). The parent must recognize any gain on a distribution
in satisfaction of a debt that the subsidiary owes to it, e.g., payment of the face amount of
a bond issued by the subsidiary at a discount to the parent. Reg. § 1.332-7. A subsidiary
that distributes the parent’s debt to it as part of a liquidation also recognizes no gain, and
the parent recognizes no gain upon such a distribution. See Rev. Rul. 74-54, 1974-1 C.B.
76 (holding that a note is “property”).
When a subsidiary liquidates, the parent succeeds to the subsidiary’s tax attributes listed
in § 381(c). § 381(a)(1). Some of the tax attributes to which the parent succeeds include92
the subsidiary’s –
•net operating loss, § 381(c)(1);
•earnings and profits (or deficit in earnings and profits93), § 381(c)(2);
•capital loss carryover, § 381(c)(3);
•accounting method, § 381(c)(4);
•accounting for inventories, § 381(c)(5);
•method of depreciation of remaining basis, § 381(c)(6);
•computation of installment method income, § 381(c)(8);
•computation of bond premium or bond discount amortization, § 381(c)(9);
•recovery of tax benefit items under § 111, § 381(c)(12);
•determinations of basis and recognizable income in § 1033 involuntary
conversions, § 381(c)(13);
•deductions upon paying or accruing deductible liabilities of the transferring
subsidiary, § 381(c)(16);
•excess charitable contribution carryovers, § 381(c)(19); and
92 This is not the complete list of § 381(c) – which contains twenty-three items.
93 A deficit offsets only the acquiring corporation’s earnings and profits accumulated after the date of transfer. §

381(c)(2)(B).

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•disallowed business interest carryovers, § 381(c)(20).
The parent may not carry back a liquidating subsidiary’s net operating loss or a net capital
loss. § 381(b)(3).94
Insolvent subsidiary: If the subsidiary is insolvent, § 332 does not apply. Reg. § 1.3322(b) provides in part that “Section 332 applies only when the recipient corporation receives
at least partial payment for each class of stock that it owns in the liquidating corporation.”
An insolvent subsidiary cannot make even a partial payment for the stock that the parent
owns and so cannot qualify for a § 332 liquidation.
If a shareholder receives no payment for its stock in a liquidation of the
corporation, neither § 331 nor § 332 applies to the liquidation. The fact that a
shareholder receives no payment for its stock in a liquidation of the corporation
demonstrates that such shareholder’s stock is worthless. In addition, the liquidation
is an identifiable event that fixes the loss with respect to the stock.
A shareholder receives no payment for its stock in a liquidation if, at the time of
the liquidation, the fair market value of the corporation’s assets is less than the
corporation’s liabilities. In determining the fair market value of a corporation’s
assets, all of the corporation’s assets, including tangible and intangible assets (such
as goodwill and going concern value) and assets that may not appear on the
corporation’s balance sheet, must be taken into account.
Rev. Rul. 2003-125, 2003-52 I.R.B. 1243. The parent may treat its stock in the subsidiary
as a “worthless security” under § 165(g). Moreover, the stock is not a “capital asset,” and
the loss is “ordinary.” § 165(g)(3); Reg. § 1.165-5(d). Since § 332 is not applicable, neither
is § 381 applicable. This means that a subsidiary’s net operating loss does not pass to the
parent corporation. Rather, like magic, such attributes simply vanish. Section 337 only
applies if § 332 applies (§ 337(a)). But, the inapplicability of §§ 332 or 337 also means
that the subsidiary may recognize gain on any distribution. The subsidiary may not
recognize loss on the disposition of its assets. The subsidiary may not recognize loss until
the property is transferred outside the control group of which the parent and subsidiary are
members. § 267(a)(1), § 267(f)(2)(B).
Subsidiary status: For a liquidation of a subsidiary to qualify for tax deferred treatment
under § 332, the parent must own at least 80% of the subsidiary’s stock by vote and value
from the time the parties adopt the plan of liquidation until receipt of property from the

94 After enactment of the Tax Cuts and Jobs Act (2017), there are no NOL carrybacks except for farming losses

and insurance company losses. § 172(b)(1)(B and C) (except no NOL carryback for life insurance companies).

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subsidiary. § 332(b)(1); Reg. § 1.332-2(a).95 This does not include preferred stock of the
subsidiary that is not entitled to vote, is limited and preferred as to dividends, does not
participate in corporate growth, has redemption and liquidation rights that do not exceed
the issue price of the stock, and is not convertible into another class of stock. § 1504(a)(4)
(defining such stock as not “stock” for purposes of § 1504(a)). Failure to be qualified at
the time of the first distribution and to remain qualified (i.e., in “status of liquidation,”
Reg. § 1.332-2(c)) at all times results in nonqualification for § 332 nonrecognition
treatment. Reg. § 1.332-2(a). The distribution must be in complete redemption or
cancellation of the subsidiary’s stock. §§ 332(b)(2), 332(b)(3). If a transfer of property by
one corporation to another in exchange for stock is not a complete liquidation, the
distributing corporation must recognize gain or loss (if allowed) on each distribution. That
is the effect of the language in § 336(a) “[e]xcept as provided in this section or section 337
…”
Timing of distributions: The Code contemplates either a one-year or a three-year
liquidation of a subsidiary. The starting date of the one-year period is the start of the
taxable year in which the distribution(s) occur (§ 332(b)(2)), and the start of the three-year
period is the first day of the first taxable year after the first distribution is made
(§332(b)(3)). The focus of both rules is the time of the first distribution, not the adoption
of a plan of liquidation.
•Distributions within the taxable year: The liquidating corporation distributes all
its property in complete cancellation or redemption of all its stock within the
taxable year. A resolution authorizing a distribution of all the corporation’s assets
in complete cancellation or redemption of all its stock is considered to be adoption
of a plan of liquidation, even though the resolution does not specify the time for
completing the transfer of property. § 332(b)(2). The distributee corporation must
own the specified amount of the liquidating corporation’s stock and continue to
own the specified amount until all the liquidating corporation’s assets are
transferred within the taxable year. Reg. § 1.332-3.
•Distributions within three years of close of taxable year during which first
distribution is made: The liquidating corporation must distribute all its property in
complete cancellation or redemption of all its stock in accordance with a plan of
liquidation that calls for transfer of all the corporation’s property within three years
from the end of a taxable year during which occurs the first of the distributions
under the plan. § 332(b)(3).
•If the taxpayer fails to be continuously in a qualified status or fails to
distribute all its property within the three-year period, no distribution is

95 Section 332 does not invoke the attribution rules of § 318. Cf. Reg. § 1.332-1(a) (corporation must be “the actual

owner of stock (in the liquidating corporation)”).

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considered to be a distribution in complete liquidations. § 332(b)(3). In
such a case, §§ 336/331 apply.
•The plan must state the period during which transfers of property to
shareholders is to be completed. Reg. § 1.332-4(a)(1).
•The recipient corporation must file with the district director a waiver of
the statute of limitations on assessment to a date at least one year after the
last date of the period for assessment for the last taxable year property
transfers may be completed. Reg. § 1.332-4(a)(2).
•For each of the years of the distribution period the recipient corporation
may be required to file a bond assuring prompt payment of the tax
computed without regard to §§ 332/334(b).
•If the transfer(s) of property is not completed within the three-year period
or the recipient corporation does not continue to be qualified with respect
to its stock ownership of the transferor corporation, then tax liability on
every distribution must be recomputed without regard to §§ 332/334(b).
•Liquidation status and necessity of cessation of business: “A status of liquidation
exists when the corporation ceases to be a going concern and its activities are
merely for the purpose of winding up its affairs, paying its debts and distributing
any remaining balance to its shareholders.” Reg. § 1.332-2(c).
Opting in or opting out of §§ 332/337: The basis that a subsidiary has in its assets compared
to the basis that the parent has in the stock of its subsidiary may determine whether a parent
wants tax-deferred treatment of a liquidation of the subsidiary. Should a corporation be
permitted to adjust its holdings in another corporation with a view towards getting the tax
treatment it wants when it knows that it will liquidate the subsidiary corporation?

Granite Trust Co. v. United States, 238 F.2d 670 (1st Cir. 1956)
MAGRUDER
Granite Trust Company sued the United States in the federal court for the District of
Massachusetts to recover an overpayment of income tax and declared value excess profits
tax for the year 1943. From a judgment for the defendant the taxpayer has taken this appeal.
....
In 1928 the Building Corporation was organized by Granite Trust Company for the
purpose of acquiring land and constructing an office building thereon to be occupied by
the bank. The land and building cost over $1,000,000 and were financed through the
purchase by the taxpayer bank of all the stock of the Building Corporation. ...
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Beginning at least as early as 1936, the amount at which the stock of the Building
Corporation was carried upon the taxpayer’s books was subjected to continuous criticism
by various banking authorities. At a result, the taxpayer wrote down the value of the stock
on its books, but nevertheless the examining authorities continued to press for further
annual reductions.
At some time prior to October, 1943, the taxpayer’s management commenced the
formulation of a plan to bring this issue to a close by the expedient of having Granite Trust
Company purchase the real estate from the Building Corporation for $550,000, a fair
current appraisal, after which the subsidiary Building Corporation was to be liquidated.
The practical problem in the execution of this plan resulted from the fact that the
distribution in the liquidation of the subsidiary corporation was expected to amount to
something between $65 and $66 per share upon the shares of common stock in the
Building Corporation for which the taxpayer had paid $100 per share. In thus contributing
to the simplification of the corporate structure of the taxpayer as a holding company, an
end deemed desirable by the Congress, Granite Trust Company naturally wanted to be
assured that its prospective loss to be realized upon the liquidation of its subsidiary would
lawfully be ‘recognized’ at once so as to be available as a tax deduction.
In order that this forthcoming loss upon its investment might not be denied recognition by
§ 112(b)(6) of the Internal Revenue Code of 1939,96 the taxpayer, on advice of counsel,
proceeded to divest itself of some of its shares of common stock in the Building
Corporation by means of several purported sales and of a gift, the facts concerning which
are as follows:
As of December 1, 1943, the outstanding capital stock of the Building Corporation, all
owned by the taxpayer, consisted of 2,250 shares of preferred stock and 5,000 shares of
common stock, the latter being the sole voting stock. On December 6, 1943, the taxpayer
sold to, or went through the form of selling to, Howard D. Johnson Company 1025 shares
of common stock of the Building Corporation, that being 20.5 per cent of the outstanding
voting stock. Howard D. Johnson Company paid $65.50 per share, a total of $67,137.50
...
At a meeting of the Building Corporation stockholders held on December 10, 1943, the
taxpayer submitted a written offer to purchase the real estate for $550,000. The
stockholders voted to accept this offer, and at the same meeting the following vote was
taken:
‘That if and when this Corporation shall receive $550,000, ... this Corporation shall
be completely liquidated, and after payment or provision for payment of all debts

96 [Text of Code section omitted. The substance of § 112(b)(6) is now in § 332(a and b).]

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of, claims against and obligations of this Corporation, all of its remaining assets
shall be distributed at such time or times to stockholders of record at such date or
dates, and under and subject to such circumstances as the Board of Directors may
determine, to the stockholders of the Corporation pro rata in accordance with the
respective priorities of the outstanding shares of the Corporation, provided,
however, that such liquidation and distribution shall be made and shall be entirely
completed prior to December 30, 1943.’
At the date of the foregoing corporate action by the Building Corporation, namely,
December 10, 1943, Granite Trust Company was the legal and equitable holder of 3,975
shares (79.5 per cent) of the then outstanding 5,000 shares of common stock. ...
Thereafter, on December 13, 1943, the taxpayer sold, or went through the form of selling,
ten shares each of the common stock in the Building Corporation to Howard D. Johnson
individually and to one Ralph E. Richmond, for a price of $65.50 per share. On the same
day the taxpayer donated to the Greater Boston United War Fund two shares of the
common stock of the Building Corporation. …
At no time after the making of the above sales and gift did the taxpayer acquire any
additional common stock in the Building Corporation.
On December 15, 1943, the real estate was conveyed to the taxpayer by the Building
Corporation, and the taxpayer paid the Building Corporation the price of $550,000 ... The
real estate was thereby brought on to the taxpayer’s books at a cost equivalent to current
fair market value, thus satisfying the banking authorities.
On December 17, 1943, the Building Corporation called for retirement at par of its
outstanding preferred stock and paid the taxpayer therefor the sum of $225,000. On the
same day the Building Corporation paid a final liquidating distribution in the amount of
$65.77 per share with respect to each share of its outstanding common stock, and all
holders surrendered their certificates for such outstanding shares. The taxpayer, as the
owner of 3,953 shares of common stock, received $259,988.81. The owners of the other
1,047 shares of the Building Corporation common stock received, respectively: Howard
D. Johnson Company, $67,414.25; Howard D. Johnson, $657.70; Ralph E. Richmond,
$657.70; Greater Boston United War Fund, $131.54. Each payee received and retained
these amounts.
On December 30, 1943, a final meeting of the Building Corporation stockholders was held,
there being represented at the meeting the taxpayer, Howard D. Johnson Company,
Howard D. Johnson, Ralph E. Richmond, and Greater Boston United War Found.
Dissolution was voted, with authority to the corporation’s directors and officers to take all
steps necessary or advisable to that end.

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The taxpayer concedes that it would not have made the sales described above had it not
been for § 112(b)(6) [§ 332] of the Internal Revenue Code of 1939. …
The precise issue before us is whether or not to give effect for tax purposes to the aforesaid
sales and gift by the taxpayer. If the answer is in the affirmative, there is no doubt that the
liquidation distribution of the property of the Building Corporation was not in ‘complete
liquidation’ within the very special meaning of that phrase in § 112(b)(6) of the 1939 Code
[§ 332], and, accordingly, the taxpayer may recognize the loss on its investment.
Although there is no dispute that the transactions in form at least purport to be sales and a
gift, the Commissioner nevertheless maintains that we should not accord them that
significance. The Commissioner’s argument is in two parts: The first proposition derives
from the basic finding of the district court that the taxpayer effected the liquidation ‘in
such manner as to achieve a tax reduction’ and that this was ‘without legal or moral
justification.’ The Commissioner attempts to bolster this argument by his traditional
corporation reorganization analysis to the effect that, so long as the ‘end-result’ of the
transactions involved complies with the ‘criteria of the statute,’ intermediary steps (in this
case the sales and gift) should be ignored as if they were nonexistent. His reasoning is that,
if the final outcome is complete liquidation of a subsidiary corporation which at the outset
was wholly owned by the taxpayer, the entire procedure comes within the intendment of
the statute and ‘circuitous steps to avoid § § 112(b)(6) [§ 332]’ occurring prior to the
ultimate liquidation should be disregarded.
The Commissioner’s second proposition is that there were in fact no valid sales or gift of
stock made by the taxpayer. This argument rests on the taxpayer’s admission that the
transfers were motivated solely by tax considerations and were made in a friendly
atmosphere to friendly people who knew of the decision to liquidate the corporation before
the end of the year. As the Commissioner points out, the liquidation took place shortly
after the transfers, and the transferees then received back the money they had paid in, plus
a small profit. Therefore, the Commissioner argues, relying heavily on Gregory v.
Helvering, 293 U.S. 465 (1935) that ‘the stock transfers in question had no independent
purpose or meaning – either for the transferor or the transferees – but constituted merely a
transitory and circuitous routing of legal title for the purpose of avoiding taxes, within the
meaning of Gregory v. Helvering, supra. It was not expected or intended by any of the
parties that the transferees should become true stockholders. Legal title passed; but
beneficial ownership surely never passed. The transferees who paid money for their stock
knew that the subsidiary would be liquidated in a few days and that they would get their
money back – as in fact they did, with additional amounts to pay them for their cooperation
in serving as conduits of title.’ The gift of stock to the United War Fund is dismissed as
‘nothing more than a gift of the cash.’
....

305

Our conclusion is that the Commissioner’s arguments must be rejected, and that the
taxpayer should be permitted to ‘recognize’ the loss on its investment, which it
undoubtedly realized upon the liquidation of the Building Corporation.
Initially we may note, without ruling upon it, one legal argument made by the
Commissioner having to do with the efficacy of the purported sale of 1,025 shares of stock
to Howard D. Johnson Company on December 6, 1943. The Commissioner contends that,
to satisfy the first condition of nonrecognition prescribed in § 112(b)(6) [§ 332], it is not
necessary to have a formal plan of liquidation, evidenced by a corporate resolution, but it
is sufficient if there is a ‘definitive determination’ to achieve dissolution. It is claimed by
the Commissioner that such a definitive determination existed here by November 10, 1943,
and, therefore, that the sale of stock to Howard D. Johnson Company which took place on
December 6, 1943 (before the formal adoption of the plan of liquidation) occurred after
the ‘adoption of the plan of liquidation’ within the meaning of § 112(b)(6) [§ 332]. In this
view the taxpayer owned 100 per cent of the subsidiary’s stock on the date the plan of
liquidation was adopted, from which it would follow, on the basis of the first condition of
§ 112(b)(6) [§ 332], that the loss should not be ‘recognized.’
We need not consider the foregoing legal argument on its merits, because the subsequent
actions by the taxpayer – the sales to Johnson individually and to Richmond on December
13, 1943, and the gift of stock on the same day to the United War Fund – of themselves,
if valid, successfully accomplished the taxpayer’s purpose of avoiding the nonrecognition
provisions of § 112(b)(6) [§ 332] under the second condition contained in that subsection.
This second condition97 prescribes, in a sort of backhanded way, that gain or loss shall be
recognized if, at any time on or after the date of the adoption of the plan of liquidation and
prior to the date of the receipt of the property distributed in final liquidation, the receiving
corporation is the owner of a greater percentage of any class of stock of the corporation
being liquidated than the percentage of such stock owned by it at the time of the receipt of
the property – which means that this condition precedent to the nonrecognition of a
realized gain or loss is not satisfied if, in the described period, the receiving corporation
has made an effective disposition of any of the shares of stock held in the subsidiary
corporation, without making any countervailing acquisitions of such stock.
Turning then to the basic contentions of the Commissioner, not much need be said with
reference to the proposition that the tax motive for the sales and gift rendered the
transactions ‘immoral’ and thus vitiated them. Again and again the courts have pointed
out that a ‘purpose to minimize or avoid taxation is not an illicit motive.’ [citations
omitted].

97 [This condition is now part of § 332. See infra.]

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As for the Commissioner’s ‘end-result’ argument, the very terms of § 112(b)(6) [§ 332]
make it evident that it is not an ‘end-result’ provision, but rather one which prescribes
specific conditions for the nonrecognition of realized gains or losses, conditions which, if
not strictly met, make the section inapplicable. In fact, the Commissioner’s own
regulations (Reg. 111, § 29.112(b)(6)) emphasize the rigid requirements of the section and
make no allowance for the type of ‘step transaction’ theory advanced in this case.
The legislative history of § 112(b)(6) [§ 332] likewise tends to support the position of the
taxpayer. That history indicates that Congress was primarily concerned with providing a
means of facilitating the simplification of corporate structures pursuant to the general
policy enunciated in the Public Utility Holding Company Act of 1935, 49 Stat. 803, 15
U.S.C. § 79 et seq. [citations omitted]. This fact, while perhaps not conclusive as to the
proper interpretation of § 112(b)(6) [§ 332], nevertheless does lend a favorable background
to the taxpayer’s contention that the subsection, as a relief measure, was ‘not designed as
a strait jacket into which corporations should be forced at the penalty of forfeiture of losses
on liquidation of subsidiaries.’
The more specific and more important bit of legislative history is found in the Report of
the Senate Finance Committee at the time that § 112(b)(6) was reenacted, with
amendments, as § 332 of the Internal Revenue Code of 1954. At this time, when Congress
was engaged in a comprehensive reexamination of the Internal Revenue Code, the wellknown case of Commissioner of Internal Revenue v. Day & Zimmermann, Inc., 151 F.2d
517 (CA3 1945), had been decided in favor of the taxpayer, and it reasonably could be
supposed that Congress, had it disapproved of the decision in that case, would have
overturned its conclusion by making over § 112(b)(6) [§ 332] into an ‘end-result’
provision. In the Day & Zimmermann case, the taxpayer, admittedly in order to avoid the
nonrecognition provisions of § 112(b)(6) [§ 332], had sold at public auction a sufficient
number of shares of a wholly owned subsidiary corporation to reduce its holdings below
80 per cent. These shares were bought, after general bidding, by the treasurer of the
taxpayer, who, after receiving cash dividends in the subsequent liquidation of the
companies, reported his gain and paid income tax thereon. The Third Circuit held that §
112(b)(6) [§ 332] did not apply to the liquidation, emphasizing that the treasurer had paid
a fair price for the shares, had used his own money, had not been directed by anyone to
bid, and that there had been no showing of any understanding existing between him and
the corporation by which the latter was to retain any sort of interest in the securities or in
the proceeds therefrom. [citation omitted]. Commissioner of Internal Revenue v. Day &
Zimmermann, Inc., is not to be distinguished, as the Commissioner suggests, on the ground
that the sale of stock was at public auction, without specific negotiation between the
treasurer and the taxpayer. The significant thing in the case is its ultimate rationale that the
purported sales of stock to the treasurer were in fact sales, notwithstanding the tax motive
which prompted the corporation to enter into the transaction; from which it would seem to
be irrelevant how the transfer was arranged, or whether or not it occurred at a public

307

auction or exchange, so long as the beneficial as well as legal title was intended to pass
and did pass.
Now, what did the Congress do in 1954 in view of Commissioner of Internal Revenue v.
Day & Zimmermann, Inc., holding that a parent corporation contemplating the liquidation
of a wholly owned subsidiary might elect, by making a transfer of an appropriate portion
of the stock in the subsidiary, to avoid the conditions precedent to the nonrecognition of
gain or loss prescribed in § 112(b)(6) [§ 332]? In reenacting that section in 1954, the
Congress struck out the second condition, but left in the first condition which the taxpayer
had successfully utilized in the Day & Zimmermann case in order to avoid a
nonrecognition of a realized loss. This is what the Report of the Senate Finance Committee
said at the time:
‘Section 332. Complete Liquidations of Subsidiaries.
‘Except for subsection (c) § 332 corresponds to and in general restates § 112(b)(6)
of the 1939 Code and provides for the liquidation of a subsidiary corporation by
its parent without the recognition of gain or loss to the parent corporation. Your
committee has, however, deleted a provision which now appears in § 112(b)(6)(A)
which removes a liquidation from the application of that section if the parent
corporation at some time on or after the time of the adoption of the plan of
liquidation and until the receipt of the property owns more stock than that owned
at the time of the receipt of the property. Your committee has removed this
provision with the view to limiting the elective features of the section.’ (Sen.
Finance Committee Report, H.R. 8300, 83d Cong., 2d Sess. 255 (1954).)
The above reference to the ‘elective features’ of the subsection seems inescapably to reflect
a legislative understanding (admittedly not contemporaneous with enactment, however)
that taxpayers can, by taking appropriate steps, render the subsection applicable or
inapplicable as they choose, rather than be at the mercy of the Commissioner on an ‘endresult’ theory. Nowhere in the subsection is there any express reference to an ‘election’ or
an ‘option,’ and the use of the word ‘elective’ in the committee report therefore strongly
indicates, as the taxpayer argues, that the committee believed that corporations could avoid
the nonrecognition provisions by transfers designed to eliminate the specific conditions
contained in the subsection.
We come then to the Commissioner’s second major contention, resting on Gregory v.
Helvering, supra, that the sales of stock by the corporation should be ignored on the ground
that they were not bona fide, and that the taxpayer therefore retained ‘beneficial
ownership’. The Commissioner characterizes the transfers as artificial, unessential,
transitory phases of a completed tax avoidance scheme which should be disregarded.
....
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In the present case the question is whether or not there actually were sales. Why the parties
may wish to enter into a sale is one thing, but that is irrelevant under the Gregory case so
long as the consummated agreement was no different from what it purported to be.
Even the Commissioner concedes that ‘legal title’ passed to the several transferees on
December 13, 1943, but he asserts that ‘beneficial ownership’ never passed. We find no
basis on which to vitiate the purported sales, for the record is absolutely devoid of any
evidence indicating an understanding by the parties to the transfers that any interest in the
stock transferred was to be retained by the taxpayer. If Johnson or Richmond had gone
bankrupt, or the assets of both had been attached by creditors, on the day after the sales to
them, we do not see how the conclusion could be escaped that their Building Corporation
stock would have been included in their respective assets; and if Johnson or Richmond
had died, surely the holdings of stock of each would have passed to his executors of
administrators, or legatees.
In addition to what we have said, there are persuasive reasons of a general nature which
lend weight to the taxpayer’s position. To strike down these sales on the alleged defect
that they took place between friends and for tax motives would only tend to promote
duplicity and result in extensive litigation as taxpayers led courts into hairsplitting
investigations to decide when a sale was not a sale. It is no answer to argue that, under
Gregory v. Helvering, there is an inescapable judicial duty to examine into the actuality of
purported corporate reorganizations, for that was a special sort of transaction, whose bona
fides could readily be ascertained by inquiring whether the ephemeral new corporation
was in fact transacting business, or whether there was in fact a continuance of the
proprietary interests under an altered corporate form. [citation omitted].
What we have said so far is related chiefly to the validity of the sales. When we turn to the
gift on December 13, 1943, to the United War Fund, the taxpayer is on even firmer ground.
The Commissioner says that the gift was nothing more than a gift of cash, that the charity
‘was, at most, a passive transferee, without independent purpose, which held legal title to
two shares for four days.’ This assertion rests, when examined closely, on the simple fact
that the purpose for the gift was a tax avoidance one. But this does not disqualify it as an
effective gift, transferring title. A gift certainly may have a tax motive. [citations omitted].
Charitable contributions of low cost securities are an every-day type of transfer motivated
by tax purposes. The gift to the United War Fund, being valid, transferred two shares from
the taxpayer after the adoption of the plan of liquidation, and alone sufficed to put the
liquidation beyond the reach of the nonrecognition provisions of § 112(b)(6) [§ 332].
In short, though the facts in this case show a tax avoidance, they also show legal
transactions not fictitious or so lacking in substance as to be anything different from what
they purported to be, and we believe they must be given effect in the administration of §
112(b)(6) [§ 332] as well as for all other purposes. [citations omitted].
309

A judgment will be entered vacating the judgment of the District Court and remanding the
case to that court with direction to enter judgment for the plaintiff in the sum of
$57,801.32, with interest.

Questions and comments:
1. Section 267(a)(1) denies a deduction for losses incurred in the sale or exchange of
property between related persons. Sections 267(b)(3) (“controlled group”) and 267(f)
(cross-referencing § 1563(a)) include sales between parent and subsidiary. A “subsidiary”
is a corporation in which parent owns more than 50% of the stock by vote or value. §§
267(f)(1), 1563(a)(1). The loss incurred upon such a sale or exchange is not forever denied,
but rather deferred until the property is transferred outside of the controlled group.
•How would these provisions have affected Granite Trust’s plan? Note the last
sentence of § 267(a)(1).
2. In Granite Trust, taxpayer wanted to recognize losses and so had to rid itself of
sufficient shares so that it owned less than 80% of what had been a subsidiary. What if
taxpayer does not want to recognize gain upon liquidation but owns less than 80% by vote
and value of the liquidating corporation’s shares. It must acquire sufficient shares so that
it owns 80% of the corporation it wants to liquidate. How would you expect the
Commissioner to respond? How helpful are the following two revenue rulings in this
regard?

Rev. Rul. 70-106, 1970-1 C.B. 70
The liquidation of a subsidiary fails to meet the 80 percent control requirement under §
332(b)(1) of the Code where a corporate shareholder owning 75 percent of the subsidiary’s
stock causes the subsidiary to redeem the minority shareholders’ 25 percent interest before
adopting a liquidation plan.
Minority shareholders owned twenty-five percent of the capital stock of corporation X.
The remaining seventy-five percent of the capital stock of X was owned by Corporation
Y. Y desired to liquidate X in a transaction to which § 332 of the Internal Revenue Code
of 1954 would apply in order that Y would recognize no gain on the transaction. The
minority shareholders agreed to have their stock of X redeemed. Following the distribution
to the minority shareholders, Y owned all the stock of X. Y then adopted a formal plan of
complete liquidation of X and all of the remaining assets of X were distributed to Y.
Held, all of the shareholders of X received a distribution in liquidation under the provisions
of § 331 of the Code, and the gain is recognized to Y and gain or loss is recognized to the
310

minority shareholders under § 331 of the Code. The liquidation fails to meet the eighty
percent stock ownership requirements of § 332(b)(1) of the Code since the plan of
liquidation was adopted at the time Y reached the agreement with the minority
shareholders and at such time, Y owned seventy-five percent of the stock of X.

Questions and comments:
1. Apparently: Corporation Y should have purchased the stock of the minority
shareholders without informing them of an intent to liquidate Corporation X. How realistic
is this?

Rev. Rul. 75-521, 1975-2 C.B. 120
Liquidation following purchase of controlling interest. The 80-percent control requirement
of § 332(b)(1) of the Code is met by a corporate shareholder, owning 50 percent of the
stock of a corporation, that purchased all the remaining stock from individual shareholders
and immediately thereafter adopted a plan of complete liquidation of the subsidiary; Rev.
Rul. 70-106 distinguished.
Shareholders, who were all individuals, owned 50 percent of the capital stock of
corporation X. The remaining 50 percent of the capital stock of X was owned by
corporation Y for more than two years. Y desired to liquidate X in a transaction to which
§ 332(a) of the Internal Revenue Code of 1954 would apply in order that Y would
recognize no gain on the liquidation. In accordance with § 332(b)(1), 332(a) applies if the
corporation receiving the property was, on the date of the adoption of the plan of
liquidation, and has continued to be until the receipt of the property, the owner of stock of
the other corporation 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 (except preferred nonvoting stock). Y purchased all the X stock
owned by the individual shareholders for cash. Following the purchases from the
individual shareholders, Y owned all of the stock of X. Immediately thereafter, Y adopted
a plan of complete liquidation of X and all of the property of X was distributed to Y in
complete cancellation of all of its stock in X within the taxable year.
Held, no gain or loss is recognized to Y upon its receipt of the property of X distributed in
complete liquidation of X pursuant to § 332(a) of the Code. The liquidation meets the 80percent stock ownership requirement of § 332(b)(1).
Rev. Rul. 70-106, 1970-1 C.B. 70, holds that the liquidation of a subsidiary fails to meet
the 80-percent control requirement under § 332(b)(1) of the Code where a corporate
shareholder owning 75-percent of the subsidiary’s stock causes the subsidiary to redeem
311

the minority shareholders’ 25-percent interest before formally adopting a plan of
liquidation. The redemption was deemed to be a distribution in liquidation instead of a
distribution in redemption preceding a distribution in liquidation because the plan of
complete liquidation was adopted at the time the corporate shareholder reached an
agreement with the minority shareholders to have the subsidiary redeem their stock. The
entire distribution came from the subsidiary pursuant to that plan. In the instant case, the
purchase of X stock by Y cannot be viewed as part of the distribution in liquidation of X
because a mere sale of stock between shareholders does not constitute an adoption of a
plan of liquidation.
Rev. Rul. 70-106 is distinguished.

Questions and comments:
1. Does the IRS do an adequate job of distinguishing Rev. Rul. 70-106? Focus on the end
result of the transactions (i.e., Corporation X’s assets become assets of Corporation Y,
minority shareholders of Corporation X have their shares redeemed). How can we
distinguish the end result of Rev. Rul. 70-106 from that of Rev. Rul. 75-521?
2. The Tax Court may have put such questions to rest in George L. Riggs, Inc. v. Comm’r,
64 T.C. 474 (1975). In that case, taxpayer had various business reasons for wanting to
liquidate a corporation in which taxpayer owned shares but was not a parent corporation.
Taxpayer needed to acquire stock from minority shareholders and advised them of its
intent. It successfully acquired such shares by May 9, 1968. The corporation formally
adopted a plan of liquidation on June 20, 1968.
While the motives enumerated by [taxpayer] do not directly negate the notion that
a liquidation may have been contemplated, discussed, or even intended prior to
May 9, 1968, they do serve to sufficiently undermine the conclusions drawn by
[the Commissioner] from the actions and statements to offset any presumptions
that respondent’s inferences are correct. Without more concrete evidence than we
have before us, we cannot agree with respondent that a plan of liquidation of
RiggsYoung was adopted within the meaning of § 332 prior to May 9, 1968.
Lacking such a finding, we believe the date on which the resolution to liquidate
was actually adopted by the shareholders should be controlling.
The very most that can be gleaned from the evidence favorable to [the
Commissioner’s] contention is that there may have been a general intent on the
part of [taxpayer’s] advisers somewhere along the line prior to May 9, 1968, to
liquidate Riggs-Young when and if [taxpayer] achieved 80-percent ownership of
Riggs-Young stock as a result of the tender offer. However, ... the formation of a

312

conditional general intention to liquidate in the future is not the adoption of a plan
of liquidation. [citation omitted].
A mere intent by a taxpayer-corporation to liquidate a subsidiary prior to meeting
the 80-percent requirement of § 332 should not be tantamount to the adoption of a
plan of liquidation for the subsidiary at the point in time when that intent is
formulated or manifested. Such a result would thwart the congressional intent of §
332 and prior judicial interpretations of this section and its predecessor.
The predecessor of § 332, was § 112(b)(6), first enacted in 1935. The purpose of §
112(b)(6) was to encourage the simplification of corporation structures and allow
the tax-free liquidation of a subsidiary. [citation omitted].
64 T.C. at 487-88. By fixing on the date of adoption of a resolution to liquidate, it seems
that the court allows the parent to choose the means by which it acquires 80% of the
subsidiary’s stock – whether by purchase or by redemption.
3. If a complete transfer within a taxable year occurs, then the shareholders’ resolution
authorizing the distribution of all the corporation’s assets in complete cancellation or
redemption of all its stock is deemed to be adoption of a plan of liquidation. § 332(b)(2);
Reg. § 1.332-3.
A subsidiary may also adopt a plan of liquidation pursuant to which it makes one or a
series of distributions that occur within three years from the close of the taxable year
during which the first distribution occurred. § 332(b)(3). The plan must state the period
during which the distribution will occur. Reg. § 1.332-4(a)(1). If the subsidiary does not
complete the transfer within the three-year time frame, no distribution is considered to be
a distribution in complete liquidation. § 332(b)(3). The distributing corporation must
recognize gain or loss on each distribution. Reg. § 1.332-4(b).
4. The plan may be informal, but (1) must manifest an intent to liquidate; (2) the purpose
to terminate corporate affairs must be continuing; and (3) the activities of the corporation
and its shareholders must be directed toward that objective. See Rendina v. Comm’r, T.C.
Memo. 1996-392, supra (§ 331).
5. Notice that application of § 332 by its terms (“No gain or loss shall be recognized ...” §
332(a)) is not optional. Taxpayer exercises the option to make it apply (or not apply) through
the ownership (or non-ownership) of shares.
6. When the parent does not own 100% of the stock of the subsidiary, i.e., there are
minority shareholders, the liquidation of the minority shareholders’ interests is treated as
a liquidation under §§ 331/336, infra. However, the distributing liquidating corporation
may not recognize loss on any distribution to a minority shareholder. § 336(d)(3). If it
313

were otherwise, the recognized loss would pass through to the benefit of the parent
corporation. See §§ 381(c)(1 and 3).
7. Failure to comply with all the requirements of § 332 will mean that §§ 331 and 336,
infra, govern the liquidation. The parent and subsidiary may both be exchanging
appreciated property. A problem may arise if a liquidation is not completed within the
three-year period of § 332(b)(3). Reg. § 1.332-4(b) (last sentence) provides for
recomputation of gain and loss on each distribution. While that regulation concerns the
distributee parent, presumably the same rule applies to the distributor subsidiary.

Problems:
P Corporation owns all the stock of S Corporation. P’s basis in the stock is $100,000. S
Corporation’s assets have a basis of $40,000 and a fmv of $150,000. S Corporation has
accumulated earnings and profits of $60,000.
a. S Corporation is liquidated. The liquidation meets the requirements of § 332(b). What
are the tax consequences to the parties?
b. What will P’s aggregate basis be in the assets it acquires from S Corporation?
c. How would your answers change if S Corporation was indebted to P Corporation for
$25,000?
d. Suppose that the fair market value of S Corporation’s assets was $75,000. What
disadvantages would there be in such a liquidation? What might the parties do to avoid
such disadvantage while going through with their plans to liquidate?

Do the CALI exercise:
Corporate Taxation: Liquidations: Subsidiary Liquidations: Section 332.

314

Chapter 7: Subchapter S

I. Introduction
In 1958, Congress enacted subchapter S, which creates a tax regime for “small business
corporation[s]” whereby only the owners of the business recognize the corporation’s
income, gain, deductions, and losses. The subchapter S regime offered business owners
the limited liability of a corporation under state law without the double tax on corporate
income. For an S corporation, income, gain, deductions, and losses “pass through” the
corporate entity to the corporation’s owners/shareholders. Except as specifically provided
in subchapter S itself, the corporation is not a taxpaying entity. § 1363(a).98 In contrast to
the C corporation, income of the corporation that S shareholders receive is subject to only
one level of income tax, not two. The importance of this point grew as the difference
between relatively low corporate income tax rates and relatively high individual income
tax rates shrank through the 1980s and 1990s. Beginning in the 1980s, the limited liability
company (LLC) emerged as another means of limiting liability and incurring only one
level of income tax.
Why choose to be an S corporation rather than an LLC: The LLC offers its owners great
flexibility in its allocations of income, gain, deductions, and losses. Nevertheless, there are
reasons to choose to do business as an S corporation rather than as an LLC.99 For example
–
•In some respects, an LLC permits greater flexibility to business owners in how
they allocate income, gain, deduction, and loss. But the very fact that S
corporations may have less flexibility is a benefit to some business owners who
want the clear structure and rules that corporate law provides. The flexibility that
an LLC may enjoy can come at the cost of unwanted and unneeded complexity.
•An S corporation is a corporation, and an LLC is not a corporation. The Code
provides some benefits to corporations, irrespective of whether they are S or C
corporations that are not available to an LLC, e.g., a deduction of at least a portion
of dividends received from another corporation under § 243 and a deduction of all
dividends received from a foreign subsidiary, § 245A.
•The tax consequences of certain transactions to business owners are not always
the same between an S corporation and an LLC, e.g., loans incurred by the entity,
property distributions to owners. The circumstances of the taxpayer dictate
whether one treatment or the other of such transactions is to be preferred.

98 The S corporation is not subject “to the taxes imposed by this chapter.” That includes the alternative minimum

tax, the accumulated earnings tax, and the personal holding company tax – as well as the income tax.
See generally Bradley T. Borden, Ten Reasons to Prefer Tax Partnerships Over S-Corporations, 22 NYSBA N.Y. BUS. J.,
no. 2, Winter 2018, at 47 (includes reasons to prefer S-corporations).

99

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•Shareholders of an S corporation do not pay employment taxes on the dividends
they receive. Owners of LLC interests do pay employment taxes.
•The sale of S corporation stock is straight-forwardly the sale of a capital asset and
so gain is capital gain. The sale of an LLC interest is riddled with special rules
preserving the character of built-in gain (and
loss) as ordinary.
Default definition and tax rules
•An S corporation can be a party to a tax-deferred applicable to C and S
reorganization (see chapter 9, infra). Hence, the corporations: A “C corporation”
shareholders of the S corporation can exchange is “a corporation which is not an
their interest on a tax-deferred basis and enjoy S corporation for such year.” §
pass-through treatment before the reorganization. 1361(a)(2). Unless subchapter S
The tax consequences of reorganizations provides otherwise, subchapter
involving a “disregarded entity” are more C’s rules apply to S corporations
and their shareholders, except
problematic.
•A C corporation may elect to become an S to the extent inconsistent with it.
corporation if it is a “small business corporation” § 1371(a). Subchapter S leaves
and elects to be an S corporation. It can do this many topics untouched – and so
they are governed by the
without incurring the tax consequences of
principles of subchapter C.
liquidating, See chapter 6, supra. It cannot so
easily become an LLC.
•Both S corporations and LLCs are “pass-through” entities and can benefit from
the deduction of up to 20% of “qualified business income” under § 199A. S
corporations must pay reasonable compensation to shareholder-employees, and
such payments reduce the S corporation’s “qualified business income” and so also
its § 199A deduction.
Disqualified entities: Section
1361(b)(2) provides that an S
corporation may not be –
•a financial institution;
•an insurance company;
•a corporation that has
elected to receive a credit
under § 936 for income
derived from sources
within a U.S. possession; or
•a DISC or former DISC,
i.e., domestic international
sales corporation.

Definition of “small business corporation”: The Code
defines “small business corporation” in terms of its
ownership and of its stock – not in terms of assets,
profitability, or revenue. An “S corporation” is a “small
business corporation for which an election under §
1362(a) is in effect …” § 1361(a)(1). The fact of an
election or the failure to make an effective election has
considerable significance.

We note here the conditions of being a “small business
corporation.” The trend has been to expand eligibility
for S corporation status – but the conditions are quite
rigid. Meeting these conditions and continuing to
meet
them are very important because failure to do so results in a corporation at once becoming
a C corporation – whose income is subject to two levels of income tax if that income moves
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to the hands of shareholders. Section 1361(b)(1) provides that a “small business
corporation may have –
•no more than 100100 shareholders;
•only individuals as shareholders, as well as estates (decedent’s estate or bankrupt’s
estate, § 1361(c)(3)), certain trusts, tax-exempt § 501(c)(3) organizations, and taxexempt employer stock bonus, pension, or profit-sharing plans.
Thus, C corporations, partnerships, or other entities may not own shares of an S
corporation. A “small business corporation” may not have –
•a nonresident alien as a shareholder;101 or
•more than one class of stock.
An S corporation may own a C corporation, but a C corporation may not own an S
corporation. § 1361(b)(1)(B). In fact, an S corporation may not own shares of another S
corporation,102 unless it owns all the shares of an S corporation subsidiary.
Subsidiary S corporations: While a C corporation may S subsidiaries: Formation of a
not own shares of an S corporation, § 1361(b)(1)(B), an subsidiary enables the parent to
S corporation may have an S corporation as a wholly- shield itself from liabilities
arising from the subsidiary’s
owned subsidiary (“Qualified Subchapter S Subsidiary”
activities. There are no tax
(QSSS) or “Qsub”). The S corporation must own 100%
reasons for an S corporation to
of the Qsub’s stock and affirmatively elect to treat the form
an
S
corporation
subsidiary as a Qsub. § 1361(b)(3)(B). The Qsub is not subsidiary.
treated as a separate corporation for federal tax
purposes. Reg. § 1.1361-4(a)(i). Except for the 100% stock ownership requirement, the
Qsub’s stock is disregarded for federal tax purposes. Reg. § 1.13614(a)(4). “[A]ll assets,
liabilities, and items of income, deduction, and credit of a qualified subchapter S
subsidiary shall be treated as assets, liabilities, and such items (as the case may be) of the
S corporation.” § 1361(b)(3)(A)(ii).
If the Qsub ceases to qualify for Qsub status, then the Code requires that it be treated as a
new corporation that acquires all the former Qsub’s assets from the S corporation and
assumes all its liabilities immediately prior to such cessation in exchange for all the new
corporation’s stock. §1361(b)(3)(C)(i).

100 This number has been increased from 10 to 15, from 15 to 25, from 25 to 35, from 35 to 75, and from 75 to

100.
101 The Tax Cuts and Jobs Act (2017) amended § 1361(c)(2)(B) to permit a non-resident alien to be the beneficiary

of an electing small business trust.
102 Actually, the S corporation of which an S corporation may want to own shares cannot definitionally be an S

corporation. § 1361(b)(1)(B).

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•If termination of Qsub status occurs because the parent corporation sold stock of
the corporation and so is no longer the sole shareholder, the sale is to be treated as
the sale of an undivided interest in the assets of the former Qsub (pro rated to the
number of shares sold) followed by the Qsub corporation’s acquisition of all the
corporation’s assets and liabilities in a transaction to which § 351 applies. §
1361(b)(3)(C)(ii).
•A Qsub corporation whose status as such is terminated will not be eligible to make
a subchapter S election until the fifth taxable year that begins after the first taxable
year for which the termination was effective. § 1361(b)(3)(D). 103 Reg. § 13615(c)(2) provides that a former Qsub may make an S election if immediately
following termination it is otherwise eligible to make such an election and makes
such an election immediately following the termination of the Qsub election.

II. Conditions of Qualification for S Corporation Status
A. Counting Shareholders: Whom to Count
An S corporation can have no more than 100 shareholders. As a business grows and more
persons wish to own an interest in it, perhaps offspring of the founders, the importance of
rules for counting shareholders increases. Again, the penalty for running afoul of the rules
is that the corporation becomes a C corporation.
Basic rule: Reg. § 1.1361-1(e)(1) provides in part that “[o]rdinarily, the person who would
have to include in gross income dividends distributed with respect to the stock of the
corporation (if the corporation were a C corporation) is considered to be the shareholder
of the corporation.” Thus, each tenant in common and each joint tenant is a shareholder.
Id. “The person for whom stock of a corporation is held by a nominee, guardian, custodian,
or an agent is considered to be the shareholder of the corporation ...” Id.
Section 1361 does not contain attribution rules, but instead counts persons in various
relationships as a single shareholder. Counting two or more persons as a single shareholder
for purposes of counting shareholders does not eliminate the need for all such persons to
meet the other qualifications of being a shareholder of an S corporation.
•A husband and wife (and their estates) are treated as a single shareholder. §
1361(c)(1)(A)(i). Both must be citizens or residents of the United States. Reg. §
1.1361-1(e)(2). A married couple that divorces becomes two shareholders instead

103 ... unless the Secretary consents.

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of one. 104 Reg. § 1.1361-1(e)(2) (treatment as single shareholder ceases “upon
dissolution of the marriage for any reason other than death”).
•The American Jobs Creation Act of 2004 considerably enhanced the availability
of S corporation status to family-owned businesses. Members of a family (and their
estates) are treated as a single shareholder. § 1361(c)(1)(A)(ii). The phrase
“members of a family” means a “common ancestor, any lineal descendant of such
common ancestor, and any spouse or former spouse of such common ancestor or
any lineal descendant.” § 1361(c)(1)(B)(i).
•A “common ancestor” must on the “applicable date” be no more than six
generations removed from the youngest generation of shareholders. §
1361(c)(1)(B)(ii). The “applicable date” is the latest of the date of a subchapter S
election, the earliest date on which a family member owns stock, or October 22,
2004. § 1361(c)(1)(B)(iii).
•Thus, any and all of six generations of persons who trace their lineage back to one
common ancestor – no doubt long since dead – counts as one shareholder. This
rule applies when counting the number of shareholders and not for other purposes.
Reg. § 1.1361-1(e)(3)(i). Thus, any member of a family who owns shares must be
a citizen or resident of the United States, be an individual, and must consent to
election to be an S corporation. Reg. § 1.1361-1(e)(3)(i).
•As a descendant from a new generation acquires stock, the determinant “common
ancestor” moves down one generation.
With some planning, the 100-shareholder rule will not create insurmountable problems.
Nothing prevents would-be shareholders from forming a new subchapter S corporation
and then forming a partnership with one or more existing subchapter S corporations. Rev.
Rul. 94-43, 1994-2 C.B. 198 (“a shareholder of one S corporation [should not] be
considered a shareholder of another S corporation because the S corporations are partners
in a partnership”). The non-resident alien and non-entity ownership limitations may be the
more serious obstacles.

B. Who Can Be a Shareholder
Section 1361(b)(1)(B) provides – with some exceptions noted herein – that only an
“individual” may own stock in a “small business corporation.” This means that the stock
of an S corporation may not be owned by business entities, e.g., corporations, partnerships,
LLCs, and even other S corporations. See Reg. § 1.1361-1(f). Section 1361(b)(1)(C)
specifies that an S corporation may not have a nonresident alien as a shareholder.

104 A tax planner should anticipate this eventuality, perhaps by making divorce the triggering event of a transfer

of stock to one spouse by the other.

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Section 1361(b)(1)(B) permits an “estate” to be the shareholder of an S corporation. The
estate, and not its beneficiary(ies), is the shareholder. Reg. § 1.1361-1(e)(1). An “estate”
may be the “estate” of an “individual” in a bankruptcy case. § 1361(c)(3).
Section 1361(b)(1)(B) provides that certain trusts may be shareholders of a “small business
corporation.” Such trusts include –
•a grantor trust (subject to §§ 671-679) “all of which is treated ... as owned by an
individual who is a citizen or resident of the United States,” § 1361(c)(2)(A)(i); the
owner is the shareholder, § 1361(c)(2)(B)(i);
•a grantor trust whose owner dies and which continues in existence after the owner’s
death for no more than two years after the owner’s
death, § 1361(c)(2)(A)(ii); the estate of the deemed
Trusts: How many shareholders
to count. In examining the
owner is the shareholder, § 1361(c)(2)(B)(ii);
shareholder count when a trust
•a trust with respect to stock transferred to it by will
holds shares of the S
for no more than two years after such transfer, §
corporation, notice when we do
1361(c)(2)(A)(iii); the estate of the testator is the
not “look through” the entity –
shareholder, § 1361(c)(B)(iii);
thereby potentially enlarging
•a trust created “primarily to exercise the voting
the count.
power of stock transferred to it,” §
1361(c)(2)(A)(iv); each beneficiary is a
shareholder, § 1361(c)(2)(B)(iv);
•“[a]n electing small business trust,” infra, § 1361(c)(2)(A)(v); each potential
beneficiary is a shareholder unless there is no beneficiary, in which case the trust
is a shareholder, § 1361(c)(2)(B)(v); and
•an IRA trust or Roth IRA trust held by a financial institution to the extent of the
stock held by such trusts when this provision was enacted,105 § 1361(c)(2)(A)(vi);
the individual for whose benefit the trust was created is a shareholder, §
1361(c)(2)(B)(v).
Qualified Subchapter S Trust (QSST): A QSST is treated
The point of a QSST: A QSST is
as a “grantor trust.” A QSST is a trust whose terms require
an estate planning tool. Rather
that –
than gifting stock to persons to
•during the life of the current income beneficiary whom the owner of the stock
there can be only one beneficiary of the trust, § may not wish to transfer control,
1361(d)(3)(A)(i);
the owner of stock can shift
•any distribution of trust corpus during the life of income and appreciation in the
the current income beneficiary can be made only stock’s value to them.
to that beneficiary, § 1361(d)(3)(A)(ii);
•the income interest of the current beneficiary must terminate on the earlier of the
income beneficiary’s death or the termination of the trust, § 1361(d)(3)(A)(iii);

105 October 22, 2004. American Jobs Creation Act of 2204, P.L. 108-357, § 233(a).

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•upon termination of the trust during the income beneficiary’s life, the trust must
distribute all its assets to that beneficiary, § 1361(d)(3)(A)(iv); and
•the individual to whom all the income is distributed (or required to be distributed)
currently is a United States citizen or resident, § 1361(d)(3)(B).
“If the terms of the trust do not preclude the possibility that any of the[se] requirements ...
will not be met, the trust will not qualify as a QSST.” Reg. § 1.1361-1(j)(1)(iii). “A
substantially separate and independent share of a trust within the meaning of § 663(c)106
shall be treated as a separate trust” for these purposes. § 1361(d)(3).
If the beneficiary of a QSST elects, 107 the trust will be treated as a grantor trust, §
1361(d)(1)(A), and the beneficiary treated as the owner of stock in the corporation with
respect to which the election is made, § 1361(d)(1)(B). The trust’s disposition of the stock
is treated as a disposition by the beneficiary – thus allowing the beneficiary to deduct
losses suspended under §§ 465 and 469. § 1361(d)(1)(C).
Electing Small Business Trust (ESBT): An “electing small business trust” is a trust that has
as beneficiaries only –
•an individual,
•an estate,
•the charitable organizations listed in §§ 170(c)(2, 3, 4, and 5),108 and
•organizations that are charitable under § 170(c)(1) and which hold a contingent
interest in the trust and are not current beneficiaries.109 § 1361(e)(1)(A)(i).
No interest in an ESBT may be acquired by purchase. § 1361(e)(1)(A)(ii). The trustee must
make an election for a trust to be an ESBT. §§ 1361(e)(1)(A), 1361(e)(3). The following
entities may not be beneficiaries of an ESBT:
•a QSST;
•a trust whose income is exempt from income tax; or
•a charitable remainder trust or charitable remainder unitrust. § 1361(e)(1)(B).
An ESBT is an eligible shareholder. § 1361(c)(2)(A)(v). An ESBT may have more than
one beneficiary, but unlike a QSST, each “potential current beneficiary” counts as a
106 These sections establish rules for the distribution by a single trust to more than one beneficiary and the

treatment of the trust as separate trusts.
107 Section 1361(d)(2) establishes rules governing the timing and effect of the election as well as its application to

successive beneficiaries. The election is revocable only upon consent of the Secretary, § 1361(d)(2)(C).
108 This includes all the organizations to which or for the use of which a taxpayer may deduct a contribution –

except for governmental entities within the United States. §§ 170(c)(2, 3, 4, and 5).
109 This includes governmental units within the United States. § 170(c)(1).

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shareholder. Reg. § 1.1361-1(m)(4)(i). The Tax Cuts and Jobs Act amended §
1361(c)(2)(B)(v) to permit a “potential current beneficiary” to be a non-resident alien. “A
person is treated as a shareholder of the S corporation at any moment in time when that
person is entitled to, or in the discretion of any person may, receive a distribution of
principal or income of the trust.” Reg. § 1361-1(m)(4)(i); see § 1361(c)(2)(B)(v). If there
is no potential current beneficiary, then the trust is treated as the shareholder. §
1361(c)(2)(B)(v). There are special rules for taxing the income of the ESBT. Like the
QSST, the ESBT is particularly useful as an estate planning tool.

Problems:
1. Can a corporation with 101 shareholders, two of whom are first cousins, qualify as a
“small business corporation, assuming it meets all of the other requirements and elects to
be an S corporation?
2. The XYZ partnership engages in the practice of law; its specialty is probate law. The
ABC partnership engages in the practice of law; its specialty is criminal law. The PQR
partnership engages in the practice of law; its specialty is real estate law. All three
partnerships have their offices in the Fourth National Bank Building. Many other tenants
also rent space in the Fourth National Bank Building. The three partnerships are
considering forming an S corporation for the purpose of offering various services useful
to other businesses in the Fourth National Bank Building on an occasional basis, e.g., large
copying jobs, preparation of packages for mailing. There are a total of 21 partners in the
three law firms, and all are U.S. citizens. Would the entity they contemplate forming be a
“small business corporation?”
3. Taxpayer married a university student that he met while taking a night class. The student
is in the United States on a student visa and is classified as a non-resident alien. Can
taxpayer be a shareholder in an S corporation?
4. XYZ formed a “small business corporation” that elected S corporation status. Z died. Z’s
estate now owns all the property that Z owned. Has the XYZ Corporation lost its S
corporation status?

C. One Class of Stock
An S corporation may not have more than one class of stock. § 1361(b)(1)(D). In enacting
this limitation, Congress did not intend that S corporations could issue only one, plain
vanilla, class of common stock.
Identical rights to distributions and to share in corporate growth: A corporation does not
have more than one “class of stock solely because there are differences in voting rights
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among the shares of common stock.” § 1361(c)(4). “[A] corporation is treated as having
only one class of stock if all outstanding shares of stock of the corporation confer identical
rights to distribution and liquidation proceeds. Differences in voting rights are disregarded
in determining whether a corporation has more than one class of stock.” Reg. §
1.13611(l)(1).
•Reg. § 1.1361-1(l)(2)(i) provides in part: “The determination of whether all
outstanding shares confer identical rights to distribution and liquidation proceeds
is made based on the corporate charter, articles of incorporation, bylaws,
applicable state law, and binding agreements relating to distributions and
liquidation proceeds (collectively, the governing provisions). A commercial
contractual agreement, such as a lease, employment agreement, or loan agreement
is not a binding agreement relating to distribution and liquidation proceeds and
thus is not a governing provision unless a principal purpose of the agreement is to
circumvent the one class of stock requirement ...”
Standing alone, distributions that take account of shareholders’ varying interests in the
current or immediately preceding taxable year do not alter the rights to liquidation and
distribution proceeds. Reg. § 1.1361-1(l)(2)(iv).
Some common planning devices and financing devices might appear to confer different
rights to distributions and to liquidation proceeds. The regulations provide specific
guidance.
Buy-sell and redemption agreements: Buy-sell and redemption agreements are often
important instruments of transition in closely-held corporations. “Buy-sell agreements
among shareholders, agreements restricting the transferability of stock, and redemption
agreements are disregarded in determining whether a corporation’s outstanding shares of
stock confer identical distribution and liquidation rights ...” Reg. § 1.1361-(l)(2)(iii)(A).
Exceptions to this rule are made for –
•agreements whose purpose is to circumvent the one-class of-stock requirement.
Reg. § 1.1361-1(l)(2)(iii)(A)(1).
•agreements that establish a purchase price “significantly” greater than or less than
the fair market value of the stock. Reg. § 1.1361-(l)(2)(iii)(A)(2). A price that is
“at book value or at a price between fair market value and book value ... [is not]
significantly in excess of or below the fair market value of the stock, and, thus [is]
disregarded in determining whether the outstanding shares of stock confer identical
rights.” Id.
•bona fide agreements “to redeem or purchase stock at the time of death,
divorce, disability, or termination of employment ...” Reg. §
1.13611(l)(2)(iii)(B) are disregarded in determining whether a
corporation’s shares confer identical rights.
•forfeiture provisions that cause stock to be nonvested are also disregarded.
Id.
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Debt: Certain debt instruments might constitute a second class of stock; deferred
compensation plans do not.110 Reg. § 1.1361-1(l)(4)(i). If an instrument, obligation, or
arrangement (including convertible debt, Reg. § 1.1361-1(l)(4)(iv)(A)) constitutes an
equity interest for purposes of federal tax law and has a principal purpose of circumventing
others’ rights to distribution or liquidation proceeds or circumventing the limitation on
eligible shareholders, then it constitutes a second class of stock. Reg. § 1.13611(l)(4)(ii)(A).
•There are two safe harbors to this rule.
•Shareholder advances of $10,000 or less, i.e., “[u]nwritten advances from
a shareholder that do not exceed $10,000 in the aggregate at any time
during the taxable year of the corporation, are treated as debt by the parties,
and are expected to be repaid within a reasonable time are not treated as a
second class of stock ...” Reg. § 1.1361-1(l)(4)(ii)(B)(1).
•Shareholders who hold the same class of obligation proportionately do not
hold a second class of stock even if such obligations are considered equity
under federal law unless “a principal purpose of the obligations is to
circumvent the rights of the outstanding shares of stock or the limitation on
eligible shareholders to distribution or liquidation proceeds or to
circumvent the limitation on the number of eligible shareholders. Reg.
§ 1.1361-1(l)(4)(ii)(B)(2).
Calls and convertible debt: A call option may be a second class of stock if it is
“substantially certain” to be exercised and has a strike price substantially below the fair
market value of the underlying stock on the date the call option is issued, is transferred to
one not eligible to be a subchapter S shareholder, or is substantially modified. Reg. §
1.1361-1(l)(4)(iii)(A). The same is true of convertible debt that embodies these rights. Reg.
§ 1.1361-1(l)(4)(iv)(B).
•A strike price that is more than 90% of the fair market value of the underlying
stock on the date the option is issued is not substantially below its fair market value.
Reg. § 1.13611(l)(4)(iii)(C).
•A call option does not have a strike price substantially below the fair market value
of the stock at the time of issue if pursuant to the terms of the instrument the price
at the time of exercise cannot be substantially below the fair market value at the
time of exercise. Reg. § 1.13611(l)(4)(iii)(A).
•The regulations make exceptions to this rule for those in the business of lending
and the call option is issued “in connection with a commercially reasonable loan
to the corporation.” Reg. § 1.1361-1(l)(4)(iii)(B)(1).

110 ... so long as the plan does not convey the right to vote, is an unfunded and unsecured promise to pay in the

future, is issued to individual who is an employee or independent contractor who performs services for the
corporation, and whose benefits are not subject to current tax. See Reg. § 1.1361-1(b)(4).

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•There is also an exception for call options issued to employees or independent
contractors “in connection with” the performance of services for the corporation
(or a related corporation) if the call option is not transferable and does not have a
readily ascertainable fair market value. Reg. § 1.1361-1(l)(4)(iii)(B)(2).
“Straight Debt”: “Straight debt” is not a second class of stock, § 1361(c)(5)(A), even if it
is treated as equity under general principles of tax law, Reg. § 1.1361-1(l)(iv). “Straight
debt” is a “written unconditional promise to pay” a sum certain in money on a specified
date. § 1361(c)(5)(B). The interest rate on “straight debt” may not be contingent on profits,
the borrower’s discretion, etc., the debt cannot be directly or indirectly convertible into
stock, and the lender must be an individual, an estate, a trust eligible to be a shareholder,
or “person” actively and regularly “engaged in the business of lending money.” §
1361(c)(5)(B). Subordinated debt can be “straight debt.” Reg. § 1.1361-1(l)(5)(ii).

Problems:
In the following situations, has the corporation issued a second class of stock?
1. The law of State A requires that permission be obtained from the State Commissioner
of Corporations before stock may be issued by a corporation. The Commissioner grants
permission to S, a corporation, to issue its stock subject to the restriction that any person
who is issued stock in exchange for property, and not cash, must waive all rights to receive
distributions until the shareholders who contributed cash for stock have received
distributions in the amount of their cash contributions. See Reg. § 1.1361-1(l)(2)(vi)
Example 1. See also Paige v. United States, 580 F.2d 960 (9th Cir. 1978).
2. S, a corporation, has two equal shareholders, A and B. Under S’s bylaws, A and B are
entitled to equal distributions. S distributes $50,000 to A in the current year, but does not
distribute $50,000 to B until one year later. The circumstances indicate that the difference
in timing did not occur by reason of a binding agreement relating to distribution or
liquidation proceeds. See Reg. § 1.1361-1(l)(2)(vi) Example 2.
3. S, a corporation, has two equal shareholders, C and D, who are each employed by S
and have binding employment agreements with S. The compensation paid by S to C under
C’s employment agreement is reasonable. The compensation paid by S to D under D’s
employment agreement, however, is found to be excessive. The facts and circumstances
do not reflect that a principal purpose of D’s employment agreement is to circumvent the
one class of stock requirement. See Reg. § 1.1361-1(l)(2)(vi) Example 3.
4. S, a corporation, is required under binding agreements to pay accident and health
insurance premiums on behalf of certain of its employees who are also shareholders.
Different premium amounts are paid by S for each employee-shareholder. The facts and
circumstances do not reflect that a principal purpose of the agreements is to circumvent
the one class of stock requirement. See Reg. § 1.1361-1(l)(2)(vi) Example 4.
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5. E is a shareholder of S, a corporation. S makes a below-market loan to E that is a
corporation-shareholder loan to which § 7872 applies. Under § 7872, E is deemed to
receive a distribution with respect to S stock by reason of the loan. The facts and
circumstances do not reflect that a principal purpose of the loan is to circumvent the one
class of stock requirement. See Reg. § 1.1361-1(l)(2)(vi) Example 5.
6. S, a corporation, executes a binding agreement with its shareholders to modify its
normal distribution policy by making upward adjustments of its distributions to those
shareholders who bear heavier state tax burdens. The adjustments are based on a formula
that will give the shareholders equal after-tax distributions. See Reg. § 1.1361-1(l)(2)(vi)
Example 6.
7. F, G, and H are shareholders of S, a corporation. F is also an employee of S. By
agreement, S is to redeem F’s shares on the termination of F’s employment. See Reg. §
1.1361-1(l)(2)(vi) Example 8.

Do the CALI exercise:
S Corporation Taxation: Formation and Qualification: Eligibility as Small Business
Corporation.

D. Making the Election and Terminating the Election
A “small business corporation” may “elect” to be an S corporation. § 1362(a)(1). All
shareholders must consent to the election. § 1362(a)(2). The statute and regulations
prescribe rules governing this election, and the consequences of not following them can
be costly. A corporation that is not an S corporation is a C corporation, and a C
corporation’s income that devolves to a shareholder is subject to two levels of income tax.
The corporation and its shareholders make their election by filing Form 2553. Reg. §
1.1362-6(a)(2). A shareholder may alternatively make an election on a separate statement.
Reg. § 1.1362-6(b)(3)(i). Once an election is effective, new shareholders need not consent
to the election. Reg. § 1.1362-6(a)(2)(i).
The statute prescribes when the election is effective – an important matter because until
the election is effective, the “small business corporation” is a C corporation.
•An election that the shareholders make any time during a taxable year is effective
for the next taxable year. § 1362(b)(1)(A).
•The shareholders may also make an election for the current taxable year any time
before the 15th day of the third month of its taxable year, § 1362(b)(1)(B), but the
corporation must have been a “small business corporation” for every single day
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prior to the election and every shareholder who held stock during that period must
have consented to the election, § 1362(b)(2)(B).
•However, if the effective date of the election is in the future, the “small business
corporation” must be such on the day of the election and the day of effectiveness
– but not necessarily the time between. Reg. § 1.1362-2(b)(2) (“election does not
terminate even if the corporation was not a small business corporation during all
or part of the period beginning after the date the election was made and ending
before the first day of the taxable year for which the election is effective”).
•An election made after the 15th day of the third month of the taxable year is treated
as made for the following taxable year. § 1362(b)(3).
•The Secretary may determine that there was reasonable cause for not making the
election and treat the election as having been timely made. § 1362(b)(5).
•The election, once effective, is effective for all succeeding years until terminated.
§ 1362(c).
If –
•an election with respect to an S corporation or an S subsidiary is not effective
because of failure to be a “small business corporation,” for failure to obtain the
necessary consents, for failure to make an election in compliance with the rules
governing trusts or QSSTs (§ 1362(f)(1)), and
•the Secretary determines the circumstances causing such ineffectiveness or
termination of election were inadvertent, § 1362(f)(2), and
•after the lapse of no more than a reasonable time, steps are taken to bring the
corporation into compliance, § 1362(f)(3), and
•the corporation and every person who was a shareholder at any time such steps
are executed agrees to make such adjustments that the Secretary prescribes, THEN
•the corporation will be an S corporation or subchapter S subsidiary during the
period that the Secretary names. § 1362(f) (carryout ¶).
A corporation (and its successors111) whose valid election has been terminated may not
again make an S corporation election before the fifth taxable year that begins after the first
taxable year for which the termination was effective – unless the Secretary consents to
such an election. § 1362(g). Thus, if a revocation is effective in year 1, the corporation
may elect subchapter S status effective for the first day of year 6. The Secretary
automatically consents if the election was invalid from its inception – even if manifested
by retroactive revocation – so that the S corporation election was never effective. Reg. §
1.1362-5(c).
111 A corporation is a successor if 50% or more of its shares are owned, directly or indirectly, by the same persons

who owned 50% or more of the predecessor corporation on the date of termination, and the successor
corporation must already own or acquire a substantial portion of the assets of the predecessor corporation. Reg.
§ 1362-5(b).

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Do the CALI exercise:
S Corporation Taxation: Formation and Qualification: S Corporation Elections.

The following cases raise several formation/termination issues and may give some context
to the rules, as well as a sense of what is at stake.

Kean v. Commissioner, 469 F.2d 1183 (9th Cir. 1972)
WM. MATTHEW BYRNE, Jr., District Judge
Appellants, petitioners in the Tax Court, were shareholders in Ocean Shores Bowl, Inc.,
hereinafter referred to as Bowl, a Washington corporation. They appeal from a judgment
of the Tax Court invalidating Bowl’s election under Subchapter S, §§ 1371-1379 of the
Code, and disallowing petitioners’ deductions on their personal tax returns of their pro rata
shares of Bowl’s 1962 and 1963 net operating losses.
Bowl was formed on March 20, 1962 and had only one class of stock issued and
outstanding. On October 30, 1962 Bowl filed a timely election to be taxed as a small
business corporation pursuant to § 1372 of the Code. Consents to such election were
contemporaneously filed by all of the shareholders of record and their wives. As a result
of the election, Bowl’s net operating losses of $15,316 for the short taxable year 1962 and
$56,638.28 for 1963 were deducted in pro rata shares by petitioners on their 1962 and
1963 personal income tax returns.
Some Bowl debentures and 125 shares of Bowl stock were held in the name of petitioner,
William MacPherson. He and his brother, petitioner Murdock MacPherson, were engaged
in the real estate business in a company called MacPhersons, Inc. Each brother owned 45%
of the stock of MacPhersons, Inc. with the remaining 10% being held by their mother.
William and Murdock MacPherson had many joint investments which were conducted
without any written agreement. Whoever initiated the investment would normally be
responsible for its management. Neither held a power of attorney for the other. The books
and records of MacPhersons, Inc. were maintained by its employee, Donald Minkler.
On their 1962 joint income tax return William MacPherson and his wife deducted the net
operating loss of Bowl accruing to the 125 shares in William’s name. In 1963 William
MacPherson and his wife deducted one half of the net operating loss for that year attributed
to said shares while Murdock MacPherson and his wife deducted the other one half on
their joint return. In 1964 the William MacPhersons and the Murdock MacPhersons each
reported the sale of one half of the 125 shares of Bowl stock and one half of the Bowl
debentures. All of these returns were prepared by Donald Minkler.
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A 1965 Internal Revenue Service audit disclosed that the 125 shares of Bowl stock and
Bowl debentures, issued to William MacPherson in 1962, were purchased with a
MacPhersons, Inc. check. The cost of the purchase was charged on the books of
MacPhersons, Inc. equally against the drawing accounts of William and Murdock.
Murdock MacPherson has never been repaid by William MacPherson for the amounts
taken out of his drawing account to pay for the stock and debentures.
Murdock MacPherson was not a shareholder of record of Bowl. Neither he nor his wife
were mentioned in the Subchapter S election filed with the Internal Revenue Service in
October, 1962; nor did they file a consent to the election. None of the other shareholders
knew that Murdock MacPherson was involved in any way with Bowl until the 1965 audit.
The Tax Court held that Bowl’s Subchapter S election was invalid because Murdock
MacPherson, as a beneficial owner of Bowl stock, was a shareholder within the meaning
of § 1372 and had not consented to the corporation’s election. Based on this finding, the
court disallowed petitioners’ deduction of their pro rata shares of the corporation’s net
operating losses.
Subchapter S of the Internal Revenue Code of 1954 allows a small business corporation,
as defined by § 1371, to elect to be exempt from corporate income taxes with the
consequence that its shareholders are taxed directly on the corporation’s earnings or may
deduct the corporation’s losses. Section 1372 provides that the corporation’s election is
“valid only if all persons who are shareholders ... consent to such election.”
Petitioners contend that since Murdock MacPherson was not a shareholder of record and
was not able to exercise any rights as a shareholder under Washington law, he was not a
“shareholder” under § 1372. We disagree. The question of who is a shareholder as the term
is used in Subchapter S must be determined by federal rather than state law. [citations
omitted]. Reg. § 1.1371-1(d)(1), implementing Subchapter S, states that “Ordinarily, the
persons who would have to include in gross income dividends distributed with respect to
the stock of the corporation are considered to be shareholders of the corporation.”
Petitioners challenge the validity of this regulation on the ground that it has no statutory
basis and is in conflict with the legislative history. They rely on a portion of the report of
the Senate Finance Committee discussing Subchapter S which stated:
An election may be made to supply the tax treatment provided by this new
subchapter only if all of the shareholders consent to this election. For this purpose
the shareholders are those of record as of the first day of the taxable year in
question, or if the election is made after that time, shareholders of record when the
election is made.

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S. REP. NO. 1900, 85th Cong., 2nd Sess., p. 87.
The Tax Court in Alfred N. Hoffman, 47 T.C. 218, 235 (1966), aff’d sub nom. Hoffman v.
Commissioner of Internal Revenue, 391 F.2d 930 (5th Cir. 1968), in considering the
contention that a shareholder of record rather than the beneficial owner of the stock must
consent to the Subchapter S election, discussed the report of the Senate Finance Committee
as follows:
While this use of the words ‘of record’ furnishes some support for petitioner’s
position, it is entirely inconsistent with the basic congressional purpose to tax the
undistributed corporate income only to the persons who are accountable for
dividends paid by the corporation, and those persons are the real owners of the
stock whether or not they are the shareholders ‘of record.’ In the circumstances,
we must rely upon the all pervasive legislative purpose and not upon the foregoing
fragmentary phrase in the committee report.
Subchapter S allows shareholders of a small business corporation to elect alternative tax
consequences resulting from stock ownership. Without a Subchapter S election the
corporation is liable for corporate taxes, the shareholders cannot deduct corporate losses,
and only distributed dividends are subject to the personal income tax. If the election is
made, the corporation is exempt from corporate taxes and the shareholders may deduct
corporate net operating losses but must pay personal income tax on all corporate income
whether distributed or not. The desirability of a Subchapter S election depends upon the
individual tax considerations of each shareholder. The final determination of whether there
is to be an election should be made by those who would suffer the tax consequences of it.
Therefore, “shareholders” who must file a consent are not necessarily “shareholders of
record” but rather beneficial owners of shares “who would have to include in gross income
dividends distributed with respect to the stock of the corporation.” Reg. § 1.1371-1(d)(1),
Alfred N. Hoffman, supra.
A treasury regulation which supplies the definition that Congress omitted must be
sustained unless unreasonable and obviously inconsistent with the statute. [citations
omitted]. Reg. § 1.1371-1(d)(1) is consistent with the basic purpose of Subchapter S and
reasonably implements the legislative mandate.
We conclude, as did the Tax Court, that William and Murdock MacPherson jointly
invested in the 125 shares of Bowl stock issued to William MacPherson. Murdock
MacPherson was the beneficial owner of one half of that stock in William MacPherson’s
name and must be considered a “shareholder” for the purpose of § 1372. Murdock
MacPherson’s failure to file a consent invalidates Bowl’s Subchapter S election.
Therefore, petitioners were not entitled to deduct their pro rata shares of Bowl’s net
operating loss for 1962 and 1963.

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....
... [P]etitioners contend that the District Director abused the discretion reposed in him by
Reg. § 1.1372-3(c)112 and that the Tax Court erred in refusing to review the exercise of
the District Director’s discretion.
After the judgment of the Tax Court finding that Bowl’s Subchapter S election was invalid
due to Murdock MacPherson’s failure to consent, petitioners requested of the District
Director an extension of time, pursuant to Reg. § 1.1372-3(c), in which to file consents.
All the petitioners offered to file new consents for the years 1962 and 1963.
The District Director denied the request. Petitioners then filed a motion in the Tax Court
for retrial, further trial or reconsideration, seeking a review of the discretion exercised by
the District Director. The Tax Court denied the motion.
The District Director advised petitioners that he was rejecting the request for an extension
because the Tax Court had “issued an opinion in these cases ... and because we do not feel
the circumstances of this matter meet the requirements of Regs. § 1.1372-3(c).” [footnote
omitted].
The fact that the Tax Court had issued an opinion invalidating Bowl’s Subchapter S
election was not a basis for refusing to allow petitioners an extension of time to file
consents. At the time the opinion was filed, no request had been made to the District
Director and nothing in the opinion precluded him from granting a subsequent request for
extension.

112

Reg. § 1.1372-3(c):

Extension of time for filing consents. An election which is timely filed for any taxable year and which would be
valid, or would not have terminated, except for the failure of any shareholder to file a consent within the time
prescribed in paragraph (a) or (b) of this section will not be invalid, or will not be treated as having terminated,
for such reason if –
(1) It is shown to the satisfaction of the district director or director of the service center that there was
reasonable cause for the failure to file such consent and that the interests of the Government will not
be jeopardized by treating such election as valid, or as not having terminated,
(2) Such shareholder files a proper consent to the election within such extended period of time as may
be granted by the Internal Revenue Service, and
(3) New consents are filed within such extended period of time as may be granted by the Internal
Revenue Service, by all persons who were shareholders of the corporation at any time during the taxable
year with respect to which the failure to consent would (but for the provisions of this paragraph) cause
the corporation’s election to be invalid or to terminate, and by all persons who were shareholders of the
corporation subsequent to such taxable year and prior to the date on which an extension of time is
granted in accordance with this paragraph.

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Additionally, there is no valid basis for the District Director’s determination that the
requirements of Reg. § 1.1372-3(c) had not been met. Under the regulation the failure to
file a consent will not invalidate the Subchapter S election and an extension of time to file
new consents should be granted if it is shown to the satisfaction of the District Director
that: (1) there was reasonable cause for the failure to file such consent, and (2) the
government interest will not be jeopardized by treating the Subchapter S election as valid.
There was reasonable cause for Murdock MacPherson’s failure to file a timely consent.
Murdock MacPherson was not a shareholder of record. He believed that whatever
ownership interest he had in the shares did not necessitate his consent to Bowl’s election.
When the Internal Revenue Service disagreed with this position, the petitioners sought a
judicial determination. Until the Tax Court issued its opinion, Murdock MacPherson did
not know that his consent was required to consummate Bowl’s election under § 1371.
Furthermore, there is nothing to indicate that any government interest is jeopardized by
now validating the Subchapter S election.
At the time of the Subchapter S election, petitioners, other than possibly the MacPhersons,
did not know or have reason to suspect that Murdock MacPherson had any ownership
interest in Bowl’s stock. The District Director’s failure to exercise his discretion so as to
allow petitioners to file their consents deprives eight taxpayers of deductions taken in good
faith ten years earlier and saddles each taxpayer with a substantial liability for back taxes.
It is apparent that Reg. § 1.1372-3(c) was promulgated to prevent the harsh result reached
in cases of this kind.
The District Director abused his discretion by arbitrarily refusing to allow petitioners an
extension of time in which to file their consent to Bowl’s Subchapter S election. [citations
omitted].
We affirm the opinion of the Tax Court, except with regard to its refusal to review the
exercise of the District Director’s discretion, and order the District Director to grant
petitioners an extension of time to file the consents pursuant to Reg. § 1.1372-3(c).

Questions and comments:
1. What is now § 1362 was § 1372. The numbers of the relevant regulations similarly
changed.
2. “Beneficial owners” of stock must consent to the election to be an S corporation. The
court said of this requirement:
Reg. § 1.1371-1(d)(1), implementing Subchapter S, states that “Ordinarily, the
persons who would have to include in gross income dividends distributed with

332

respect to the stock of the corporation are considered to be shareholders of the
corporation.”
The quoted portion of this excerpt is now included verbatim at Reg. § 1.1361-1(e)(1).
3. Tax consequences of incorporation: The tax consequences of incorporation are
established in §§ 351, 358, and 362. The basic rules of subchapter K, which governs
income taxation of partnerships, are that built-in gains on contributions of property are not
recognized. However, when a recognition event occurs with respect to property that a
partner contributed, gains/losses must be recognized by the contributing partner to the
extent thereof at the time of contribution.113 In what significant way(s) do tax-deferred
transfers to an S corporation differ from tax-deferred contributions to a partnership?
4. What happens when one minority shareholder wants to terminate the S election, but the
majority of shareholders do not want to terminate the election? All the minority
shareholder needs to do to get her way is transfer a few shares to an ineligible shareholder,
and the majority shareholders can do nothing to stop her, right?

A.W. Chesterton Company, Inc. v. Chesterton, 128 F.3d 1 (1st Cir. 1997)
LYNCH, Circuit Judge
This appeal involves the duties imposed by Massachusetts law on a minority shareholder
in a closely held corporation. Arthur W. Chesterton (“Chesterton”), a minority shareholder
in the A.W. Chesterton Company, frustrated in his efforts to dispose of his shares,
proposed to transfer a portion of his stock in the Company to two shell corporations.
Because such a transfer would terminate the Company’s advantageous Subchapter S status
..., the district court found that the proposed transfer violated Chesterton’s fiduciary duty
to the Company and enjoined him from proceeding with the transfer. Chesterton appeals
this finding and injunction, as well as the district court’s denial of Chesterton’s
counterclaim for relief under M.G.L. ch. 156B. We affirm.
I.
....
The Company has been a closely held Massachusetts corporation since its inception in
1885, and is currently owned and operated by the descendants of the Company’s founder,
Arthur W. Chesterton. Chesterton, the defendant in this case and the grandson of the

113 This may be a policy of subchapter K, but it is not perfectly executed in all cases.

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original Arthur Chesterton, is currently the Company’s largest shareholder, with 27.06%
of the Company’s stock. The Company and its affiliates manufacture mechanical seals,
packaging, pumps and related products, which are distributed throughout the world.
….
… [I]n 1985, … the Company’s Board of Directors voted to change the Company’s status
... from a Subchapter C corporation to a Subchapter S corporation. The Board perceived
Subchapter S status as advantageous to the Company because it allows shareholders in a
small business corporation to avoid the double taxation of income to which shareholders
in a Subchapter C corporation are subject. The income of a Subchapter C corporation is
taxed first at the corporate level when the company earns income, and a second time at the
shareholder level when the shareholders receive the income in the form of dividends. A
Subchapter S corporation, in contrast, is not taxed at the corporate level; rather, each
shareholder pays income tax individually in proportion to her share of ownership in the
corporation.114 See 26 U.S.C. §§ 1361-1399.
In order to qualify for Subchapter S treatment, a corporation must be a domestic
corporation which does not (1) have more than [100] shareholders, (2) have a corporation
or other nonindividual as a shareholder, (3) have a non-resident alien as a shareholder, and
(4) have more than one class of stock. 26 U.S.C. § 1361(b). Failure to abide by any of
these limitations results in automatic termination of Subchapter S status. 26 U.S.C.
§ 1362(d)(2).
After the Company Board voted to adopt Subchapter S status, the officers and directors
sought to inform the shareholders about the benefits and limitations of the S election, and
recommended that the shareholders give their consent. ... [T]he unanimous consent of the
shareholders of a corporation is required in order to finalize a Subchapter S election. 26
U.S.C. § 1362(a)(2). As an officer and director of the Company at the time, Chesterton
was heavily involved in this process. He led and participated in shareholder meetings
regarding the Subchapter S election. At those meetings the shareholders were provided
with information regarding the benefits of Subchapter S election, as well as the limitations
it imposed. The shareholders unanimously consented to the Subchapter S election. Implicit
in this consent was a general understanding among the shareholders that they would take
no action that would adversely affect the Company’s Subchapter S status.

114 There is a drawback to Subchapter S status known as “phantom income.” That phrase describes the liability

that shareholders in an S corporation face for taxes on their share of the corporation’s profits, even if those profits
are not distributed to the shareholders as dividends. …

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In the early 1990’s, Chesterton became discontented with the Company’s performance,
including its declining profits, heavy debt, and credit problems.115 Chesterton also objects
to a financial arrangement that the Company has with Chesterton International, B.V.
(“BV”), a Company affiliate. 116 Under the arrangement, the affiliate BV pays the
Company a large management fee,117 which has allowed the Company to continue to pay
dividends to its shareholders, despite its poor financial performance. Chesterton believes
that this arrangement masks the Company’s dire financial straights [sic straits]. He also
objects to the arrangement because much of the management fee is funnelled into
Company pension plans, from which Chesterton does not benefit because he is not a
current Company employee.
Because of his dissatisfaction with the Company, Chesterton sought to sell his Company
stock. He found little interest because all he could offer was a minority of shares. After
some failed efforts to locate an investor willing to purchase his stock outright, Chesterton
devised the scheme at issue in this case. Chesterton proposed to transfer a portion of his
shares to two shell corporations which are wholly-owned by him. Chesterton complied
with the Articles of Organization by providing the Company with the proper notice of his
proposed transfer so that it could purchase his shares. The Company, however, declined
because it lacks the ability to purchase the shares.
When the Company would not purchase his shares, Chesterton sought to proceed with the
transfer. But that transfer would have a deleterious effect on the Company’s tax status.
The Company and its shareholders derive significant tax benefits from the Company’s
status as a Subchapter S corporation. Should a corporation become a Company
shareholder, as it would under Chesterton’s proposed transfer, the Subchapter S status
terminates automatically. 26 U.S.C. § 1362(d)(2). If Chesterton were to consummate his
proposed transfer to the shell corporations, the Company would revert to Subchapter C
status. The Company’s Subchapter S status enabled it to distribute an additional $5.3
million in dividends between 1985 and 1995. Reversion to Subchapter C status would
represent a significant financial loss for the Company and its shareholders. Once a
corporation loses its Subchapter S status, it cannot reattain that status for a minimum of
five years. 26 U.S.C. § 1362(g). In fact, loss of Subchapter S status would have a more
severe effect on the Company because it is currently grandfathered under an old provision
which exempted Subchapter S corporations from taxes on the sale of corporate assets. See

115 Chesterton points to testimony which showed that the Company currently has $16,000,000 in outstanding

debt, that it has violated its loan agreements, and that in 1994 the Company needed to borrow money to pay
dividends.

116 The affiliate BV is owned and operated by the same shareholders and Board of Directors as the Company.
117 Chesterton asserts that this management fee does not actually reflect the value of services provided to the BV

by the Company. He argues that because the Internal Revenue Service could reclassify the excess of the fee over
the value of the services as dividends to the BV shareholders, this incongruity exposes the shareholders to
increased tax liability.

335

26 U.S.C. § 1374(c)(1). Even if the Company eventually regained its Subchapter S status,
it would permanently lose its grandfathered status.
Fearing the loss of its Subchapter S status, the Company and its shareholders instituted
suit, seeking to enjoin Chesterton from effectuating his plan. … [The complaint alleged a
claim for] breach of fiduciary duty … Plaintiffs … agreed to “waive their claims for
damages, but [not] their claims for equitable relief.” After a bench trial, the district court
ruled that the proposed transfers would violate Chesterton’s fiduciary duty under
Massachusetts law and that they would result in irreparable harm to the Company. The
court enjoined the transfers and denied Chesterton’s counterclaim for monetary relief
under Mass. Gen. Laws ch. 156B.
Chesterton argues that the district court improperly determined the scope of Chesterton’s
fiduciary duty under Massachusetts law. … He argues that the district court improperly
concluded that the Subchapter S election imposed an implied restriction on transferability
of stock, where the Company did not follow the legal requirements for imposing stock
transfer restrictions under Mass. Gen. Laws ch. 156B. ... We reject Chesterton’s
arguments.
II.
We review the district court’s grant of a permanent injunction for abuse of discretion.
[citations omitted]. The standard for issuing a permanent injunction requires the district
court to find that (1) plaintiffs prevail on the merits; (2) plaintiffs would suffer irreparable
injury in the absence of injunctive relief; (3) the harm to plaintiffs would outweigh the
harm the defendant would suffer from the imposition of an injunction; and (4) the public
interest would not be adversely affected by an injunction. [citation omitted]. The district
court found, and we agree, that the public interest was not at issue in this case. We turn to
the remaining three factors.
A. Success on the Merits
In Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578, 328 N.E.2d
505 (1975), the Massachusetts Supreme Judicial Court first announced that shareholders
in a closely held corporation owe an elevated fiduciary duty to one another. [citation
omitted]. …
....
The Donahue family of cases establishes that Chesterton owes the Company and its other
shareholders a fiduciary duty of “utmost good faith and loyalty.” The district court did not
abuse its discretion in finding that Chesterton breached that duty. If Chesterton were to
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effectuate his proposed transfer, the Company and its shareholders would lose the
substantial financial benefits they have derived from the Company’s Subchapter S status.
Such benefits are likely to continue if the Company maintains its Subchapter S status.
Chesterton, disgruntled with overall Company performance and in pursuit of his own selfinterest, has threatened to destroy these substantial benefits. No claim is before us as to
whether the Company and its other shareholders have acted fairly toward Chesterton over
the years; we decide only that the district court did not abuse its discretion in holding that
he has not acted fairly towards them.
Chesterton’s attack focuses on part of the district court’s analysis:
At the time of the S election, the shareholders were informed and understood that
the Company would lose its S status if a shareholder sold shares to another
corporation. By unanimously electing S status, the shareholders agreed that they
would not act in any way that would cause the Company to lose the considerable
benefits of S status.... In view of the agreement regarding S status, which
Defendant supported and facilitated, he cannot now sell his shares in a manner that
would terminate the Company’s S status, even though he would have been entitled
to do so under the Articles had there been no S status agreement.
A.W. Chesterton Co. v. Chesterton, 951 F. Supp. 291, 295 (D. Mass.1997). … Under
Massachusetts law, the expectations and understanding of the shareholders are relevant to
a breach of fiduciary duty determination. See, e.g., Wilkes v. Springside Nursing Home,
Inc., 370 Mass. 842, 353 N.E.2d 657, 664 (1976) (holding that the duty of utmost good
faith and loyalty at a minimum requires shareholders to consider their actions in light of
company policies or long-standing understandings of the shareholders). … The existence
of the agreement simply sheds light on the Company’s and other shareholders’
expectations, and reinforces the disloyal nature of Chesterton’s proposed plan. Further, the
strict duty Chesterton owes is created at law and would exist regardless of any agreement.
....
Chesterton argues that the only legitimate restrictions on the transferability of Company
stock are those found in the 1975 Restated Articles of Organization and that he complied
with the Articles’ procedural requirements by providing the Company with the proper
notice of his proposed transfer. This argument misses the point. … Chesterton cannot
defend a breach of fiduciary duty claim on the basis that he has not violated the Articles
of Organization.
....

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We reject all of Chesterton’s inventive arguments, and affirm the district court’s finding
that plaintiffs succeed on the merits of their breach of fiduciary duty claim.
B. Irreparable Harm
The district court found that the Company would suffer irreparable harm from the loss of
its Subchapter S status, in part because that harm is not measurable. Chesterton argues that
because the harm to the Company from the loss of its Subchapter S status is entirely
financial, equitable relief is inappropriate. Where the harm is not measurable, it is not an
abuse of discretion to award equitable relief. Ross-Simons of Warwick, Inc. v. Baccarat,
Inc., 102 F.3d 12, 19 (1st Cir. 1996) (“If the plaintiff suffers a substantial injury that is not
accurately measurable ... irreparable harm is a natural sequel.”). The loss of advantageous
tax status can form the basis for a finding of irreparable harm. See San Francisco Real
Estate Investors v. Real Estate Inv. Trust of Am., 701 F.2d 1000, 1007 (1st Cir. 1983)
(relying on loss of advantageous tax status and other findings to support a preliminary
injunction). The district court found that the actual degree of the injury was not
measurable, “because the amount of the increased tax liability would be contingent on the
Company’s future earnings and distributions.” This finding is supported by the record and
common sense, and is not an abuse of discretion.
….
C. Balance of Equities
The final consideration regarding the propriety of injunctive relief is whether, on balance,
the harm plaintiffs will suffer from the proposed transfers outweighs the harm that
Chesterton will suffer if his transfers are enjoined. The district court found that an
injunction would not harm Chesterton because the proposed sales would do little to
advance his efforts to sell the stock. The court stated that, “if [Chesterton] was unable to
find a buyer for his shares in the Company, it strains logic to believe that he would be able
to find a buyer for shares in [the shell corporations] when their primary assets are the very
same shares he was previously unable to sell.” Chesterton claims that by transferring the
shares to his shell corporations, he will somehow increase the liquidity of those shares.
The claim is counter-intuitive and no evidence was presented to support it. On this record,
the district court’s finding that the potential harm to plaintiffs outweighs the harm to
defendant was proper.
....
The decision of the district court is affirmed.

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Questions and comments:
1. If Chesterton had sold his shares to the shell corporations before the plaintiffs brought
this suit, what would have been the result?
2. The definition of “small business corporation” essentially gives every shareholder, no
matter how small her interest, a veto power over whether to continue as an S corporation.
This case represents one approach to controlling exercise of that veto power.

III. Income Tax Rules Applicable to S Corporations and Their Shareholders
A. Tax Rules Applicable to S Corporations
Subchapter S establishes a “pass-through” regime, i.e., tax items “pass through” the
corporation – which pays no income tax – to the shareholders. Section 1363(a) provides
that “[e]xcept as otherwise provided,” an S corporation shall not be subject to the taxes
imposed by this chapter.”118 However, the S corporation does compute its taxable income
in the same manner that an individual computes her taxable income. § 1363(b). The S
corporation files an information return and reports pro rata shares to its shareholders. §
6037. The S corporation must file its return by the 15th day of the third month following
the end of its taxable year. Reg. § 1.6037-1(b). The S corporation computes its taxable
income without regard to items that may affect different individual shareholders
differently, i.e., personal exemptions, taxes paid to foreign countries, charitable
contributions, net operating losses, various deductions for personal expenditures, and
depletion allowances for mines, oil and gas wells, other natural deposits, and timber. §
1363(b)(2), cross-referencing § 703(a)(2). Elections that affect the computation of taxable
income are made at the corporate level. § 1363(c)(1). 119 The S corporation treats its
organizational expenditures in the same manner as a C corporation treats its organizational
expenditures. § 1363(b)(3), cross-referencing § 248. As a pass-through entity, S
corporation shareholders benefit from § 199A, infra.
The shareholder of an S corporation must report her pro rata share of the corporation’s
separately-stated items of income (including tax exempt income), loss, deduction, or credit
that may affect individual shareholders’ tax liability differently. 1366(a)(1)(A). The
shareholder must also report her pro rata share of nonseparately stated income or loss. §
1366(a)(1)(B). If necessary to determine the gross income of a shareholder, the
shareholder’s gross income is her pro rata share of the corporation’s gross income. §

118 The Code does “otherwise provide” in some cases of S corporations that were previously C corporations.
119 There are exceptions for deduction and recapture of certain mining and exploration expenditures and for taxes

paid to foreign countries.

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1366(c). The character of income and loss items is “determined as if such item were
realized directly from the source from which realized by the corporation, or incurred in the
same manner as incurred by the corporation.” § 1366(b). Section 1377(a)(1) requires pro
rating both as among shares and as to the days of a taxable year. Reg. § 1.1377-1(a)(1)
provides in part:
[E]ach shareholder’s pro rata share of any S corporation item described in §
1366(a) for any taxable year is the sum of the amounts determined with respect to
the shareholder by assigning an equal portion of the item to each day of the S
corporation’s taxable year, and then dividing that portion pro rata among the shares
outstanding on that day.
If a shareholder terminates her interest in the S corporation, the corporation and all affected
shareholders may agree to close the taxable year on the date of termination. §
1377(a)(2)(A). “Affected shareholders” are the shareholder who has terminated her
interest and the transferee(s) of such shareholder’s shares; if the corporation is a transferee,
“affected shareholders” include all persons who were shareholders during the taxable year.
§ 1377(a)(2)(B).
There are special rules in the case of shareholders who are members of the same family,
i.e., “spouse, ancestors, lineal descendants, and trusts for the primary benefit of such
persons.” § 1366(e), cross-referencing 704(e)(3). The S corporation must provide
reasonable compensation to a family member for services rendered or capital provided, or
the Secretary may make adjustments necessary to reflect the value of the services or capital
provided to the corporation. § 1366(e).

Problems:
1. The stock of an S corporation is owned 50 percent by F and 50 percent by T, the minor
son of F. For the taxable year, the corporation has items of taxable income equal to
$70,000. Compensation of $10,000 is paid by the corporation to F for services rendered
during the taxable year, and no compensation is paid to T, who rendered no services. Based
on all the relevant facts and circumstances, reasonable compensation for the services
rendered by F would be $30,000. What is the maximum amount of additional income that
the IRS may allocate to F as compensation? What would the taxable income of the
corporation be if the IRS exercised such discretion? See Reg. § 1.1366-3(b) Example 1.

B. Section 199A: Qualified Business Income Deduction
In the Tax Cuts and Jobs Act, Congress repealed § 199, which had provided a deduction
for a portion of a taxpayer’s income derived from domestic production activities. In its

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place, Congress enacted § 199A. 120 Section 199A provides a deduction to certain
taxpayers who derive income in a trade or business that they own until and through
December 31, 2025. § 199A(i). The availability of the deduction depends on the amount
of taxpayer’s trade or business income and, at higher levels of such income, the specific
types of those trades or businesses. The gist of § 199A is that non-C-corporation owners
of trades or businesses may deduct (up to) 20% of their business income – thereby
effectively paying income tax on as little as 80% of such income. The rules governing
availability of the deduction become more exacting as the amount of a taxpayer’s “taxable
income” increases. Definitions and conditions define the scope of a § 199A deduction.
Section 199A(a) states that a taxpayer may deduct the lesser of two amounts: (1) taxpayer’s
“combined qualified business income amount” (CQBIA), or (2) 20% of taxpayer’s
(taxable income 121 minus net capital gain 122 ). § 199A(a). The “combined qualified
business income amount” is itself a figure that is 20% of a larger amount, so the multipliers
of the two amounts are the same. See § 199A(b)(1 and 2).
•The second of the two amounts named by § 199A(a) is fairly easily measured.
Section 199A measures the first of the two amounts (CQBIA) more granularly. The
great majority of the text of § 199A is given to defining CQBIA, the first of the two
amounts.
•Once measured, § 199A(a) requires a comparison.
•Observation: If a taxpayer has no income from a business that he owns,
his “combined qualified business income amount” will be $0. Obviously
that amount will be the lesser of two figures. Thus § 199A only helps
taxpayers who own a trade or business.
•Defining the taxpayer’s “combined qualified business income amount” requires
us to dive into the middle of Section 199A and then to work our way back up.
•Initially, note that a taxpayer’s CQBIA is 20% of the sum of a taxpayer’s
“qualified business income” subject to conditions applicable to each
“qualified trade or business,” plus 20% of his [qualified REIT dividends
income plus qualified publicly traded partnership income]. § 199A(b)(1).

120 The TCJA was signed into law on December 22, 2017.

On March 23, 2018, Congress amended § 199A to
provide a deduction from the income of certain agricultural or horticultural cooperatives. See § 199A(g). That
deduction is beyond the scope of this introductory discussion.
121 “Taxable income” is gross income minus allowable deductions, § 63(a), except for the deduction that § 199A

itself allows. § 199A(e)(1).
122 “Net capital gain” is a taxpayer’s “net long-term capital gain” minus “net short-term capital loss.” § 1222(11)..

For non-corporate taxpayers and for purposes of § 199A, § 1(h)(11) includes within net capital gain dividends paid
by domestic corporations, dividends paid by corporations incorporated in a country with which the United States
has a tax treaty, or dividends paid by foreign corporations whose stock is readily traded in an established securities
market in the United States.

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Taxpayers who may avail themselves of this deduction may be sole proprietors or owners
of “pass-through” entities or partnerships. “Pass-through” entities pay no income tax.
Rather their income tax items (items of income, gain, deduction, and loss) “pass through”
to the individual owners of the trade or business.123
•Taxpayers who are C corporations, § 199A(a), and taxpayers who are
employees,124 § 199A(d)(1)(B), may not avail themselves of a § 199A deduction.
•An S corporation is of course a pass-through entity. Section 199A applies at the
shareholder level. § 199A(f)(1)(A).
CQBIA and Qualified Business Income: Initially, CQBIA includes 20% of a taxpayer’s
“qualified business income.” “Qualified business income” (QBI) 125 is the net income
taxpayer derives from the conduct of a “qualified trade or business” to the extent the
income tax items are “effectively connected with the conduct of a trade or business within
the United States ...” § 199A(c)(1); § 199A(c)(3)(A)(i). QBI does not include various items
of investment income.126 Net losses carry over to succeeding years. § 199A(c)(2).
•Section 199A defines “qualified trade or business” as any trade or business other
than a “specified service trade or business” or the trade or business of performing
services as an employee. § 199A(d)(1). BUT: the definition of “qualified trade or
business” varies, depending on the level of a taxpayer’s “taxable income.”
•Section 199A articulates these variations by establishing a “threshold amount” –
which refers to a level of a taxpayer’s “taxable income,” indexed for inflation. See
§ 199A(e)(2). 127 Taxpayer’s taxable income will fall into one of three income
ranges. Section 199A establishes consequences that depend upon whether
taxpayer’s “taxable income” (1) falls below the “threshold amount,” (2) falls above
the “threshold amount” and within a phase-out range, or (3) falls above the
“threshold amount” plus the phase-out range.

123 See § 199A(f)(1)(A)(i) (§ 199A applies at the individual or S corporation shareholder level).
124 Partners who derive income from a partnership in a capacity other than as a partner or who receive guaranteed

payments may not avail themselves of a deduction under § 199A. § 199A(c)(4).
125 QBI does not include “qualified REIT dividends” or “qualified publicly traded partnership income.” §

199A(c)(1). Section 199A(a)(1)(B) names these income items separately and includes them in a taxpayers
“combined qualified business income amount,” i.e., CQBIA.
126 Specifically, the net amount of QBI does not include capital gains/losses, dividend income, interest income

not properly allocable to a trade or business, gains/losses from commodities transactions or gains/loss from
foreign currency transactions, gains/losses from certain “notional” contracts, amounts received from annuity
contracts not connected with a trade or business properly allocable to one of these items. § 199A(c)(3)(B).
127 “Taxable income” is a taxpayer’s gross income minus either itemized deductions or the standard deduction,

computed without regard to the deduction that § 199A allows. § 63(a and b); § 199A(e)(1).

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Threshold Income Amounts: Relevance to Specified Trade or Businesses, and to
CQBIA. Section 199A(e)(2) defines a “threshold amount,” which serves as the threshold
at which restrictions on the § 199A deduction “phase in.” The “threshold amount” is
$157,500, indexed for inflation, § 199A(e)(2)(B), and twice that amount for a joint return.
§ 199A(e)(2)(A). The “threshold amount” is relevant for two purposes:
•(1) Special rules limit that availability of the § 199A deduction for taxpayers
engaged in a “specified service trade or business” (SSTB). A “specified service
trade or business” is a “trade or business involving the performance of services in
the fields of” health, law, accounting, actuarial science, performing arts,
consulting, athletics, financial services, brokerage service, and any trade or
business where the principal asset is the reputation of one or more of its employees
or owners, § 1202(e)(3)(A), cross-referenced and as modified by § 199A(d)(2) (not
including engineering or architecture). Additionally, a “specified trade or
business” is any trade or business “which involves performance of services that
consist of investing, trading, or dealing in securities ..., partnership interests, or
commodities ...” § 199A(d)(2)(B). A taxpayer engaged in an SSTB whose “taxable
income” is greater than the threshold amount by less than $50,000 or $100,000 for
taxpayers married filing jointly will see their § 199A deduction phase out
altogether. See § 199A(d)(1)(A), § 199A(d)(2).
•(2) Taxpayers engaged in any trade or business (including an SSTB) that generates
QBI whose “taxable income” is less than the threshold amount may include 20%
of that QBI in their CQBIA, irrespective of conditions applicable to taxpayers
whose “taxable income” is more than the threshold amount. See § 199A(d)(3)
(SSTB), § 199A(b)(3)(A) (wage and basis requirements). But: wage and property
restrictions “phase in” as the “taxable income” of the owner of a non-SSTB rises
above the threshold amount by $50,000 (or $100,000 for taxpayers married filing
jointly), infra.
Taxpayer’s CQBIA and Wage/Basis Conditions: A taxpayer’s CQBIA is the sum of –
•20% of taxpayer’s aggregate amount of qualified REIT dividends128 and qualified
publicly traded partnership income, § 199A(d)(3); PLUS
•20% of the QBI of each qualified trade or business, but not more than the greater
of
•50% of the W-2 wages taxpayer pays with respect to that trade or business, OR
•25% of the W-2 wages taxpayer pays with respect to that trade or business plus
2.5% of the unadjusted basis of “qualified property” immediately after acquisition
and held for use in that trade or business. § 199A(b)(2)(B); § 199A(b)(6)(a)(i).

128 A “qualified REIT dividend” is any dividend from a real estate investment trust that is neither a capital gain

dividend nor a “qualified dividend” under § 1(h)(11). § 199A(e)(3).

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•A shareholder’s allocable
share of W-2 wages is the same
as the shareholder’s allocable
share of wage expenses. §
199A(f)(1)(A) (carryout ¶). A
shareholder’s allocable share
of the unadjusted basis of the S
corporation’s
property
is
determined in the same manner
as the shareholder’s allocable
share of depreciation. §
199A(f)(1)(A) (carryout ¶).

Visualizing § 199A CQBIA
•Work from the bottom up, QBI by QBI.
•Deduct CQBIA or 20% of [(taxable income) ÷ (NCG)], whichever is less.

§ 199A
deduction
= Lesser of
20% of QBI
or
wage/basis
floor

Wage/basis floor amount =
Greater of (50% of W-2
wages) or (25% of W-2 wages
+ 2.5% of unadjusted basis)

There are three different
treatments of taxpayer’s QBI –
the treatment dependent on the
level of taxpayer’s “taxable
income.”
•(1) Taxpayers who own a
TI = $207,500 ($415,000 (mfj))
Phase-in of
“qualified trade or business”
W-2/W-2that is not a “specified service
basis
trade or business” may deduct
threshold
TI = $157,500 ($315,000 (mfj))
their
CQBIA
computed
without regard to the W-2
§ 199A
and/or qualified property
deduction =
conditions if the taxpayer’s
20% of QBI;
taxable income does not
no
exceed the indexed threshold
wage/basis
amount. § 199A(b)(3)(A).
floor
•(2) If taxpayer’s taxable
income does exceed the
No § 199A
indexed threshold amount by
(Taxable Income)
deduction
less than $50,000 ($100,000
– (QBI)
for a taxpayer married filing
jointly), and if taxpayer’s QBI
determined without regard to
the W-2 and qualified property
•Dollar figures are indexed for inflation.
conditions would be greater
than the relevant
W-2
wage/property basis limitation, then taxpayer must reduce his deduction by the
percentage of $50,000 ($100,000 for taxpayers married filing jointly) by which
20% of his QBI exceeds the otherwise applicable W-2 and qualified property
conditions. § 199A(b)(3)(B).
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•Example: Taxpayer is a sole proprietor. Taxpayer’s filing status is married
filing jointly. Taxpayer has $300K of QBI and $350K of taxable income.
Taxpayer paid W-2 wages of $45K. Taxpayer has no depreciable property.
•Taxpayer would be entitled to a $60K § 199A deduction if there were no
wage/basis condition.
•Taxpayer’s “taxable income” exceeds the threshold amount by $35K, i.e.,
($350K $315K).
•The W-2 wage condition is 50% of $45K, i.e., $22,500.
•Taxpayer’s potential § 199A deduction exceeds the wage condition by
$37,500, i.e. ($60,000 − $22,500).
•This is the “excess amount.” § 199A(b)(3)(B)(iii).
•Taxpayer’s § 199A deduction is reduced from its unrestricted potential by
the percentage of the “excess amount” equal to the same percentage that
$35K is of $100K, i.e., 35%. 35% of $37,500K = $13,125.
Taxpayer may claim a § 199A deduction of $46,875, i.e., ($60K −
$13,125).
•Example: Same facts except that taxpayer paid $0 in W-2 wages. The W2
wage limitation is $0. Taxpayer’s potential § 199A deduction exceeds the
wage limitation by $60,000. 35% of $60,000 = $21,000. Taxpayer may
claim a § 199A deduction of $39,000.
•(3) When a taxpayer’s “taxable income” exceeds the “threshold amount” plus
$50,000 ($100,000 for taxpayers married filing jointly), taxpayer computes his §
199A deduction by applying the W-2/property basis ceiling rules noted above
without adjustments.
Specified Service Trade or Business (SSTB): Taxpayers engaged in a “specified service
trade or business” may include the income they derive from such a trade or business in
their CQBIA if their “taxable income” is less than the threshold level. The amount of SSTB
income that they may include in the CQBIA decreases to $0 as their taxable income rises
by less than $50K (or $100K for taxpayers married filing jointly) above the threshold. See
§ 199A(b)(3)(A), § 199A(d)(3). Thus, there are three levels of § 199A deduction for a
taxpayer engaged in an SSTB:
•(1) Taxpayers whose “taxable income” is less than the threshold amount and are
engaged in an SSTB may treat all of their trade or business income as QBI without
restrictions.
•(2) Taxpayers engaged in an SSTB whose “taxable income” is greater than the
threshold amount but less than the threshold amount plus $50,000 ($100,000 for
taxpayers married filing jointly) may include in their QBI the “applicable
percentage” of all their SSTB income items. The same “applicable percentage”
applies to the wage/basis limitations restrictions applicable to CQBIA, infra. The
“applicable percentage” is 100% minus the percentage that taxpayer’s excess
“taxable income” is relative to $50,000 ($100,000 for taxpayers married filing

345

jointly). § 199A(d)(3). Taxpayer’s excess “taxable income” is the amount by which
taxpayer’s “taxable income” exceeds the threshold amount.
•Example:129 Taxpayer has taxable income of $200,000, of which $125,000
is attributable to an accounting sole proprietorship after paying wages of
$40,000 to employees. Taxpayer uses no depreciable property. Taxpayer
has an “applicable percentage” of 15%, determined thus:
1 − [($200,000 − $157,500)/$50,000]
1 −$ 42,500/$50,000
1 − 0.85
0.15, or 15%
In determining includible QBI, taxpayer takes into account 15% of
$125,000, i.e., $18,750. In determining the includible W-2 wages, taxpayer
takes into account 15% of $40,000, i.e., $6000. Taxpayer’s CQBIA
deduction is the lesser of130 20% of $18,750, i.e., $3750 – or 50% of $6000,
i.e., $3000.
Taxpayer may take a § 199A deduction of $3000.
•(3) Taxpayers engaged in an SSTB with taxable income greater than the threshold
amount plus $50,000 ($100,000 for taxpayers married filing jointly) are not entitled
to any § 199A deduction.
See generally Robert E. Ward, Tax Cuts and Jobs Act of 2017 – Individual Tax Provisions,
TAXES THE TAX MAGAZINE 49, 51-53 (July 2018).

129 This example is derived from Conference Report on H.R. 1, Tax Cuts and Jobs Act, H. REP. 115-466 (1st Sess. 2017).
130 ... i.e., the lesser of 20% of QBI or 50% of W-2 wages. Thus, the Code requires a pro-rated application of rules

applicable to a non-SSTB taxpayer.

346

Visualizing Specified Service Trade or Business and §199A
Dollar figures are indexed for inflation.
Wage/basis floor amount = Greater of
(50% of W-2 wages) or (25% of W-2
wages + 2.5% of unadjusted basis)

No § 199A deduction
when taxable income
is greater than
threshold
$207,500 ($415,000 (mfj))
§ 199A deduction=
Lesser of 20% of SSTB
or wage/basis floor

Deduction phase out range

$157,500 ($315,000 (mfj))

§ 199A deduction =
20% of SSTB Income

(Taxable Income) –
(SSTB Income)

No § 199A deduction

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Returning to the § 199A Comparison: Recall: § 199A(a) permits taxpayer to deduct the
lesser of CQBIA, or 20% of (“taxable income” minus net capital gain). QBI is of course
included in a taxpayer’s “taxable income.” The difference between taxpayer’s “taxable
income” and “net capital gain” will be less than a taxpayer’s CQBIA when the taxpayer
derives a substantial portion of his taxable income from capital gains and “qualified
dividends.” As a taxpayer’s net capital gain increases, eventually the taxpayer’s CQBIA
becomes the greater figure.
•Describe a typical taxpayer for whom the CQBIA would be the lesser amount.
Comment: Section 199A replaced § 199, a measure designed to encourage all taxpayers,
including corporations, to engage in manufacturing trades or businesses in the United
States. Section 199A, on the other hand, provides benefits only to “pass-through” entities
and sole proprietorships. The justification for this different treatment for corporations lies
in the fact that the TCJA reduced the top corporate tax rate from 35% to 21%. By defining
the limits of the § 199A deduction through reference to W-2 wages and depreciable
property used to generate income effectively connected with a trade or business within the
United States, Congress clearly aims to encourage certain forms of economic activity
within the United States.
Notice that § 199A is not part of the Code’s methods of determining a taxpayer’s net
income. Rather, it provides a reward for doing something that Congress wants passthrough entities that own a trade or business to do, i.e., generate taxable income in the
United States. And: the more profit such a taxpayer can derive from his domestic economic
activities, the greater his deduction.
Section 199 was an effort to make U.S. manufacturers more competitive vis-a-vis foreign
competition. A byproduct of this effort would be that export activity would increase. By
rewarding successful businesses, Congress is (likely to be) rewarding exporters the most.
Congress has pursued similar objectives in other tax legislation, but the World Trade
Organization (WTO) found that such legislation violated the General Agreement on
Tariffs and Trade (GATT). Section 199A may also be vulnerable to a challenge before the
WTO.131

Problems:
*In these problems, use the figures that appear in the text of § 199A, not the figures that
have been indexed for inflation.

131 Section 199 provided a deduction to all taxpayers, including C corporations, engaged in domestic production

activities. The business activity on which § 199A focuses is different, but the intent to stimulate only domestic
business activity is apparent.

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1. Mary Taxpayer lives in a medium-sized town with a large university. Mary and her
husband live only a few blocks from the university. She and her husband file their income
tax return married filing jointly. Taxpayer and husband both have jobs from which they
derive employment income. Their wage income from these jobs is $250,000. They have
$50,000 of net capital gain. In addition, Mary has a t-shirt silk screening business that she
runs out of her garage. The university has athletic teams that participate in several sports.
When there is a home game, thousands of people descend on the town to attend the games.
Mary pays attention to the athletic schedules and designs and produces t-shirts in only a
few hours with timely messages. She sells the t-shirts to persons that pass by several kiosks
that she rents. Her gross revenue from t-shirt sales for the tax year is $180,000. Deductions
for supplies and kiosk rental come to $30,000. She pays two employees a total of $40,000
in wages. She has no “qualified REIT dividends” or “qualified publicly-traded partnership
income.”
1A. How much can Mary and her husband claim as a § 199A deduction?
1B. What if Mary and her husband had total taxable wages income from their other jobs
of $100,000, and still had the same capital gain and business income and expenses from
the sale of t-shirts?
1C. What if Mary and her husband had total taxable income from their other jobs of
$500,000?
2. Mike Perch is a baseball player for the Rockville Hellions. He makes a minor league
salary and works in the off-season in a brewery where his employer pays him wages. His
“taxable income” from these jobs is $50,000. He also made $10,000 of net capital gain.
On the side, he has his own business as a personal trainer “to the stars.” He grossed $85,000
as a personal trainer. He paid an assistant, Lopez Schaden, an illegal immigrant, $20,000
cash under-the-table. These are all of his expenses. Hence, he netted $65,000 as a personal
trainer. Perch lives alone in an apartment and his tax filing status is single. Perch has no
“qualified REIT dividends” or “qualified publicly-traded partnership income.”
2A. How much can Perch claim for a § 199A deduction?
2B. Suppose Perch’s “taxable income” from his wages as a baseball player and brewery
worker was $100,000. Furthermore, suppose that Lopez Schaden is not an illegal
immigrant and that the wages Perch paid him are W-2 wages. How much could Perch
claim as a § 199A deduction?
2C. Suppose Perch made the major leagues and quit his job at the brewery. His salary
jumped to $500,000. He continued his trade or business of being a personal trainer with
the same revenue and expenses. How much could Perch claim as a § 199A deduction?

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C. Income Tax Rules for S Corporations and Shareholders’ Basis
Basis is how we keep score with the government. Section 1012 defines “basis” to be “cost,”
but the Code treats basis as money that will not (again) be subject to tax. The amount of
money that will not be subject to income tax is taxpayer’s “basis.” Hence, if a taxpayer
uses after-tax money to make an investment, that money should not again be subject to
income tax. In the case of a subchapter S corporation, the shareholder invests after-tax
money in shares, and the amount of investment is the shareholder’s “basis.”
The income, gain, deductions, or losses, that the S corporation generates pass through to
the shareholders who recognize those items without any deferral. The shareholder must
pay income tax on her share of the S corporation’s taxable income and gain. Those
amounts are treated as shareholder investments. Since they have been subject to income
tax, they should not again be subject to income tax. Hence, the shareholder increases her
basis in her stock by such amounts. § 1367(a)(1). The shareholder is entitled to increase
her basis in her shares by the amount of any tax-exempt income that passes through the
corporation to her lest such income be subject to income tax at some time in the future –
in which case it would not in fact be tax-exempt. § 1367(a)(1)(A). Conversely, when a
shareholder reduces her taxable income by the amount of deductions or losses that pass
through to her, the shareholder must reduce her basis in her shares in the S corporation. §
1367(a)(2). The shareholder also reduces basis in her stock by the amount of any expenses
that are neither deductible nor chargeable to capital account. § 1367(a)(2)(D). Generally,
a distribution to a shareholder is not a recognition event. § 1368(b). When the S
corporation makes a distribution to a shareholder, the amount of the distribution is no
longer invested in the corporation, and shareholder must reduce her basis in her shares of
the S corporation. § 1367(a)(2)(A). The shareholder must recognize gain as if from the
sale or exchange of property if a distribution exceeds her basis in her stock. § 1368(a)(2).
When a shareholder transfers property to an S
corporation in a § 351 transaction, the basis rules of §§
358 and 362 apply, i.e., shareholders carry over the
basis they had in the property they transferred to the
shares they now own, and the corporation takes the
shareholders’ bases in the property they transferred.
Section 357 applies to corporate assumption of
liabilities. A special rule applies when a shareholder
acquires shares in an S corporation by reason of death. While § 1014 gives the shareholders
a stepped-up (or stepped-down) basis, the basis is reduced by the portion of the value
attributable to income in respect of the decedent. § 1367(b)(4)(B).

You can’t run a tab with the
Government. A shareholder may
not take into account deductions
in excess of her basis in her S
corporation stock. § 1366(d)(1).
Excess losses are carried to the
succeeding tax year indefinitely.
§ 1366(d)(2).

Basis adjustments are made at the close of the taxable year, unless the shareholder has
disposed of stock during the corporation’s taxable year. Reg. § 1.1367-1(d). In that case,

350

the adjustments are made immediately prior to the sale. Reg. § 1.1367-1(d). Reg. § 1.13671(f) provides the sequence of basis adjustments:
1. Increases under § 1367(a)(1);
2. Decreases under § 1367(a)(2)(A), i.e., distributions to shareholders that are not
included in their income;
3. Decreases under § 1367(a)(2)(D and E), i.e., nondeductible expenditures,
expenditures not chargeable to capital account, and the excess of the basis of oil
and gas property over depletion allowance;
4. Decreases under § 1367(a)(2)(B and C), i.e., the shareholder’s pro rata share of
the corporation’s losses and of losses attributable to separately stated items.
A shareholder may elect to reverse #s 3 and 4. Reg. § 1.1367-1(g). The sequence is
important to determinations of what losses and deductions will be allowed. In the event
that the decreases exceed the shareholder’s basis, the excess is carried over to the next year
as a loss of the same character. Reg. § 1.1367-1(g).

Problems:
1. The stock of an S corporation is owned 25% by D, E, F, and G. Each has a $50,000
adjusted basis in her stock. The corporation has items of taxable income for the current
year of $120,000. The corporation elected to distribute none of its earnings and to invest
its earnings in expansion instead. G objected because she wanted a distribution of $30,000
cash. How much taxable income does G have for the year and what adjustments should be
made to G’s basis in her stock? See Knott v. Comm’r, T.C. Memo. 1991-352, 62 T.C.M.
287 (1991).
2. Same facts as #1, except that halfway through the year, the S corporation distributed
$8000 to each shareholder, including G. How much taxable income does G have for the
year and what adjustment should be made to G’s basis in her stock?
3. Same as #2 but the distributions were $90K each.

Do the CALI exercise:
S Corporation Taxation: Taxation of the Shareholder: S Corporation Separately Stated
Items.

Do the CALI exercise:
S Corporation Taxation: Distributions: Distributions of Cash by an S Corporation.

351

D. Subchapter S and Cancellation of Indebtedness Income
Prior to the enactment of the Jobs Creation and Workers Assistance Act of 2002, an issue
on which courts were divided was whether cancellation of indebtedness income increased
S corporation shareholders’ bases in their stock, and if so, whether such increases occurred
before their reduction of § 108(b) tax attributes. The United States Supreme Court resolved
the conflict in the lower courts by answering the questions “yes” and “before.” Gitlitz v.
Commissioner, 531 U.S. 206 (2001). Hence, a loss could offset cancellation of
indebtedness income. Congress reversed this holding by amending § 108(d)(7)(A), which
requires that cancellation of indebtedness income be taken into account at the corporate
level rather than at the individual shareholder level.
Then it gets tricky. A corollary to the basic principle that For another explanation of the
we tax income once is that losses or deductions can be rules governing canceled S
claimed only once. A shareholder of an S corporation may corporation debt, see William C.
claim a deduction or loss only to the extent she has basis Hood, Canceled S Corporation
in her stock or basis in corporate indebtedness to her. § Debt and Deemed NOLs, TAXES
1366(d)(1). Excess deductions are carried over THE TAX MAG., JULY 2019, AT 39.
indefinitely to succeeding years. § 1366(d)(2). If an S
corporation has cancellation of indebtedness income and its shareholders have excess
losses, the unpaid debt can be treated as a source of the excess loss. This is what §
108(d)(7)(A) does. That section treats excess shareholder losses as corporate level NOLs
to the extent of the corporation’s cancellation of indebtedness income (except for qualified
real property indebtedness). Any excess corporate level NOL is allocated back to the
shareholders to the extent that the NOL exceeds what would have been a shareholder’s
share of the corporation’s cancellation of indebtedness income according to her
proportionate share of all the shareholders’ individual excess NOLs. Similar rules of
proportionality determine the character of those losses. This is illustrated in Reg. § 1.1087(e), Example 5, reprinted here:
Example 5. (i) Facts. During the entire calendar year 2009, A, B, and C each own equal
shares of stock in X, a calendar year S corporation. As of December 31, 2009, A, B, and C
each have a zero stock basis and X does not have any indebtedness to A, B, or C. For the
2009 taxable year, X excludes from gross income $45,000 of COD income under §
108(a)(1)(A). The COD income (had it not been excluded) would have been allocated
$15,000 to A, $15,000 to B, and $15,000 to C under § 1366(a). For the 2009 taxable year,
X has $30,000 of losses and deductions that X passes through pro rata to A, B, and C in the
amount of $10,000 each. The losses and deductions that pass through to A, B, and C are
disallowed under § 1366(d)(1) [(loss in excess of basis not allowed)]. In addition, B has
$10,000 of § 1366(d) losses from prior years and C has $20,000 of § 1366(d) losses from
prior years. A’s ($10,000), B’s ($20,000) and C’s ($30,000) combined $60,000 of
disallowed losses and deductions for the taxable year of the discharge are treated as a

352

current year net operating loss tax attribute of X under § 108(d)(7)(B) (deemed NOL) for
purposes of the § 108(b) reduction of tax attributes.
(ii) Allocation. Under § 108(b)(2)(A), X’s $45,000 of excluded COD income reduces the
$60,000 deemed NOL to $15,000. Therefore, X has a $15,000 excess net operating loss
(excess deemed NOL) to allocate to its shareholders. Under paragraph (d)(2)(ii)(C) of this
section, none of the $15,000 excess deemed NOL is allocated to A because A’s § 1366(d)
losses and deductions immediately prior to the § 108(b)(2)(A) reduction ($10,000) do not
exceed A’s share of the excluded COD income for 2008 ($15,000). Thus, A has no
shareholder’s excess amount. Each of B’s and C’s respective § 1366(d) losses and
deductions immediately prior to the § 108(b)(2)(A) reduction exceed each of B’s and C’s
respective shares of the excluded COD income for 2008. B’s excess amount is $5,000
($20,000 − $15,000) and C’s excess amount is $15,000 ($30,000 − $15,000). Therefore,
the total of all shareholders’ excess amounts is $20,000. Under paragraph (d)(2) of this
section, X will allocate $3,750 of the $15,000 excess deemed NOL to B ($15,000 x
$5,000/$20,000) and $11,250 of the $15,000 excess deemed NOL to C ($15,000 x
$15,000/$20,000). These amounts are treated as losses and deductions disallowed under §
1366(d)(1) for the taxable year of the discharge. Accordingly, at the beginning of 2010, A
has no § 1366(d)(2) carryovers, B has $3,750 of carryovers, and C has $11,250 of
carryovers.
(iii) Character. Immediately prior to the § 108(b)(2)(A) reduction, B’s $20,000 of §
1366(d) losses and deductions consisted of $8,000 of long-term capital losses, $7,000 of §
1231 losses, and $5,000 of ordinary losses. After the § 108(b)(2)(A) tax attribute reduction,
X will allocate $3,750 of the excess deemed NOL to B. Under paragraph (d)(3) of this
section, the $3,750 excess deemed NOL allocated to B consists of $1,500 of long-term
capital losses (($8,000/$20,000) x $3,750), $1,312.50 of section 1231 losses
(($7,000/$20,000) x $3,750), and $937.50 of ordinary losses (($5,000/$20,000) x $3,750).
As a result, at the beginning of 2010, B’s $3,750 of § 1366(d)(2) carryovers consist of
$1,500 of long-term capital losses, $1,312.50 of § 1231 losses, and $937.50 of ordinary
losses.

E. Corporate Indebtedness and Shareholder Basis
To an S corporation shareholder, a deduction is only usable to the extent that the
shareholder has basis in her shares. § 1366(d)(1). This makes the determination of basis
very important. In a partnership, each partner may include in her basis a share of the
partnership’s debt – whether recourse or non-recourse. By way of contrast, an S
corporation shareholder may not include in her basis any share of the corporation’s
indebtedness.
Section 1367(b)(2) provides that a shareholder does have basis in the S corporation’s
indebtedness to her. Only after the shareholder’s basis in her stock has been reduced to $0
may the shareholder use losses – but not distributions – to reduce the basis of such
353

indebtedness. § 1367(b)(2)(A). Subsequent increases to basis must be used first to restore
the basis of such indebtedness before increasing a shareholder’s basis in her stock. §
1367(b)(2)(B).
•Basis adjustments are made at the close of the taxable year, unless the shareholder
has terminated her interest in the corporation – in which case the adjustments are
made immediately before the shareholder terminates her interest. Reg. §
1.13672(d)(1).
Lenders often look to the creditworthiness of the individual shareholders of an S
corporation rather than to the corporation itself. [Indeed, in the following case, the
creditworthiness of the corporation was almost meaningless.] Shareholders must exercise
caution to establish the precise relationship they want.

Estate of Leavitt v. Commissioner, 875 F.2d 420 (4th Cir.), cert. denied, 493 U.S. 958
(1989)
MURNAGHAN, Circuit Judge
The appellants, Anthony D. and Marjorie F. Cuzzocrea and the Estate of Daniel Leavitt,
Deceased, et al., appeal the Tax Court’s decision holding them liable for tax deficiencies
for the tax years 1979, 1980 and 1981. Finding the appellants’ arguments unpersuasive,
we affirm the Tax Court.
I.
As shareholders of VAFLA Corporation,132 a subchapter S corporation during the years at
issue, the appellants claimed deductions133 under § 1374134 of the Code [footnote omitted]
to reflect the corporation’s operating losses during the three years in question. 135 The

132 VAFLA is a Virginia corporation incorporated in February 1979 to acquire and operate the Six-Gun Territory

Amusement Park near Tampa, Florida. At that time, both Cuzzocrea and Leavitt each paid $10,000 for their
respective shares of VAFLA. Therefore, the adjusted bases of their stock amounted to $10,000 each, the cost of
the stock.
133 The Leavitts deducted a loss of $13,808 attributable to the corporation on their 1979 joint federal income tax

return. The appellee disallowed $3,808 of that deduction. The Cuzzocreas deducted losses of $13,808, $29,921
and $22,746 attributable to the corporation on their 1979, 1980 and 1981 joint federal income tax returns,
respectively. The appellee disallowed all of the deductions in excess of $10,000.
134 [The principles of § 1374 are now stated in § 1366.]
135 The first taxable year of VAFLA consisted of seven months and ended on September 30, 1979. The

corporation had suffered a net operating loss of $265,566.47 and had a retained earnings deficit of $345,370.29.
During its second taxable year ending September 30, 1980, the corporation suffered a net operating loss of
$482,181.22 and had a retained earnings deficit of $1,093,383.56. During its third taxable year ending September

354

Commissioner disallowed deductions above the $10,000 bases each appellant had from
their original investments.
The appellants contend, however, that the adjusted bases in their stock should be increased
to reflect a $300,000 loan which VAFLA obtained from the Bank of Virginia (“Bank”) on
September 12, 1979, after the appellants, along with five other shareholders
(“Shareholders-Guarantors”), had signed guarantee agreements whereby each agreed to be
jointly and severally liable for all indebtedness of the corporation to the Bank.136 At the
time of the loan, VAFLA’s liability exceeded its assets, [footnote omitted] it could not
meet its cash flow requirements and it had virtually no assets to use as collateral. The
appellants assert that the Bank would not have lent the $300,000 without their personal
guarantees.
VAFLA’s financial statements and tax returns indicated that the bank loan was a loan from
the Shareholders-Guarantors. Despite the representation to that effect, VAFLA made all
of the loan payments, principal and interest, to the Bank. The appellants made no such
payments. In addition, neither VAFLA nor the Shareholders-Guarantors treated the
corporate payments on the loan as constructive income taxable to the ShareholdersGuarantors.
The appellants present the question whether the $300,000 bank loan is really, despite its
form as a borrowing from the Bank, a capital contribution from the appellants to VAFLA.
They contend that if the bank loan is characterized as equity, they are entitled to add a pro
rata share of the $300,000 bank loan to their adjusted bases, thereby increasing the size of
their operating loss deductions.137 Implicit in the appellants’ characterization of the bank
loan as equity in VAFLA is a determination that the Bank lent the $300,000 to the
Shareholders-Guarantors who then contributed the funds to the corporation. The
appellants’ approach fails to realize that the $300,000 transaction, regardless of whether it
is equity or debt, would permit them to adjust the bases in their stock if, indeed, the
appellants, and not the Bank, had advanced VAFLA the money. The more precise
question, which the appellants fail initially to ask, is whether the guaranteed loan from the
Bank to VAFLA is an economic outlay of any kind by the Shareholders-Guarantors. To

30, 1981, the corporation suffered a net operating loss of $475,175.70 and had a retained earnings deficit of
$1,908,680.22.
136 All the guarantees to the Bank were unlimited except the guarantee of Cuzzocrea which was limited to

$300,000. The Shareholders-Guarantors had an aggregate net worth of $3,407,286 and immediate liquidity of
$382,542.
137 Former § 1374 ... which was in effect during the years in issue provides that a shareholder of an electing small

business corporation may deduct from gross income an amount equal to his or her portion of the corporation’s
net operating loss to the extent provided for in § 1374(c)(2). Such deduction is limited, however, to the sum of
(a) the adjusted basis of the shareholder’s stock in the corporation, and (b) the adjusted basis of any indebtedness
of the corporation to the shareholder, as determined as of the close of the corporation’s taxable year.

355

decide this question, we must determine whether the transaction involving the $300,000
was a loan from the Bank to VAFLA or was it instead a loan to the Shareholders
Guarantors who then gave it to VAFLA, as either a loan or a capital contribution.
Finding no economic outlay, we need not address the question, which is extensively
addressed in the briefs, of whether the characterization of the $300,000 was debt or equity.
II.
To increase the basis in the stock of a subchapter S corporation, there must be an economic
outlay on the part of the shareholder. See Brown v. Commissioner, 706 F.2d 755, 756 (6th
Cir. 1983), aff’g. T.C. Memo 1981-608 (1981) (“In similar cases, the courts have
consistently required some economic outlay by the guarantor in order to convert a mere
loan guarantee into an investment.”); Blum v. Commissioner, 59 T.C. 436, 440 (1972)
(bank expected repayment of its loan from the corporation and not the taxpayers, i.e., no
economic outlay from taxpayers). 138 A guarantee, in and of itself, cannot fulfill that
requirement. The guarantee is merely a promise to pay in the future if certain unfortunate
events should occur. At the present time, the appellants have experienced no such call as
guarantors, have engaged in no economic outlay, and have suffered no cost. [footnote
omitted].
The situation would be different if VAFLA had defaulted on the loan payments and the
Shareholders-Guarantors had made actual disbursements on the corporate indebtedness.
Those payments would represent corporate indebtedness to the shareholders which would
increase their bases for the purpose of deducting net operating losses under §
1374(c)(2)(B) [now § 1366(d)(1)(B)]. Brown, 706 F.2d at 757. See also Raynor v.
Commissioner, 50 T.C. 762, 77071 (1968) (“No form of indirect borrowing, be it guaranty,
surety, accommodation, comaking or otherwise, gives rise to indebtedness from the
corporation to the shareholders until and unless the shareholders pay part or all of the
obligation.”).
The appellants accuse the Tax Court of not recognizing the critical distinction between §
1374(c)(2)(A) [§ 1366(d)(1)(A)] (adjusted basis in stock) and § 1374(c)(2)(B) [§
1366(d)(1)(B)] (adjusted basis in indebtedness of corporation to shareholder). They argue
that the “loan” is not really a loan, but is a capital contribution (equity). Therefore, they
conclude, § 1374(c)(2)(A) applies and § 1374(c)(2)(B) is irrelevant. However, the
appellants once again fail to distinguish between the initial question of economic outlay
and the secondary issue of debt or equity. Only if the first question had an affirmative
answer, would the second arise.
138 Even the Eleventh Circuit case on which the appellants heavily rely applies this first step. See Selfe v. United

States, 778 F.2d 769, 772 (11th Cir. 1985) (“We agree with Brown inasmuch as that court reaffirms that economic
outlay is required before a stockholder in a Subchapter S corporation may increase her basis.”).

356

The majority opinion of the Tax Court, focusing on the first issue of economic outlay,
determined that a guarantee, in and of itself, is not an event for which basis can be adjusted.
It distinguished the situation presented to it from one where the guarantee is triggered and
actual payments are made. In the latter scenario, the first question of economic outlay is
answered affirmatively (and the second issue is apparent on its face, i.e., the payments
represent indebtedness from the corporation to the shareholder as opposed to capital
contribution from the shareholder to the corporation). To the contrary is the situation
presented here. The Tax Court, far from confusing the issue by discussing irrelevant
matters, was comprehensively explaining why the transaction before it could not represent
any kind of economic outlay by the appellants.
The Tax Court correctly determined that the appellants’ guarantees, unaccompanied by
further acts, in and of themselves, have not constituted contributions of cash or other
property which might increase the bases of the appellants’ stock in the corporation.
The appellants, while they do not disagree with the Tax Court that the guarantees, standing
alone, cannot adjust their bases in the stock, nevertheless argue that the “loan” to VAFLA
was in its “true sense” a loan to the Shareholders-Guarantors who then theoretically
advanced the $300,000 to the corporation as a capital contribution. The Tax Court declined
the invitation to treat a loan and its uncalled-on security, the guarantee, as identical and to
adopt the appellants’ view of the “substance” of the transaction over the “form” of the
transaction they took. The Tax Court did not err in doing so.
Generally, taxpayers are liable for the tax consequences of the transaction they actually
execute and may not reap the benefit of recasting the transaction into another one
substantially different in economic effect that they might have made. They are bound by
the “form” of their transaction and may not argue that the “substance” of their transaction
triggers different tax consequences. Don E. Williams Co. v. Commissioner, 429 U.S. 569,
579-80 (1977); Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S.
134, 149 (1974).139 In the situation of guaranteed corporate debt, where the form of the
transaction may not be so clear, courts have permitted the taxpayer to argue that the
substance of the transaction was in actuality a loan to the shareholder. See Blum, 59 T.C.
at 440. However, the burden is on the taxpayer and it has been a difficult one to meet. That
is especially so where, as here, the transaction is cast in sufficiently ambiguous terms to
permit an argument either way depending on which is subsequently advantageous from a
tax point of view.

139 On the other hand, the Commissioner is not so bound and may recharacterize the nature of the transaction

according to its substance while overlooking the form selected by the taxpayer. Higgins v. Smith, 308 U.S. 473,
477 (1940). ...

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In the case before us, the Tax Court found that the “form” and “substance” of the
transaction was a loan from the Bank to VAFLA and not to the appellants:
The Bank of Virginia loaned the money to the corporation and not to petitioners.
The proceeds of the loan were to be used in the operation of the corporation’s
business. Petitioners submitted no evidence that they were free to dispose of the
proceeds of the loan as they wished. Nor were the payments on the loan reported
as constructive dividends on the corporation’s Federal income tax returns or on the
petitioners’ Federal income tax returns during the years in issue. Accordingly, we
find that the transaction was in fact a loan by the bank to the corporation guaranteed
by the shareholders.
Whether the $300,000 was lent to the corporation or to the Shareholders/Guarantors is a
factual issue which should not be disturbed unless clearly erroneous. Finding no error, we
affirm.
It must be borne in mind that we do not merely encounter naive taxpayers caught in a
complex trap for the unwary. They sought to claim deductions because the corporation lost
money. If, however, VAFLA had been profitable, they would be arguing that the loan was
in reality from the Bank to the corporation, and not to them, for that would then lessen
their taxes. Under that description of the transaction, the loan repayments made by VAFLA
would not be on the appellants’ behalf, and, consequently, would not be taxed as
constructive income to them. See Old Colony Trust Co. v. Commissioner, 279 U.S. 716
(1929) (payment by a corporation of a personal expense or debt of a shareholder is
considered as the receipt of a taxable benefit). It came down in effect to an ambiguity as
to which way the appellants would jump, an effort to play both ends against the middle,
until it should be determined whether VAFLA was a profitable or money-losing
proposition. At that point, the appellants attempted to treat the transaction as cloaked in
the guise having the more beneficial tax consequences for them.
Finally, the appellants complain that the Tax Court erred by failing to apply debt-equity
principles [footnote omitted] to determine the “form” of the loan. We believe that the Tax
Court correctly refused to apply debt-equity principles here, a methodology which is only
relevant, if at all,140 to resolution of the second inquiry – what is the nature of the economic
outlay. Of course, the second inquiry cannot be reached unless the first question
concerning whether an economic outlay exists is answered affirmatively. Here it is not.
In a § 1374 [§ 1366(d)(1)] subchapter S corporation case, the inquiry whether or not the economic outlay,
assuming there is one, is debt or equity appears not to matter since the economic outlay, regardless of its
characterization as debt or equity, will increase the adjusted basis. There are no different tax consequences from
the point of view of the taxpayer on the narrow issue of what amount of net operating losses may be deducted.
Therefore, application of debt-equity principles in a case such as this one appears to be a red herring. However,
we do not reach that issue because the Tax Court’s factual finding that the appellants have shown no economic
outlay on their part is not clearly erroneous.

140

358

The appellants, in effect, attempt to collapse a two-step analysis into a one-step inquiry
which would eliminate the initial determination of economic outlay by first concluding
that the proceeds were a capital contribution (equity). Obviously, a capital contribution is
an economic outlay so the basis in the stock would be adjusted accordingly. But such an
approach simply ignores the factual determination by the Tax Court that the Bank lent the
$300,000 to the corporation and not to the Shareholders-Guarantors.
The appellants rely on Blum v. Commissioner, 59 T.C. 436 (1972), and Selfe v. United
States, 778 F.2d 769 (11th Cir. 1985), to support their position. However, the appellants
have misread those cases. In Blum, the Tax Court declined to apply debt-equity principles
to determine whether the taxpayer’s guarantee of a loan from a bank to a corporation was
an indirect capital contribution.141 The Tax Court held that the taxpayer had failed to carry
his burden of proving that the transaction was in “substance” a loan from the bank to the
shareholder rather than a loan to the corporation. The Blum court found dispositive the fact
that “the bank expected repayment of its loan from the corporation and not the petitioner.”
Blum, 59 T.C. at 440.142

141

The Blum court stated:
The respondent [Commissioner] has argued that the entire equity-contribution argument espoused
by petitioner is inimical to the subch. S area. Because of our holding that the facts do not warrant
the applicability of this doctrine to the present case we will not consider this rather fascinating
question.

Blum, 59 T.C. at 439 n. 4. In other words, the Blum court never reached the second step of the analysis, if there
is a second step, because it found that there was no economic outlay. The Tax Court focused on the first inquiry:
“we must find that the bank in substance loaned the sums to petitioner, not the corporation, and that petitioner
then proceeded to advance such funds to the corporation.” Id. at 440. The court found that “there is no evidence
to refute the fact that the bank expected repayment of its loan from the corporation and not the petitioner.” Id.
Similarly, in Brown, the Sixth Circuit refused to “accept petitioners’ contorted view of the transaction in
furtherance of their ‘substance over form’ argument when, as the court below observed, ‘the substance matched
the form.’” Brown, 706 F.2d at 756. In other words, the loan to the corporation was, indeed, a loan to the
corporation. See also In re Breit, 460 F. Supp. 873 (E.D. Va. 1978).
142

The appellants and Judge Fay, in his dissent, contend that the Tax Court has misread its earlier opinion.
Indeed, Judge Fay was the author of Blum. However, the Tax Court, sitting en banc, has now had the opportunity
to interpret more precisely the language of Blum in light of subsequent cases and arguments. Leavitt v.
Commissioner, 90 T.C. 206 (1988) (court reviewed). We agree with the amplification the Tax Court has given
Blum.
The confusion may be explained to some degree because the test applied in Blum to determine whether the bank
lent the money to the corporation or to the shareholders sounds similar to one of the debt-equity factors, i.e., the
source of the payments. When focusing on the proper question, however, it becomes clear that the debt-equity
principles are simply irrelevant to the determination of whether the $300,000, unquestionably a loan when it left
the Bank, went to VAFLA or to the appellants. In Blum, the fact that the bank expected repayment from the
corporation indicated that it actually lent the funds to the corporation and not the shareholder. Similarly, in the
case before us, the fact that VAFLA paid the principal and interest on the $300,000 loan and did not treat the

359

With regard to Selfe, the Tax Court stated:
the Eleventh Circuit applied a debt-equity analysis and held that a shareholder’s
guarantee of a loan made to a subchapter S corporation may be treated for tax
purposes as an equity investment in the corporation where the lender looks to the
shareholder as the primary obligor. We respectfully disagree with the Eleventh
Circuit and hold that a shareholder’s guarantee of a loan to a subchapter S
corporation may not be treated as an equity investment in the corporation absent
an economic outlay by the shareholder. [footnote omitted].
The Tax Court then distinguished Plantation Patterns, 462 F.2d 712 (5th Cir. 1972), relied
on by Selfe, because that case involved a C corporation, reasoning that the application of
debt-equity principles to subchapter S corporations would defeat Congress’ intent to limit
a shareholder’s pass-through deduction to the amount he or she has actually invested in
the corporation.143
....
Although Selfe does refer to debt-equity principles, the specific issue before it was whether
any material facts existed making summary judgment inappropriate. The Eleventh Circuit
said:
At issue here, however, is not whether the taxpayer’s contribution was either a loan
to or an equity investment in Jane Simon, Inc. The issue is whether the taxpayer’s
guarantee of the corporate loan was in itself a contribution to the corporation [as
opposed to a loan from the bank] sufficient to increase the taxpayer’s basis in the
corporation.

payments as constructive income taxable to the Shareholders-Guarantors, indicated that the Bank actually lent
the money to VAFLA and not the appellants.
143

The Committee on Finance of the Senate stated in its report:
The amount of the net operating loss apportioned to any shareholder pursuant to the above rule is
limited under § 1374(c)(2) to the adjusted basis of the shareholder’s investment in the corporation; that
is, to the adjusted basis of the stock in the corporation owned by the shareholder and the adjusted basis
of any indebtedness of the corporation to the shareholder.

S. REP. NO. 1983, 85th Cong., 2d Sess. at 220, (1958-3 Cum. Bull. at 1141). The word “investment” was construed
to mean the actual economic outlay of the shareholder in question. Perry v. Commissioner, 54 T.C. 1293, 1296
(1970).
In other words, the economic outlay must be found to exist first.

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The Selfe court found that there was evidence that the bank primarily looked to the
taxpayer and not the corporation for repayment of the loan.144 Therefore, it remanded for
“a determination of whether or not the bank primarily looked to Jane Selfe [taxpayer] for
repayment [the first inquiry] and for the court to apply the [thirteen] factors set out in In
re Lane[, 742 F.2d 1311 (1st Cir. 1984)] and § 385 to determine if the taxpayer’s guarantee
amounted to either an equity investment in or shareholder loan to Jane Simon, Inc. [the
second inquiry].” Id. at 775. The implications are that there is still a two-step analysis and
that the debt-equity principles apply only to the determination of the characterization of
the economic outlay, once one is found.
Granted, that conclusion is clouded by the next and final statement of the Selfe court: “In
short, we remand for the district court to apply Plantation Patterns and determine if the
bank loan to Jane Simon, Inc. was in reality a loan to the taxpayer.”145 To the degree that
the Selfe court agreed with Brown that an economic outlay is required before a shareholder
may increase her basis in a subchapter S corporation, Selfe does not contradict current law
or our resolution of the case before us. Furthermore, to the extent that the Selfe court
remanded because material facts existed by which the taxpayer could show that the bank
actually lent the money to her rather than the corporation, we are still able to agree.146 It is
because of the Selfe court’s suggestion that debt-equity principles must be applied to
resolve the question of whether the bank actually lent the money to the
taxpayer/shareholder or the corporation, that we must part company with the Eleventh
Circuit for the reasons stated above.
144

The loan officer so stated during deposition testimony. Furthermore, the bank originally extended a credit
line to the taxpayer in consideration of her pledge of 4500 shares of stock in another corporation. When her
business was later incorporated, the bank converted the loans made on the existing credit line to corporate loans,
accompanied by taxpayer’s agreement guaranteeing the corporation’s indebtedness to the bank. The Eleventh
Circuit noted that “a guarantor who has pledged stock to secure a loan has experienced an economic outlay to
the extent that that pledged stock is not available as collateral for other investments.” Id. at 772 n. 7. Thus, upon
remand, the district court could determine that there was an economic outlay on that basis alone, before deciding
whether the form of the loan was to the taxpayer or to the corporation.
This particular situation is not before us and we decline to address the question of whether a guarantee can be an
economic outlay when accompanied by pledged collateral.
It is unclear whether the reference to Plantation Patterns means that debt-equity principles should be applied
or refers back to an earlier statement in the Selfe court’s opinion which related to the initial inquiry:

145

In Plantation Patterns, the Fifth Circuit held that a loan is deemed to be made to a stockholder who has
guaranteed a corporate note when the facts indicate that the lender is looking primarily to the
stockholder for repayment.
Selfe, 778 F.2d at 771.
146

We note, however, that under the circumstances presented here, the Tax Court resolved that factual
determination against the appellants because they could not overcome the uncontradicted fact that they did not
treat the loan repayments made by VAFLA as constructive income to them. Such a position was inconsistent
with their claim that the transaction was in actuality a loan from the Bank to them followed by their contribution
of the $300,000 to the corporation.

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In conclusion, the Tax Court correctly focused on the initial inquiry of whether an
economic outlay existed. Finding none, the issue of whether debt-equity principles ought
to apply to determine the nature of the economic outlay was not before the Tax Court. The
Tax Court is
AFFIRMED.

Questions and comments:
1. Section 1374 is now § 1366(d)(1).
2. Courts now uniformly reach the same conclusion as the court did in Estate of Levitt.
See Messina v. Commissioner, T.C. Memo 2017-213 (2017), aff’d, 799 Fed. Appx. 466,
124 A.F.T.R.2d (RIA), 2020-1 USTC ¶ 50,108 (CA9 2019) (“S Corporation’s
indebtedness to another entity, even one wholly owned by the shareholder, does not
increase the amount of pass-through deductions the shareholder can claim”); Meruelo v.
Commissioner, 923 F.3d 938, 944-46 (CA11 2019) (inter-company loans among affiliated
pass-throughs did not establish shareholder basis because debt ran to affiliates); Hargis v
Koskinen, 893 F.3d 540, 544 (CA8 2018) (taxpayer was a co-borrower or guarantor of
loans to S corporations); Uri v. Commissioner, 949 F.2d 371 (10th Cir. 1991) (reached a
conclusion similar to the one reached by the court in Estate of Leavitt).
3. The court implied that the taxpayers were taking a “heads-I-win-tails-you-lose” position
on the burden of repaying the loan. The court indicated that the shareholders would not
pay income tax if the corporation repaid the loan. True?
•If the S corporation makes payments on the loan, presumably from its taxable
income, who pays income taxes on that income?
•As the amount of a corporation’s indebtedness decreased, the amount of
shareholders’ bases would increase.
•The only real question is whether the tax burden is assessed in the same proportion
as the guarantee obligations assumed by the individual shareholder?
Reg. § 1.1366-2(a)(2)(ii) states the rule of this case.
4. Suppose: Shareholder is given indebtedness basis for having guaranteed the repayment
of a loan extended to the corporation (as the taxpayers in Leavitt wanted). Shareholder
could then use that indebtedness basis to absorb corporate losses passed through to her.
Shareholder would have to reduce her basis by the amount of such losses. Assume that the
corporation makes payments on the loan.
•What effect should such repayment have on shareholder’s indebtedness basis?

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•Shouldn’t shareholder have to recognize taxable income every time the
corporation made a payment?
5. Reg. § 1.1366-2(a)(2)(i) states the requirements of basis indebtedness. What are they?
6. If shareholders want the lender to look to the corporation for repayment, but still be
entitled to indebtedness basis, is there a better way to structure the loan transaction?
•How about a back-to-back loan? The bank lends money to the shareholders
individually who in turn loan the money to the corporation. The bank loans would
have to be in the same proportion as the shareholders wished to assign guarantee
obligations amongst themselves. See Reg. § 1.1366-2(a)(2)(iii), Example 2.

Problem:
M forms an S corporation, and she is the sole shareholder. The corporation is a calendar
year taxpayer. M transfers $25,000 cash for all the corporation’s stock. In addition, she
contributes $25,000 in exchange for a bond. Furthermore, the corporation borrows $50,000
from the Fifth National Bank; M guarantees the loan. On October 1 of year 1, the
corporation distributes $30,000 to M. The corporation also loses $27,500. What are the tax
consequences to M? If M anticipated that there would be a distribution and losses in the
first year, how might she have planned these transactions more to her advantage?

IV. From C to S
A C corporation can become an S corporation simply by qualifying to be one (i.e., a “small
business corporation”) and making the election. Such a course will reduce the income tax
on corporate income that shareholders receive because such income will be subject to
income tax only at the shareholder level – and not at both the corporate and shareholder
levels. Of course, corporate income will pass through to shareholders and be taxed without
the benefit of any deferral that otherwise results if a C corporation retains income after
paying income tax on it.
This transition can be accomplished at very little tax cost, unlike a liquidation of a C
corporation – taxable at both the corporate and shareholder levels – followed by transfer
of the C corporation’s assets to another entity, e.g., a partnership, an LLC, or a corporation.
However, the fact that an S corporation was once a C corporation is not forgotten. The
earnings and profits that a corporation accumulated while a C corporation are still subject
to income tax as dividends if and when the corporation distributes them to shareholders.
The pass-through nature of an S corporation assures that there will be no current earnings
and profits. Only distributions and redemptions from accumulated earnings and profits
will cause an adjustment to that account. § 1371(c).
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The statute must provide some means of distinguishing between distributions that are from
an S corporation’s current income and distributions that are from its earnings and profits
accumulated while it was a C corporation. Section 1368 distinguishes between S
corporations that do and do not have accumulated earnings and profits. § 1368(a). The
distribution of an S corporation without accumulated earnings and profits first reduces the
shareholder’s basis in her stock; distributions in excess of basis are treated as gain from
the sale or exchange of property. § 1368(b)(1 and 2).
S corporations that were C corporations may have accumulated earnings and profits. Cf. §
1368(c). Distributions from corporations with such a history require a bit more tracing.
Section 1368 identifies distributions from S corporation earnings (and not from
accumulated earnings and profits) by establishing an “accumulated adjustments account”
(“AAA”). This account of the corporation (and not of its shareholders) begins with a $0
balance on the first day that the corporation is an S corporation. Reg. § 1.1368-2(a)(1).
The AAA is adjusted in the same manner as shareholder basis adjustments under § 1367,
except that no adjustment is made for tax exempt income, the account can have a negative
balance, and no adjustments are made for federal taxes attributable to a year when the
corporation was a C corporation. § 1368(e)(1)(A). A distribution from the S corporation
to a shareholder reduces the corporation’s AAA – but the distribution can neither cause
nor increase a deficit in the AAA. Reg. § 1.1368-2(a)(2)(iii).
The regulations provide a sequence in which adjustments to an S corporation’s AAA are
to be made. Reg. § 1368-2(a)(5).
1. Increases to AAA;
2. Decreases to AAA without regard to “net negative adjustments” for the taxable
year, § 1368(e)(1)(C)(1), i.e., to the extent of increases;
3. Distributions to which §§ 1368(c)(1) and 1368(b) apply, i.e., “Tier 1 infra.
4. Decrease for “net negative adjustments” for the taxable year, i.e., reductions
other than for distributions MINUS increases to such account, § 1368(e)(1)(C)(ii);
5. Increase or decrease as necessary for redemptions.
This sequence is important because it identifies distributions that may or may not be
dividends.
Section 1368(c) establishes an ordering of the sources from which an S corporation’s
distribution comes. Distributions come from three tiers147 in succession:

147 See

BORIS I. BITTKER AND JAMES S. EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS AND
SHAREHOLDERS ¶ 6.08[3], at 6-47 to 6-40 (Student ed., 7th ed. 2000).

364

1. “Tier 1”: A distribution that does not exceed the corporation’s AAA is treated
the same as a distribution by an S corporation that has no accumulated earnings
and profits, i.e., it passes through to the shareholders who pay no income tax but
do reduce the bases in their stock. §§ 1368(c)(1), 1368(b)(1).
2. “Tier 2”: Distributions that exceed the corporation’s AAA are treated as
dividends to shareholders to the extent of the corporation’s accumulated earnings
and profits. § 1368(c)(2).
3. “Tier 3”: A distribution that exceeds both the corporation’s AAA and its
accumulated earnings and profits148 is treated to the extent of the excess the same
as a distribution by an S corporation that has no accumulated earnings and profits,
i.e., it passes through to the shareholders who reduce the bases in their stock to the
extent thereof and then recognize gain as from the sale or exchange of property. §§
1368(c)(3), 1368(b)(1).
The source of distributions – whether AAA or accumulated earnings and profits – is
determined by pro-rating all the distributions occurring during a taxable year to the balance
of the corporation’s AAA at the close of the taxable year. Reg. § 1.1368-2(b)(2). In the
case of a redemption treated as an exchange under § 302(a) or § 303, the AAA must be
adjusted by the same portion of it as the portion of all the shares redeemed. §
1368(e)(1)(B). If the S corporation’s AAA is negative at the time of the redemption, the S
corporation’s AAA is adjusted (upward) by the same portion of the corporation’s deficit
in its AAA as the portion of all the shares redeemed. § 1368(e)(1)(B).
The shareholders of an S corporation can avoid paying income tax on a dividend simply
by not permitting the corporation to distribute more than the corporation’s AAA. Of
course, the corporation would continue to have accumulated earnings and profits – a point
that might trigger liability for certain subchapter S taxes. See § 1375, infra. The S
corporation may elect with the consent of all affected shareholders (i.e., those to whom a
distribution is made, § 1368(e)(3)(B)) to distribute its accumulated earnings and profits
before making distributions from AAA. § 1368(e)(3)(A). This would eliminate the need
to have an AAA and eliminate the risk of triggering liability for the § 1375 tax on an S
corporation’s passive investment income.
There are various other consequences to an S corporation resulting from the fact that it
was once a C corporation. There are no carryforwards or carrybacks from a C corporation
year to an S corporation year, § 1371(b)(1), or from an S corporation year to a C
corporation year, § 1371(b)(2). Such attributes are suspended and become available should

148 For example, a distribution of the corporation’s tax exempt income.

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a corporation’s status revert to what it was. However, the different corporate status does
not toll any tax attribute that by its terms expires. § 1371(b)(3).

Problems:
1. Corporation S, an S corporation, has accumulated earnings and profits of $1,000 and a
balance in the AAA of $2,000 on January 1, 2001. S’s sole shareholder B holds 100 shares
of stock with a basis of $20 per share as of January 1, 2001. On April 1, 2001, S makes a
distribution of $1,500 to B. B’s pro rata share of the income earned by S during 2001 is
$2,000 and B’s pro rata share of S's losses is $1,500. For the taxable year ending December
31, 2001, S does not have a net negative adjustment as defined in § 1368(e)(1)(C). S does
not make the election under § 1368(e)(3) and Reg. § 1.1368-1(f)(2) to distribute its
earnings and profits before its AAA. What adjustments are made to the corporation’s AAA
and when, what adjustments are made to B’s adjusted basis in her stock, and what is B’s
taxable income? See Reg. § 1.1368-3, Example 4.
2. Corporation S, an S corporation, has accumulated earnings and profits of $1,000 and a
balance in the AAA of $2,000 on January 1, 2001. S’s sole shareholder B holds 100 shares
of stock with a basis of $20 per share as of January 1, 2001. On April 1, 2001, S makes a
distribution of $2,000 to B. B’s pro rata share of the income earned by S during 2001 is
$2,000 and B’s pro rata share of S’s losses is $3,500. For the taxable year ending December
31, 2001, S has a net negative adjustment as defined in § 1368(e)(1)(C). S does not make
the election under § 1368(e)(3) and Reg. § 1.1368-1(f)(2) to distribute its earnings and
profits before its AAA. What adjustments are made to the corporation’s AAA and when,
what adjustments are made to B’s adjusted basis in his stock, and what is B’s taxable
income? See Reg. § 1.1368-3, Example 5.
3. On January 1, 1995, Corporation S has $40 of earnings and profits and a balance in the
AAA of $100. S has two shareholders, E and F, each of whom owns 50 shares of S’s stock.
For 1995, S has taxable income of $50, which increases the AAA to $150 as of December
31, 1995 (before taking into account distributions made during 1995). On February 1,
1995, S distributes $60 to each shareholder. On September 1, 1995, S distributes $30 to
each shareholder. S does not make the election under § 1368(e)(3) and § 1.1368-1(f)(2) to
distribute its earnings and profits before its AAA. Describe the tax consequences of these
transactions as well as the adjustments to the corporation’s AAA and accumulated
earnings and profits. See Reg. § 1.1368-3, Example 8.
4. When a distribution is made from a C corporation to a shareholder who is an individual
in exchange for the shareholder’s stock, the shareholder often prefers that the distribution
be given sale or exchange treatment. Why? Why might a shareholder of an S corporation
prefer that a distribution in redemption of her stock not be given sale or exchange
treatment? See, e.g., Rev. Rul. 95-14, 1995-1 C.B. 169.

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V. S Corporation Taxes
Section 1363(a) provides that “[e]xcept as otherwise provided in [subchapter S], an S
corporation shall not be subject to the taxes imposed by this chapter.” Subchapter S does
“otherwise provide” in some instances where an S corporation was previously a C
corporation.

A. Tax Imposed on Built-in Gains
Prior to repeal of the General Utilities rule, a C corporation with substantial built-in gain
in its assets could avoid payment of the corporate level of income tax by distributing assets
in kind to its shareholders. Repeal of the General Utilities rule now makes such
distributions into recognition events at the corporate level. § 311(b)(1). However,
avoidance of the corporate level of income tax on built-in gains would appear possible by
conversion of the C corporation into an S corporation. Theoretically, the built-in gain on
assets would not be taxed at the corporate level – which was the very essence of the
General Utilities rule. Section 1374 closes this loophole for those corporations that were
not always S corporations. § 1374(c)(1). Section 1374(a) imposes the maximum corporate
rate of § 11(b) on an S corporation’s “net recognized built-in gain” derived in a taxable
year during “the recognition period.” §§ 1374(a), 1374(b)(1). The “recognition period” is
the five-year period commencing with the first day that the corporation is an S corporation.
§ 1374(d)(7)(A); Reg. § 1.1374-1(d).
We work our way through some definitions to get to the
tax base of this tax:
Net unrealized built-in gain: “Net unrealized built-in
gain” is the total fair market value of the S corporation’s
assets MINUS the aggregate adjusted bases of such
assets on the first day of the first taxable year for which
an S corporation election is in effect. § 1374(d)(1). Reg.
§ 1.1374-3(a) instructs how to compute “net unrealized
built-in gain.” Read it.

Before converting from C to S:
When examining the rules of §
1374, you should conclude that
a C corporation should inventory
its assets and determine their
bases. Such an inventory and
appraisal will probably save
tax liability later. See §
1374(d)(3)(A)
(“recognized
built-in gain” does not include
gain on disposition of assets not
held at the beginning of the first
taxable year the corporation
was an S corporation).

The corporation must pay tax on the gain it recognizes
during the “recognition period” from the disposition of
any asset that it held when it converted to an S
corporation. Section 1374(c)(2) requires that the corporation keep a running total of what
unrealized built-in gain it has previously recognized until it has recognized all its built-in
gains or the five-year “recognition period” elapses.

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•“Recognized built-in gain” does not include the appreciation in value of assets that
occurs after conversion to S corporation status. § 1374(d)(3)(B). The same rules
apply to “recognized built-in loss”. § 1374(d)(4).
•The burden is on the S corporation to establish the values and bases of assets
necessary to make these determinations. § 1374(d)(3).
Net recognized built-in gain: “Net recognized built-in gain” is the amount of recognized
gains derived in a taxable year from the disposition of assets the corporation held when it
converted to an S corporation MINUS the amount of recognized losses in the same taxable
year, OR the corporation’s taxable income for the year if it is less than such gain. §
1374(d)(2). This is the amount on which the S corporation must pay the § 1374 tax.
•The S corporation’s taxable income for this purpose is the S corporation’s taxable
income PLUS deductions allowed by §§ 241 to 249 (other than § 248
(organizational expenditures) PLUS deductions allowed by § 172 (net operating
loss). § 1374(d)(2)(A)(ii), referencing § 1375(b)(1)(B).
•In the event that “taxable income,” as defined, is less than net recognized built-in
gain for any taxable year, then
(net recognized built-in gain) MINUS (“taxable income”)
is to be treated as a “recognized built-in gain” in the next succeeding
taxable year. § 1374(d)(2)(B). The amount recognized and the amount
deferred is to be apportioned ratably among the items of income, gain,
loss, and deduction. Reg. § 1374-2(c and d). See also Reg. § 1.1374-2(e),
Example.
•The S corporation may deduct against its “net recognized built-in gain” net
operating loss carryforwards from its time as a C corporation. § 1374(b)(2). The S
corporation may also reduce the amount of the § 1374 tax by certain business
credits under § 39. § 1374(b)(3).
•Income items and deduction items that the S corporation takes into account during
the “recognition period” attributable to periods before the first taxable year for
which the corporation is an S corporation are to be treated as a recognized built-in
gain or recognized built-in loss. § 1374(d)(5)(A and B). This will necessitate an
adjustment to the S corporation’s “net unrealized built-in gain.” § 1374(d)(5)(C).
•The regulations make the predecessor C corporation into an accrual method
taxpayer for purposes of determining “recognized built-in gain or loss.” Reg. §
1.1374-4(b) provides in part:
(b) Accrual Method Rule –
1. Income Items. Except as otherwise provided in this section, any item of
income properly taken into account during the recognition period is
recognized built-in gain if the item would have been properly included in
gross income before the beginning of the recognition period by an accrual
method taxpayer (disregarding any method of accounting for which an
368

election by the taxpayer must be made unless the taxpayer actually used the
method when it was a C corporation).
2. Deduction Items. Except as otherwise provided in this section, any item
of deduction properly taken into account during the recognition period is
recognized built-in loss if the item would have been properly allowed as a
deduction against gross income before the beginning of the recognition
period to an accrual method taxpayer (disregarding any method of
accounting for which an election by the taxpayer must be made unless the
taxpayer actually used the method when it was a C corporation). In
determining whether an item would have been properly allowed as a
deduction against gross income by an accrual method taxpayer for purposes
of this paragraph, § 461(h)(2)(C) and § 1.461-4(g) (relating to liabilities for
tort, worker's compensation, breach of contract, violation of law, rebates,
refunds, awards, prizes, jackpots, insurance contracts, warranty contracts,
service contracts, taxes, and other liabilities) do not apply.
•If the basis of an asset that the S corporation holds at the beginning of the first
taxable year in which it is an S corporation is determined by reference to the basis
of another asset that the taxpayer holds (e.g., the result of a like-kind exchange),
determinations of “recognized built-in” gain or loss are made with reference to the
asset that the S corporation did hold at the beginning of its first S corporation year.
§ 1374(d)(6).
•If the exchange occurs after the S corporation’s first day as an S
corporation, the tax on “net recognized built-in gain” will be assessed on
the disposition of those assets. § 1374(d)(8)(A). In such a case, the fiveyear recognition period commences on the day the S corporation acquired
the asset in a § 1374(d)(8) transaction. Reg. § 1.1374-1(d).
•Reg. § 1.1374-1(a) provides an outline of the statutory scheme for computing the
§ 1374 tax. Read it.
•The § 1374 tax is treated as a loss that the S corporation sustained during the
taxable year. § 1366(f)(2). The character of the loss is determined by allocating the
tax proportionately among the recognized built-in gains that gave rise to the tax. §
1366(f)(2).

Do the CALI exercise:
S Corporation Taxation: Taxation of the S Corporation: S Corporation Built-in Gains:
General. (Some of the questions may raise issues that we do not cover. Roll with it.)

369

Problems:
A. X, a calendar year C corporation using the cash method, elects to become an S
corporation on January 1, 2016. On December 31, 2015, X has assets and liabilities as
follows:
Assets

FMV

Basis

Factory
$500,000
Accounts Receivable 300,000
Goodwill
250,000

$900,000
0
0

Total

$1,050,000

$900,000

Liabilities
Mortgage
Accounts Payable

Amount
$200,000
100,000

Total

$300,000

Further: X must include a total of $60,000 in taxable income in 2016, 2017, and 2018
under § 481(a) – an adjustment resulting from its accounting method in X corporation’s C
corporation period. § 1374(d)(5). What is X’s net unrealized built-in gain?
B. What is X corporation’s “net unrealized built-in gain” in 2015? See Reg. § 1.1374-3(c),
Example 1.
C. In 2019, X sold the accounts receivable for $300,000. X’s taxable income in 2019 was
$1M. How much is the tax imposed by § 1374 on this sale?
D. How does X treat the tax paid in #C when determining its income as an S corporation?

Do the CALI exercise:
S Corporation Taxation: Taxation of the S Corporation: S Corporation Built-in Gains:
Computation of the Tax.

370

B. Tax on Passive Investment Income
In addition to risking termination of S corporation status,149 an S corporation that has any
accumulated earnings and profits may have to pay a tax equal to the highest corporate tax
rate on its “excess net passive income.” §§ 1366(d)(3), 1375(a). Section 1375(b) provides
the key definitions that work towards identifying “excess net passive income,” and Reg. §
1.1375-1(b)(1) provides workable abbreviations:
•“passive investment income (“PII”):” § 1375(b)(3), incorporates the definition of
that phrase at § 1362(d)(3)(C). The phrase means gross receipts derived from
royalties, rents, dividends, interest, and annuities. § 1361(d)(3)(C)(i). There are
exceptions to this definition, most notably for interest on obligations acquired in
the ordinary course of business from the sale of inventory. § 1361(d)(3)(C)(ii).
“Passive investment income” does not include capital gains, § 1362(d)(3)(C)(i).
•“net passive income (“NPI”),” § 1375(b)(2): NPI is “passive investment income”
MINUS deductions directly connected with the production of such income.
•“gross receipts (“GR”):” The following adjustments are made to “gross receipts:”
•Dispositions of capital assets that are not stock or securities: The S
corporation measures its “gross receipts” by netting gains and losses
(“capital gain net income,” § 1222(9)) from the disposition of assets that
are not stock or securities. § 1362(d)(3)(B)(i).
•Sales or exchanges of capital assets that are stock or securities: The S
corporation measures its “gross receipts” derived from the sales or
exchanges of capital assets that are stock or securities by taking into
account only gains from such sales or exchanges. § 1362(d)(3)(B)(ii).
•“excess net passive investment income (“ENPI”),” i.e., the amount which is taxed:
ENPI is derived by performing some calculations as prescribed in § 1375(b)(1)(A):
ENPI = NPI * [(PII − (0.25 * GR)]/PII
•ENPI cannot be more than the S corporation’s taxable income PLUS
deductions allowed by §§ 241 to 249 (other than § 248 (organizational
expenditures) PLUS deductions allowed by § 172 (net operating loss).
§ 1375(b)(1)(B).
•Observation: If GR (as specially defined) is more than four times as much as PII,
there will be no § 1375 tax, and “passive investment income” will not exceed 25%
of the corporation’s “gross receipts,” thereby breaking the string of potentially
three successive years where “passive investment income” exceeds 25% of the S
corporation’s “gross receipts.”

149 An S corporation with earnings and profits whose “passive investment income” exceeds 25% of its “gross

receipts” for three consecutive years loses its S corporation status. § 1362(d)(3).

371

•The § 1375 tax reduces the shareholders’ share of the corporation’s passive investment
income that passes through to the shareholders according to the following formula:
(item of passive investment income)/(total passive investment income) * (§
1375 tax)
•§ 1366(f)(3).
•Reminder: an S corporation can avoid the § 1375 tax by not having any
accumulated earnings and profits. If the S corporation establishes to the satisfaction
of the Secretary that it in good faith believed that it had no accumulated earnings
and profits when in fact it did have such earnings and profits and within a
reasonable time distributes those earnings and profits, the Secretary may waive the
§ 1375 tax. § 1375(d).
If § 1374 and § 1375 are both applicable to a transaction, § 1374 alone applies. §
1375(b)(4).
Example (Reg. § 1.1375-1(f), Example 1: Assume Corporation M, an S corporation, has
for its taxable year total gross receipts of $200,000, passive investment income of
$100,000, $60,000 of which is interest income, and expenses directly connected with the
production of such interest income of $10,000. Assume also that at the end of the taxable
year Corporation M has subchapter C earnings and profits. Since more than 25% of
Corporation M’s total gross receipts are passive investment income, and since Corporation
M has subchapter C earnings and profits at the end of the taxable year, Corporation M will
be subject to the tax imposed by § 1375. The amount of “excess net passive income” is
$45,000, i.e.,
$90,000 * [$100,000 − ($200,000 * 0.25)]/$100,000
The § 1375 tax would be 21% of $45,000 = $9450.
*Of course, M Corporation’s taxable income must be more than $45,000.
Otherwise, its ENTI would be M Corporation’s taxable income.

Problem:
Assume an S corporation with subchapter C earnings and profits has tax-exempt income
of $400, its only passive income, gross receipts of $1,000 and taxable income of $250 and
there are no expenses associated with the tax-exempt income. What is the S corporation’s
“excess net passive income” for the taxable year? Does it matter that the S corporation’s
only passive income is otherwise tax-exempt? See Reg. 1.1375-1(f), Example 2.

Do the CALI exercise:
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S Corporation Taxation: Taxation of the S Corporation: S Corporation Tax on Passive
Investment Income.

C. LIFO Recapture Tax
In a market where the value of inventory is increasing, a taxpayer may pay less in taxes
for income derived from the sale of inventory if she accounts for such income using the
LIFO (last in, first out) method of accounting rather than FIFO (first in, first out) method
of accounting. This will continue unless the taxpayer sells all its inventory and does not
replace it before the end of a taxable year. Thus, there is built-in gain that can increase
over time. Section 1363(d) provides that a C corporation that converts to an S corporation
that used the LIFO method in its last taxable year as a C corporation must include a LIFO
recapture amount in its gross income (with appropriate adjustments to basis) for its last
taxable year as a C corporation. § 1363(d)(1).
•Taxpayer may pay the increased income tax over four years in equal installments
without interest. § 1363(d)(2)
•The LIFO recapture amount is the amount by which the inventory amount under
FIFO exceeds the inventory amount under LIFO on the last day of the taxable year
in which the corporation was a C corporation. § 1363(d)(3)

Do the CALI exercise:
S Corporation Taxation: Taxation of the Shareholder: S Corporation Entity Level
Determinations.

Do the CALI exercise:
S Corporation Taxation: Taxation of the S Corporation: S Corporation LIFO Recapture
Rules.

VI. Fringe Benefits, Employee Matters
With respect to employee fringe benefits in the context of a subchapter S corporation, §
1372 provides that the S corporation is to be treated as a partnership. A 2%-shareholder is
to be treated as a partner. § 1372(a)(2). The attribution rules of § 318 apply in determining
whether a shareholder holds “more than” 2% of the total combined voting power of the S
corporation. § 1372(b).
For purposes of health and accident insurance, the IRS has determined that an S
corporation that provides a “more than 2% shareholder” such insurance is treated the same
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as a partnership that makes a guaranteed payment to a partner under § 707(c), i.e.,
deduction for the employer and taxable income to the shareholder. Rev. Rul. 91-26, 19911 C.B. 184. The S corporation may deduct such payments. Notice 2008-1, 2008-1 C.B.
251. The 2% shareholder is entitled to a deduction under § 162(l). Chief Counsel Advice
2019-12-001 (March 22, 2019). Very little additional guidance on fringe benefits is
available.
What should be the rule about employment taxes, i.e., social security, Medicare,
unemployment? Why might an S corporation’s shareholders who are also employees
prefer to characterize a distribution as a dividend rather than the payment of salary? See
David E. Watson v. United States, 668 F.3d 1008 (8th Cir.), cert. denied, 133 S. Ct. 364
(2012).
Payments from an S corporation to a shareholder that are not salary or wages are not subject
to self-employment taxes. Moreover, an S corporation shareholder enhances his § 199A
deduction by lowering the W-2 wages floor.

VII. Termination Matters
A. Termination of Election
The subchapter S election may be terminated in one of three ways:
•(1) By consent of shareholders who hold more than one half of the shares. §
1362(d)(1)(B). If such a “revocation” is made before the 15th day of the third month
of the taxable year, it is effective from the first day of the taxable year. §
1362(d)(1)(C)(i). A revocation made after that day is effective on the first day of
the following taxable year. § 1362(d)(1)(C)(ii). The revocation may specify a date
for revocation after the date on which the revocation is made. § 1362(c)(1)(D).
•While all shareholders must consent to make an S corporation election, a
simple majority is sufficient to revoke the election. Dissenting shareholders
cannot prevent a revocation.
•A revocation may be rescinded at any time before it becomes effective.
Reg. § 1.1362-2(a)(4).
•Specifying a date for revocation can ameliorate accounting difficulties.
•(2) A subchapter S election is terminated upon the “small business corporation”
ceasing to be a “small business corporation.” § 1362(d)2)(A).150 The termination
is effective on and after that date. § 1362(d)(2)(B).

150 The corporation should prospectively take measures to prevent dissident shareholders from transferring their

shares to ineligible shareholders or to a sufficient number of shareholders that the total number of shareholders

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•A termination caused by ceasing to be a “small business corporation” is
prospective only. A “revocation,” supra, may be retroactive.
•(3) If an S corporation was previously a C corporation, has any (even $1)
accumulated earnings and profits at the close of three consecutive tax years while
an S corporation, and has “passive investment income” for those years that exceeds
25% of its gross receipts, its S election is terminated. § 1362(d)(3)(A).
•“Passive investment income” is gross receipts derived from royalties,
rents, dividends, interest, and annuities. § 1361(d)(3)(C)(i). There are
exceptions to this definition, most notably for interest on obligations
acquired in the ordinary course of business from the sale of inventory. §
1361(d)(3)(C)(ii). The termination is effective on the first day of the first
taxable year after the third year passive investment income exceeds gross
receipts. § 1362(d)(3)(A)(iii).
•Dispositions of capital assets that are not stock or securities: The S
corporation measures its “gross receipts” by netting gains and
losses (“capital gain net income,” § 1222(9) from the disposition of
assets that are not stock or securities. § 1362(d)(3)(B)(i)).
•Sales or exchanges of capital assets that are stock or securities: The
S corporation measures its “gross receipts” derived from the sales
or exchanges of capital assets that are stock or securities by taking
into account only gains from such sales or exchanges. §
1362(d)(3)(B)(ii).
•Should the S corporation want to include losses in
determining its “gross receipts?”

Do the CALI exercise:
S Corporation Taxation: Termination of the S Election: The Termination of S Election by
Revocation.
•This exercise gets into the specific requirements for a revocation. Have your
regulations handy.

Do the CALI exercise:
S Corporation Taxation: Termination of the S Election: The Termination of S Election:
Causes.
•This lesson provides a useful review of S corporation principles.

will exceed 100. The corporation should make agreement to a prohibition on such transfers a condition to
holding shares in the corporation.

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B. Termination of Election: S Short Year and C Short Year
An S corporation that no longer has a valid election in
effect remains a corporation and so becomes a C Tax Cuts and Jobs Act, § 11(b): The
corporation. A termination may occur at any time TCJA eliminated progressivity in
the corporate tax rates. The
during a taxable year and so a fortiori there will be a
corporate tax rate is now a flat
short S corporation year followed by a short C
21%. Thus, a § 1362(e)(5)(A)
corporation year. In the S termination year, the portion “gross-up” of C short-year income
of the year before the first day for which the S no longer has any effect.
termination is effective is the “S short year.” §
1362(e)(1)(A). The portion that begins on the first day for which the S termination is
effective is the “C short year.” § 1362(e)(1)(B). The due date for the “S short year” and
the “C short year” are the same, i.e., the due date for the “C short year.” § 1362(e)(6)(B).
The corporation first determines its separately stated items151 of income, loss, deduction,
or credit and nonseparately computed income and loss. § 1362(e)(2)(A). A pro-rated
amount of each is assigned to each day of the S termination year.152 § 1362(e)(2)(B). The
balance of income items is assigned to the “C short year.” The price of the workability of
the pro rata method is some inaccuracy.
•The income attributable to the C short year is “annualized,” as per the formula of §
1362(e)(5)(A). The result is that the C corporation loses the benefit of annual
progressive rates applied to a short year. But see accompanying text box.
•If all the shareholders who are or were shareholders during the S corporation’s
short year and all the persons who are shareholders of the C corporation on the first
day of the “C short year” consent, the S corporation may assign separately and
nonseparately stated items under normal tax accounting rules. § 1362(e)(3).
•If there is a sale of 50% or more of the stock of the S corporation during the S
short year, normal tax accounting rules apply rather than a pro rata allocation. §
1362(e)(6)(D).
•The pro rata method also does not apply to any “item” resulting from application
of § 338, i.e., when the S election is terminated because the corporation becomes
part of a “consolidated group.” § 1362(e)(6)(C).
•The “S short year” does not count as a year for carryover purposes in determining
the number of years an item may be carried back or forward. § 1362(e)(6)(A). A
carryforward or carryback is not allowed from an S corporation to a C corporation.
§ 1371(b)(2).

151 ... i.e., those that “could affect the liability for tax of any shareholder,” § 1366(a)(1)(A).
152 The “S termination year” is not a short year, but rather the taxable year during which an election to revoke takes

effect, other than on the first day of such year. § 1362(e)(4).

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C. Post Termination Transition Period
After termination of the S election, the corporation enters a “post termination transition
period” during which shareholders of the S corporation continue to enjoy some of the
benefits of holding shares in an S corporation rather than a C corporation. Otherwise, such
benefits would (in all likelihood) be lost. The “post-termination transition period” are the
following three periods:
#1. the period commencing the day after corporation’s last day as an S corporation
and ending on the later of
•one year after such day or
•the due date for filing the return for such last year, including extensions. §
1377(b)(1)(A).
and
#2. the 120-day period commencing on the date of any “determination” pursuant
to an audit following the termination of the corporation’s S election and which
adjusts a subchapter S item of income, loss, or deduction of the corporation during
the S period. § 1377(b)(1)(B).
and
#3. the 120-day period commencing on the date of a “determination” that the
corporation’s S election had terminated for a previous taxable year. §
1377(b)(1)(C).
A “determination” is a(n) –
•decision of the Tax Court or another court of competent jurisdiction that has
become final,
•closing agreement under § 7121 (agreement of Secretary with respect to any
internal revenue tax),
•final disposition of the Secretary of a claim for a refund, or
•agreement of the Secretary and the taxpayer in respect of an income tax. §
1377(b)(2)(A), cross-referencing 1313(a), OR
•agreement between the Secretary and the corporation that fails to qualify as an S
corporation. § 1377(b)(2)(B).
Thus, there are three different ways to measure the “post termination transition period,”
and a former S corporation and its shareholders are entitled to rely on any and all that
apply.

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D. Suspended Losses and Distributions During the Post-Termination Transition
Period
Suspended Losses: In the event a shareholder’s loss or deduction was not allowed during
the corporation’s last year as an S corporation for lack of sufficient basis, either in her
stock or indebtedness, the loss is treated as incurred on the last day of any post-termination
transition period. § 1366(d)(3)(A).
•Observe: The loss is treated as a loss of the S corporation in a year in which the
corporation is not actually an S corporation.
The amount of losses and deductions taken into account may not exceed the shareholder’s
adjusted basis in her stock, also as determined on the last day of the post-termination
transition period, § 1366(d)(3)(B), and the amount allowed as a loss or deduction reduces
the shareholder’s adjusted basis in her stock, § 1366(d)(3)(C).
•The shareholder has the opportunity to increase her basis in her stock (but not
indebtedness basis, § 1366(d)(3)(B)) in order to utilize suspended losses that will,
in all likelihood, otherwise disappear. These rules also apply to the shareholder’s
amount at risk under § 465. § 1366(d)(3)(D).
•The shareholder also increases the basis of her stock if she is allocated
income as the result of an audit. See § 1377(b)(3)(A).
Distributions: The corporation may also distribute cash, infra. Any distribution of money
during the S corporation’s post-termination transition period with respect to its stock is tax
free and reduces the corporation’s AAA to the extent thereof. § 1371(e)(1).
•A distribution of cash during the post-termination transition period in redemption
of the corporation’s stock that is characterized as a distribution subject to § 301
reduces the corporation’s AAA to the extent thereof. Rev. Rul. 2019-13, 2019-20
I.R.B. 1179.
•If the termination of S status resulted from an audit that caused an adjustment of
an S corporation item of income, loss, or deduction (i.e., § 1377(b)(1)(B), #2,
supra), a distribution of money reduces the corporation’s AAA only to the extent
that the adjustment resulted in an increase of the corporation’s AAA. §
1377(b)(3)(B). Any excess is treated as a dividend and reduces the corporation’s
accumulated earnings and profits.
•If all shareholders agree and the post-termination transition period follows a
revocation (i.e., as described in § 1377(b)(1)(A) (#1, supra), the corporation may
elect to count distributions of money first against accumulated earnings and profits
rather than AAA. § 1371(e)(2).
•Reg. § 1.1377-2(b) provides in part that distributions of money with respect to the
corporation’s stock during the post termination transition period is available only
to “those shareholders who were shareholders in the S corporation at the time of
the termination.” It is not clear what happens to any balance in a corporation’s
AAA once the post termination transition period ends.
378

•“A corporation that doesn’t distribute all of its AAA within the PTTP [may not]
still distribute its remaining AAA balance tax-free if it reelects to become an Scorp.” Tomseth v. United States, 413 F. Supp.2d 1018, 1023-29 (D. Ore. 2019).

Do the CALI exercise:
S Corporation Taxation: Termination of the S Election: The Termination of S Election:
Consequences.

Do the CALI exercise:
S Corporation Taxation: Termination of the S Election: The Post Termination Transition
Period of an S Corporation.

379

Chapter 8: Taxable Acquisitions

I. Introduction
Suppose that a corporation wishes to acquire control of another corporation or to acquire
all the assets of another corporation. A corporation may purchase the other corporation’s
stock from its shareholders or purchase the other corporation’s assets directly from it.
Compare the income tax consequences of the following:
Some standard vocabulary: Both
in tax literature and in the
regulations, the corporation that
acquires another corporation is
referred to as “Acquiring,”
“Acquiring Corporation,” or
simply as “A.” The corporation
that is being acquired is
referred to as “Target,” “Target
Corporation,” or simply as “T.”

Suppose: T Corporation owns Blackacre, and
Blackacre is T’s only asset. R owns all the stock of T
Corporation. T Corporation’s basis in Blackacre is
$10. The fmv of Blackacre is $100. R’s basis in his
stock is $10, and the fmv of R’s stock is $100. A
Corporation wishes to own Blackacre – or at least to
control its use. How might it go about acquiring
Blackacre, and what would be the income tax
consequences of doing so?

•The corporate acquirer (A Corporation) may alternatively –
•Option 1: purchase all the shares of the corporation
and continue the business of the corporation as a
subsidiary. R must pay income tax on $90 of capital
gain. T Corporation never goes out of existence and
retains all its assets and liabilities. The bases of
corporate assets do not change. A Corporation owns a
corporation that owns Blackacre.
•Should A Corporation be willing to pay $100
for R’s stock? After all, that is the stock’s fmv.
Why not? How should A Corporation
determine the value of T Corporation stock to
it?
•Option 2: purchase all the assets of the corporation. A
Corporation would purchase Blackacre from T
Corporation. T Corporation must recognize gain or
loss on the sale of its assets. (Moreover, there is no
preferential rate on the capital gains of a corporation.)
The purchaser takes a cost basis in all the assets that it
purchases. Thus, future cost recovery allowances
380

Tax-deferred
reorganizations:
When a corporation uses its own
stock, or the stock of a corporation
that it controls or that controls it as
a medium of exchange to gain
control or ownership of another
corporation, the Code may defer
imposing an income tax on the
parties to the exchange. Such tax
deferral will usually be the
preferred course. Tax-deferred
reorganizations is the subject of
the next chapter. There are
conditions on such favorable tax
treatment – and the parties may
regard satisfying those conditions
as too onerous. Moreover, the
TCJA has made the use of cash
consideration to acquire assets
more attractive. See § 168(k).

(assuming that the assets A Corporation purchased are subject to cost recovery allowances)
will be higher than if A had purchased stock of T.
•The TCJA provides bonus depreciation allowances for most depreciable property.
See § 168(k). Before 2023, the bonus is equal to 100% of the amount paid for the
asset. Over the succeeding years, the bonus drops by twenty percentage points per
year. § 168(k)(6). The allowance of “expensing” the purchase of assets will cause
more acquisitions to be made with cash.153
•Since the purchaser has acquired assets rather than stock of a corporation, the
purchaser can probably shed the corporation’s liabilities.
•After the purchase, the selling corporation (T Corporation) has only cash. T
Corporation can either purchase other assets or liquidate. If T Corporation
liquidates, R (the shareholder) must recognize taxable capital gain. § 331. Thus, a
corporate sale of assets followed by liquidation involves two levels of tax.
•From R’s standpoint, this double tax is often
costly and may impel R to prefer a stock sale.
Special
Purpose
Acquisition
Companies (SPACs): SPACs are
What must R do to convince Acquiring
corporations formed for the purpose
Corporation to purchase his stock rather than
of acquiring a firm in need of
Target Corporation’s assets?
capital.
The SPAC itself is a
corporation whose stock is public
While a reorganization offers taxpayers the
traded. Investors in the SPAC put up
advantages of tax deferral, which occurs
cash. The SPAC acquires a firm in
through the carryover of basis in stock or other
need of capital by exchanging cash
asset, there are occasions when a taxable
for shares.
Investors in SPACs
acquisition of assets provides sufficient
receive shares of a corporation that
advantages to make it the preferred course. In a
hopefully will reward them with
time of bonus depreciation and low interest rates
handsome returns. The acquired
on borrowing, this is even more likely. (N.B.
firm saves the expense and
Section 163(j) limits the deductibility of
uncertainties of an initial public
interest, essentially to 30% of a taxpayer’s
offering (IPO) and acquires needed
taxable income.) Moreover, in a taxable
cash. Of course, the acquired firm
transaction, the purchaser takes a cost
will see the value of its shares
(presumably fmv) basis in all the assets that it
diluted. Existing shareholders of the
purchases – which can provide tax benefits
acquired firm will also see their
control of it eroded. See generally
immediately or in future years. And suppose –
SPAC Invasion, ECONOMIST, Feb. 20,
•T is carrying a substantial amount of NOLs. An
2021, at 59. The actual acquisition
NOL is a tax attribute that functions only to
may take the form of a
reduce future taxable income (and so, tax
reorganization, infra, or a transfer
liability). Thus, its present value is less than its
of cash for shares.
undiscounted face amount. The corporation may
153 The number of all-cash mergers and acquisitions has “exploded.” See Steward Karlinsky, Developments in

Corporate and Partnership Tax Law, TAX NOTES (Dec. 17, 2018) 1477, 1479 (examples: Bayer AG acquisition of
Monsanto Co., CVA Health acquisition of Aetna Inc., Campbell Soup Co. acquisition of Snyder Lance Inc.).

381

not be profitable. A taxable acquisition is a means of facilitating and accelerating
use of the NOL.154 OR
•T is an S corporation. A purchase of assets would result in a single layer of income
tax, i.e., at the shareholder level. Shareholders of the S corporation have increased
the bases in their stock every time they paid income tax on the corporation’s
income – an event that occurs annually. A distribution in liquidation may result in
little additional taxable gain to shareholder R.
•Furthermore, since a C corporation may not own shares of an S
corporation, a taxable acquisition may expedite the acquisition. OR
•T is a controlled corporation. A can purchase the assets of T. T liquidates, but §
332 permits T’s parent to take the proceeds of the sale without another level of
income tax liability.
These points suggest some matters to consider in the context of taxable acquisitions. Not
surprisingly, some important considerations will be –
•whether T Corporation has NOLs;
•the time value of money, including the time value of deferring tax liabilities or
accelerating loss recognition;
•the availability of cost recovery (including bonus depreciation) or amortization
deductions, their amount, and their present and future values;
•whether shareholders would have recognizable losses in a taxable transaction;
•the tax brackets of the parties;
•the character of any taxable gain or recognizable loss; and
•others.
We should expect that parties to a taxable acquisition will negotiate with an eye towards
the tax consequences of any deal. They can in essence buy and sell tax attributes so as to
achieve the most tax efficient bargain.

II. The Immediate Tax Consequences of an Acquisition of Assets for Cash
The immediate tax consequences of an acquisition for cash will turn on a determination of
just what the purchaser has purchased and what the seller has sold. Consider this old but
controlling case:

154

Section 382 limits the use of an NOL by an acquiring corporation. See chapter 9:IV:B infra.

382

Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945)
L. HAND, Circuit Judge
....
Williams, the taxpayer, and one, Reynolds, had for many years been engaged in the
hardware business in the City of Corning, New York. On the 20th of January, 1926, they
formed a partnership, of which Williams was entitled to two-thirds of the profits, and
Reynolds, one-third. ... The business was carried on through the firm’s fiscal year, ending
January 31, 1940, in accordance with this agreement, and thereafter until Reynolds’ death
on July 18th of that year. Williams settled with Reynolds’ executrix on September 6th in
an agreement by which he promised to pay her $12,187.90, and to assume all liabilities of
the business; and he did pay her $2,187.98 in cash at once, and $10,000 on the 10th of the
following October. On September 17th of the same year, Williams sold the business as a
whole to the Corning Building Company for $63,926.28 its agreed value as of February 1,
1940 “plus an amount to be computed by multiplying the gross sales of the business from
the first day of February, 1940 to the 28th day of September, 1940,” by an agreed fraction.
This value was made up of cash of about $8100, receivables of about $7000, fixtures of
about $800, and a merchandise inventory of about $49,000, less some $1000 for bills
payable. To this was added about $6,000 credited to Williams for profits under the
language just quoted, making a total of nearly $70,000. Upon this sale Williams suffered
a loss upon his original two-thirds of the business, but he made a small gain upon the one
third which he had bought from Reynolds’ executrix; and in his income tax return he
entered both as items of “ordinary income,” and not as transactions in “capital assets.”
This the Commissioner disallowed and recomputed the tax accordingly; Williams paid the
deficiency and sued to recover it in this action. The only question is whether the business
was “capital assets” ...
It has been held that a partner’s interest in a going firm is for tax purposes to be regarded
as a “capital asset.” ... When Williams bought out Reynolds’ interest, he became the sole
owner of the business, the firm had ended upon any theory, and the situation for tax
purposes was no other than if Reynolds had never been a partner at all, except that to the
extent of one-third of the “amount realized” on Williams’ sale to the Corning Company,
his “basis” was different. … [T]he method by which the parties agreed upon the price was
irrelevant to the computation of Williams’ income. The Treasury, if that served its interest,
need not heed any fiction which the parties found it convenient to adopt; nor need Williams
do the same in his dealings with the Treasury. We have to decide only whether upon the
sale of a going business it is to be comminuted into its fragments, and these are to be
separately matched against the definition in § 117(a) (1) [i.e., § 1221(a)], or whether the
whole business is to be treated as if it were a single piece of property.

383

... [E]ven though we might agree that under the influence of the Uniform Partnership Act
a partner’s interest in the firm should be treated as indivisible, and for that reason a “capital
asset” within § 117(a)(1) [§ 1221(a)], we should be chary about extending further so exotic
a jural concept. Be that as it may, in this instance the section itself furnishes the answer. It
starts in the broadest way by declaring that all “property” is “capital assets,” and then
makes three[155] exceptions. The first is “stock in trade *** or other property of a kind
which would properly be included in the inventory”; next comes “property held ***
primarily for sale to customers”; and finally, property “used in the trade or business of a
character which is subject to *** allowance for depreciation.” In the face of this language,
... by no possibility can a whole business be so treated; and the same is true as to any
property within the other exceptions. Congress plainly did mean to comminute the
elements of a business; plainly it did not regard the whole as “capital assets.”
As has already appeared, Williams transferred to the Corning Company “cash,”
“receivables,” “fixtures” and a “merchandise inventory.” “Fixtures” are not capital
because they are subject to a depreciation allowance; the inventory, as we have just seen,
is expressly excluded. So far as appears, no allowance was made for “good-will” ... There
can of course be no gain or loss in the transfer of cash; and, although Williams does appear
to have made a gain of $1072.71 upon the “receivables,” the point has not been argued
that they are not subject to a depreciation allowance. That we leave open for decision by
the district court, if the parties cannot agree. The gain or loss upon every other item should
be computed as an item in ordinary income.
Judgment reversed.
FRANK, Circuit Judge (dissenting in part).
....
... I do not agree that we should ignore what the parties to the sale, Williams and the
Corning Company, actually did. They did not arrange for a transfer to the buyer, as if in
separate bundles, of the several ingredients of the business. They contracted for the sale of
the entire business as a going concern. ...
To carve up this transaction into distinct sales of cash, receivables, fixtures, trucks,
merchandise, and good will is to do violence to the realities. I do not think Congress
intended any such artificial result. ... Where a business is sold as a unit, the whole is greater
than its parts. Businessmen so recognize; so, too, I think, did Congress. Interpretation of
our complicated tax statutes is seldom aided by saying that taxation is an eminently
practical matter (or the like). But this is one instance where, it seems to me, the practical

155 [Now there are eight exceptions.]

384

aspects of the matter should guide our guess as to what Congress meant. I believe Congress
had those aspects in mind and was not thinking of the nice distinctions between Roman
and Anglo-American legal theories about legal entities.

Questions and comments:
1. Section 1221 provides that a “capital asset” is “property” – except for the items listed
in § 1221(a)(1 to 8). The list is longer than it was at the time Williams was decided, but
the holding is still the prevailing rule. The sale of property that is a capital asset gives rise
to capital gains or losses. The sale of property that is not a capital asset gives rise to
ordinary gains or losses.
2. comminuted: reduced to minute particles or fragments.
3. How did taxpayer measure his gain/loss on the sales of two different interests to the
Corning Building Company? How did the Commissioner measure such gain/loss? What
did the court decide?
•Why did taxpayer want to treat the sale as giving rise to “ordinary income?” Why
would the Commissioner be opposed to this?
4. When firms enter negotiations for the purchase of the assets of one by the other, we
expect – consistent with the view of Judge Frank – that they agree to an overall price. The
price of each item may only come up later, at tax time. At one time, the following rules
were in effect:
•corporations enjoyed a preferential tax rate on their capital gains;
•goodwill was a non-depreciable capital asset;
•other assets were subject to allowances for depreciation or amortization, but not
at the same rate as current cost recovery allowances; depreciation or amortization
allowances reduce a taxpayer’s ordinary income;
•investment in inventory is deductible only upon sale of the item;
•gain or loss from the sale of non-capital assets is ordinary gain or loss.
How would these rules affect the characterization of the assets that buyers and sellers
desired for the “comminuted” assets of the corporation? If firms did negotiate over the
prices of each asset, do you think that their positions were usually adverse?
•If their negotiating positions were adverse, should the fact that they on occasion
agreed on valuations be treated as highly significant? Why?
5. In 1981, Congress enacted the Economic Recovery Tax Act of 1981, P.L. 97-34. This
statute created the “accelerated cost recovery system” (ACRS). ACRS (later MACRS (M
is for Modified) and later still, ACRS) accelerated depreciation so considerably that we do
385

not even call it “depreciation” anymore. In 1986, Congress further changed the landscape
by eliminating the capital gains preference for corporations.
•Articulate the change in incentives that such legislation would cause corporate
buyers and sellers in characterizing the assets that they bought and sold.
6. In 1993, Congress enacted P.L. 103-66 – the Omnibus Budget Reconciliation Act of
1993. Section 13261(a) added § 197 to the Code. That section made the basis of “§ 197
intangibles” subject to 15-year straight-line amortization. § 197(a).
•Read § 197(c and d). How do you think this should alter the incentives of buyers and
sellers in characterizing the assets that they bought and sold?
7. In 1986, Congress enacted § 1060. Read it.
•Section 1060(a) provides that the consideration received in an “applicable asset
acquisition” will be allocated according to certain rules, i.e., § 338(b)(5).
•Notice the presumption that § 1060(a) creates when the parties agree as to
valuation.
•Notice when § 1060 applies. § 1060(c).
8. Reg. § 1.1060-1(c)(2) kicks the rules governing
allocation of consideration among assets over to The §§ 1060/338 regulations
Regs. § 1.338-6 and § 1.338-7. The most important provide a framework for
provision for our immediate purposes is Reg. § 1.338- determining the measurement of
6(b). It establishes a “residual method” of valuing gain/loss and the basis of assets
goodwill and going-concern value in an “applicable in a taxable acquisition of
asset acquisition.” The consideration that the assets. We note here that
purchaser paid for goodwill and going concern value valuation questions in asset
is what remains after subtracting the value of all the acquisitions are important but
business’s other assets. Begin with the total quickly become complex – more
consideration paid and received and then subtract in so than we can consider at this
point. Do note the income tax
order amounts allocated to seven classes of assets:
consequences of placing an
•Class I assets: Class I assets are “cash and
asset in one class rather than
general deposit accounts (including savings
another.
and checking accounts) other than certificates
of deposit held in banks, savings and loan
associations, and other depository institutions.” Reg. § 1.338-6(b)(1).
•Class II assets: Class II assets are “actively traded personal property” “for which
there is an established financial market.” Reg. § 1.1092-1(a) (by cross-reference).
This includes “certificates of deposit and foreign currency even if they are not
actively traded personal property. ... Examples of Class II assets include U.S.
government securities and publicly traded stock.” Reg. § 1.338-6(b)(2)(ii).
•Class III assets: Class III assets are “assets that the taxpayer marks to market at
least annually for Federal income tax purposes and debt instruments (including
386

accounts receivable).” Reg. § 1.338-6(b)(2)(iii) (exceptions for certain related party
debts, contingent obligations, and convertible debt).
•Class IV assets: Class IV assets are “stock in trade of the taxpayer or other property
of a kind that would properly be included in the inventory of taxpayer if on hand at
the close of the taxable year, or property held by the taxpayer primarily for sale to
customers in the ordinary course of its trade or business.” Reg. § 1.338-6(b)(2)(iv).
•Class V assets: Class V is a default classification. Class V assets are assets that do
not fall within any of the other classes of assets. Reg. § 1.338-6(b)(2)(v).
•Class VI assets: Class VI assets are “all section 197 intangibles, as defined in
section 197, except goodwill and going concern value.” Reg. § 1.338-6(b)(2)(vi).
•Class VII assets: Class VII assets are “goodwill and going concern value (whether
or not the goodwill or going concern value qualifies as a § 197 intangible).” Reg.
§ 1.338-6(b)(2)(vii).
The IRS may add items to any of these classes upon sufficient notice. Reg. § 1.338-6(b)(3).
9. § 1060 (continued): Notice that the progression from classes I through VII is from
assets most easy and certain of valuation to those whose valuation would be most subject
to dispute.
10. An “applicable asset acquisition” is a transfer of a group of assets that constitute a
“trade or business” either to the buyer or to the seller. Reg. § 1.1060-1(b)(1).

Problem:
Corporation K purchased all of Corporation J’s assets for $1M. As part of the deal,
Corporation J promised to liquidate. Its founder and guiding light (Ms. L) agreed not to
compete with Corporation K anywhere in the state for five years. Corporation J’s assets
were the following:
Depreciable Equipment with cost recovery periods of 5, 7, and 10 years: $?
Inventory on hand: $?
Cash in the bank: $?
Trademark: $?
Goodwill: $?
Identify the issues that would arise in negotiations between Corporation K, Corporation J,
and (for that matter) Ms. L.156

156 Don’t forget the lessons of Norwalk v. Commissioner, supra chapter 6.

In Martin Ice Cream Co. v. Commissioner, 110
T.C. 189, 207 (1998), the Tax Court said that “personal relationships of a shareholder-employee are not corporate
assets when the employee has no employment contract with the corporation.

387

III. Purchase of Stock Treated as Asset Purchase and the § 338 Election
Consider: rather than purchase the assets of a target corporation, the acquiring corporation
might find it advantageous simply to buy all the stock of the target corporation (Option 1
supra). This would make the target corporation into a subsidiary of the acquiring
corporation. The target corporation would still exist and the bases of its assets would be
what they were prior to the stock purchase. The purchasing corporation could then proceed
with a liquidation of the subsidiary. Under § 334(b), the purchasing corporation would
take a carryover basis in the assets that it had acquired. We might expect the bases of assets
subject to cost recovery allowance to be lower than their fmv. The parties should adjust
the purchase price of the stock accordingly.
What should be the rule if the bases of the target’s assets are more than the fmv of all the
outstanding stock of the corporation? [When would this occur?] This early case presented
such an issue.

Kimbell-Diamond Milling Company v. Commissioner, 14 T.C. 74 (1950), aff’d 187
F.2d 718 (5th Cir.), cert. denied, 342 U.S. 827 (1951)
BLACK, Judge
This proceeding involves deficiencies in income, declared value excess profits, and excess
profits taxes for the fiscal years ended May 31, 1945 and 1946...
The deficiencies are primarily due to respondent’s reduction of petitioner’s basis in assets
acquired by it in December, 1942, through the liquidation of another corporation known
as Whaley Mill & Elevator Co. (sometimes hereinafter referred to as Whaley). By reason
of this reduction respondent has adjusted petitioner’s allowable depreciation ... By
appropriate assignments of error petitioner contests these adjustments. ...
....
Petitioner is a Texas corporation, engaged primarily in the business of milling, processing,
and selling grain products, and has its principal office in Fort Worth, Texas. ...
On or about August 13, 1942, petitioner sustained a fire casualty at its Wolfe City, Texas,
plant which resulted in the destruction of its mill property at that location. The assets so
destroyed, and the adjusted basis thereof, were as follows:

388

[
Total

Cost
$56,771.70

Depreciation Allowed or Allowable
$37,849.80

Adjusted Basis
$18,921.90

]
This property was covered by insurance, and on or about November 14, 1942, petitioner
collected insurance in the amount of $124,551.10 ($118,200.16 as a reimbursement for the
loss sustained by the fire and $6,350.94 as a premium refund). On December 26, 1942,
petitioner’s directors approved the transaction set forth in the minutes below:
....
BE IT RESOLVED:
1. That the proper officers of Kimbell-Diamond Milling Company be, and they
are hereby, authorized, empowered and directed to purchase the entire authorized,
issued and outstanding capital stock of Whaley Mill & Elevator Company ... for a
sum not in excess of $210,000.00; that payment for the said stock of Whaley Mill
& Elevator Company be made, to the extent possible, from the insurance proceeds
..., and that the balance of the agreed consideration for the stock of Whaley Mill &
Elevator Company be paid out of the general funds of Kimbell-Diamond Milling
Company.
2. That as soon as practicable after the purchase of the Whaley Mill & Elevator
Company stock hereby authorized has been consummated, all necessary steps be
taken to completely liquidate the said corporation by transferring its entire assets,
particularly its mill and milling equipment, to Kimbell-Diamond Milling Company
in cancellation and redemption of the entire issued and outstanding capital stock of
Whaley Mill & Elevator Company, and that the charter of said corporation be
forthwith surrendered and cancelled.
On December 26, 1942, petitioner acquired 100 per cent of the stock of Whaley Mill &
Elevator Co. of Gainesville, Texas, paying therefor $210,000 in cash which payment, to
the extent of $118,200.16, was made with the insurance proceeds received by petitioner ...
On December 29, 1942, the stockholders of Whaley assented to the dissolution and
distribution of assets thereof. On the same date an “Agreement and Program of Complete
Liquidation” was entered into between petitioner and Whaley, which provided, inter alia:
THAT, WHEREAS, KIMBELL-DIAMOND owns the entire authorized issued
and outstanding capital stock of WHALEY ..., which said stock was acquired by
KIMBELL-DIAMOND primarily for the purpose of enabling it to secure
possession and ownership of the flour mill and milling plant owned by WHALEY,
the parties herewith agree that the said mill and milling plant shall forthwith be
389

conveyed to KIMBELL-DIAMOND by WHALEY under the following program
for the complete liquidation of WHALEY ...
On December 31, 1942, the Secretary of State of the State of Texas certified that the
Whaley Mill & Elevator Co. was dissolved as of that date.
The assets so distributed to petitioner, the cost of same to Whaley, the depreciation
sustained thereon while owned by Whaley, and Whaley’s adjusted basis therefor, as of
December, 1942, were as follows:
[
Whaley’s Cost
Depreciable Assets Total

$375,962.16

Depreciation Allowed or Whaley’s or
Allowable
Adjusted Basis
$236,440.54
$139,521.62

Other Assets
Fmv of All of Whaley’s Assets

$328,736.59
$314,715.69

]
In filing its tax returns for the fiscal year ended May 31, 1943, petitioner did not include
in net taxable income the amount of the insurance proceeds, less the adjusted basis of the
destroyed assets, a net amount of $99,278.26. Respondent ... determined that petitioner
realized a gain of $99,278.26. ... [P]etitioner alleged that it came within the provisions of
§ 112(f) of the Internal Revenue Code [now § 1033], pertaining to involuntary
conversions, and realized no gain on the conversion of its assets. ... Respondent alleged
that, if petitioner had not complied with § 112(f) [§ 1033(a)(2)], its basis in these assets
would be $224,020.90, and if petitioner had complied with § 112(f) its basis would be
$110,721.94. Respondent’s allegations were based on the theory that what petitioner really
acquired was not stock in Whaley, but rather the assets of Whaley. ...
[In an earlier decision, the court determined that petitioner did comply with § 112(f).]
There is no dispute that the petitioner’s adjusted basis in its depreciable assets which were
destroyed by fire was $18,921.90; nor that the depreciable assets which it received from
Whaley had an adjusted basis in the hands of Whaley of $139,521.62. Petitioner, in the
years herein involved, proceeded under the theory that it was entitled to Whaley’s basis.
Respondent takes the position that petitioner’s cost is its basis in the assets acquired from
Whaley. ... As to the depreciable assets purchased to replace those involuntarily converted,
respondent contends that petitioner’s basis is limited by § 113(a)(9) of the Internal
Revenue Code[,]157 [which is now the essence of § 1033(b).]

157

SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.

390

... Petitioner argues that the acquisition of Whaley’s assets and the subsequent liquidation
of Whaley brings petitioner within the provisions of § 112(b)(6)[158] [now § 332(a)] and,
therefore, by reason of § 113(a)(15),[159] [now essentially § 334(b)(1)] petitioner’s basis
in these assets is the same as the basis in Whaley’s hands. In so contending, petitioner asks
that we treat the acquisition of Whaley’s stock and the subsequent liquidation of Whaley
as separate transactions. It is well settled that the incidence of taxation depends upon the
substance of a transaction. Commissioner v. Court Holding Co., 324 U.S. 331. It is
inescapable from petitioner’s minutes set out above and from the “Agreement and Program
of Complete Liquidation” entered into between petitioner and Whaley, that the only
intention petitioner ever had was to acquire Whaley’s assets.

(a) BASIS (UNADJUSTED) OF PROPERTY. – The basis of property shall be the cost of such
property; except that—
*****
(9) INVOLUNTARY CONVERSION.—If the property was acquired, after February 28, 1913, as the
result of a compulsory or involuntary conversion described in § 112(f), the basis shall be the same as
in the case of the property so converted, decreased in the amount of any money received by the
taxpayer which was not expended in accordance with the provisions of law (applicable to the year in
which such conversion was made) determining the taxable status of the gain or loss upon such
conversion, and increased in the amount of gain or decreased in the amount of loss to the taxpayer
recognized upon such conversion under the law applicable to the year in which such conversion was
made.
158

SEC. 112. RECOGNITION OF GAIN OR LOSS.
*****
(b) EXCHANGES SOLELY IN KIND.—
*****
(6) PROPERTY RECEIVED BY CORPORATION ON COMPLETE LIQUIDATION OF
ANOTHER. –
No gain or loss shall be recognized upon the receipt by a corporation of property distributed in
complete liquidation of another corporation. * * *

159

SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.
(a) BASIS (UNADJUSTED) OF PROPERTY. – The basis of property shall be the cost of such
property; except that— * * * * *
(15) PROPERTY RECEIVED BY A CORPORATION ON COMPLETE LIQUIDATION OF
ANOTHER. –
If the property was received by a corporation upon a distribution in complete liquidation of another
corporation within the meaning of § 112(b)(6), then the basis shall be the same as it would be in the
hands of the transferor. The basis of property with respect to which election has been made in
pursuance of the last sentence of § 113(a)(15) of the Revenue Act of 1936, as amended, shall in the
hands of the corporation making such election, be the basis prescribed in the Revenue Act of 1934, as
amended.

391

....
We hold that the purchase of Whaley’s stock and its subsequent liquidation must be
considered as one transaction, namely, the purchase of Whaley’s assets which was
petitioner’s sole intention. ... [P]etitioner’s basis in these assets, both depreciable and
nondepreciable, is, therefore, its cost, or $110,721.74 ($18,921.90, the basis of assets
destroyed by fire, plus $91,799.84, the amount expended over the insurance proceeds). ...
....
Decision will be entered for the respondent.

Questions and comments:
1. Aside: The tax consequences of involuntary conversions are now governed by § 1033.
Taxpayer used insurance proceeds to help pay for property that cost more than the basis
of the property that it lost to the fire plus the insurance proceeds. Taxpayer had to add
some of its own after-tax funds to make the purchase. Taxpayer may elect not to recognize
the gain realized on the “involuntary” sale of the property for the amount of the insurance
proceeds (§ 1033(a)(2)(A)), but it may not increase its basis in the replacement property
(§ 1033(b)(2) (cost basis reduced by amount of gain not recognized)). Hence, taxpayer
was entitled to a basis equal to the basis of the property lost to the fire plus the funds it had
to spend over and above the insurance proceeds.
2. Involuntary conversions (more): Section 1033(b)(3) governs basis adjustments to
property when taxpayer uses insurance proceeds to purchase stock of a corporation that
holds replacement property when taxpayer acquires replacement property by purchasing
sufficient stock (80% vote and value, § 1033(a)(2)(E)(i)) to control a corporation that owns
the property that taxpayer wants – as occurred in Kimbell-Diamond. Taxpayer must reduce
the bases of properties held by the corporation by the same reduction in its cost basis of
the stock that it made by reason of § 1033(b)(2), supra note 1, i.e., by the amount of its
unrecognized gain. § 1033(b)(3)(A).
3. When the dust settled: Kimbell-Diamond had purchased stock of a corporation
(Whaley), which of course made that corporation a subsidiary. It liquidated that
corporation. Kimbell-Diamond wanted the same basis in the corporation’s properties that
Whaley had. It would happily give up $210,000 of basis in stock in exchange for nearly
$330,000 of basis in (perhaps depreciable) assets.
•The Commissioner succeeded in limiting Kimbell-Diamond to its original
adjusted basis in properties that it held ($18,000) plus the funds that it paid over
and above insurance proceeds ($92,000) for stock (total: $110,000). It paid
$210,000 for stock to have bases in assets of $110,000.
392

General Utilities & Operating Co. v.
Helvering, 296 U.S. 200 (1935): In 1927,
General Utilities purchased 20,000 shares
of Islands Edison Company stock for $2000.
Another utility company wished to procure
the shares of Islands Edison in 1928. After
some negotiating over precisely how to
accomplish this, General Utilities declared
a dividend of $1,071,426.25 and
distributed 19,090 shares to its
shareholders as a stock dividend while
retaining the other 910 shares. The other
utility subsequently agreed with the owners
of Islands Edison stock (i.e., mostly General
Utilities’ shareholders) to purchase all
20,000 shares from the shareholders. The
Commissioner argued that General Utilities
should be taxed on the fmv of the stock
minus its basis. However, the Tax Court held
“that the declaration and payment of the
dividend resulted in no taxable income” Id.
at 204. The Supreme Court upheld this
position that the distribution of property as
a dividend gave rise to no taxable income
to the corporation. “This was no sale; assets
were not used to discharge indebtedness.”
Id. at 206.
Congress incorporated the holding of
General Utilities into what was § 311
(corporation recognizes no gain or loss on
distribution of property to shareholders
with respect to their stock), § 333 (electing
distributee corporation in complete
liquidation recognizes gain only on the
greater of money or securities received, or
ratable share of earnings and profits), §
336 (corporation recognizes no gain or loss
on distribution of all its assets in a complete
liquidation), and § 337 (liquidating
corporation recognizes no gain or loss from
the sale of assets during 12-month period
of distribution in complete liquidation of all
its assets).

393

•Kimbell-Diamond had of course
received $125,000 from the insurance
company without payment of income tax,
so naturally that amount should not be
included in its basis. [Basis is how we
keep score with the Government.]
•The basis Kimbell-Diamond had in the
assets previously owned by the Whaley
Corporation was determined (in part) by
the amount it paid for Whaley’s stock.
Because Kimbell-Diamond always
planned to liquidate Whaley, it had no
choice in the matter. Only income on
which taxpayer has paid income tax can
become basis – unless excluded from
gross income.
4. When would the purchaser of a target
corporation’s stock want the purchase
price of stock to be the basis of the assets
it owns after a liquidation, and when
would the purchaser not want the basis of
assets that it owns to be the purchase
price of the stock?
5. From 1954 until 1982, the rule of §
334(b)(2)
was
that
Acquiring
Corporation’s purchase of the stock of
Target Corporation (which became
Acquiring Corporation’s subsidiary)
followed by liquidation of Target
Corporation was to be treated as
Acquiring Corporation’s purchase of
Target Corporation’s assets. (See note 5
following Norwalk v. Commissioner,
supra chapter 6:III). The purchase price
of the stock was allocated among the
subsidiary’s assets and became their
bases. The Acquiring Corporation (i.e.,
parent) did not get Target Corporation’s
(i.e., subsidiary’s) basis in its assets.

•Section § 334(b)(2) set forth conditions concerning the timing of the purchase and
the timing of the liquidation that led to such treatment, i.e., purchase of at least
80% of the target’s stock within a 12-month period followed by liquidation of the
target within two years following completion of the purchase.
•By its terms, § 334(b)(2) required liquidation of the subsidiary. The
outcome was a stock cost basis for the target’s assets. The purchasing
corporation did not take the target’s earnings and profits or its other tax
attributes.
6. Congress replaced § 334(b)(2) with § 338 in 1982. Section 338 made irrelevant the
purchaser’s intent (or lack thereof) to liquidate the target corporation. The purchase of all
the stock of a corporation followed by a liquidation was no longer automatically treated as
the purchase of the assets of the target corporation. Instead, § 338 gives the purchasing
corporation the option of adjusting its basis in the target corporation’s assets to the price
it paid for the target corporation’s stock.
•Section 338 accomplishes this step-up or step-down in basis by hypothesizing a
sale of the target corporation’s assets for their fmv at the close of the acquisition
date followed a day later by the acquiring corporation’s purchase of the target
corporation’s assets for their fmv.
•Before the General Utilities doctrine was laid to rest in 1986, old § 337 permitted
the sale of a liquidating corporation’s assets during a 12-month distribution period
following adoption of a plan of liquidation without recognition of gain or loss –
except for gain derived from sales of stock in trade, inventory, and installment
obligations acquired before liquidation. 26 U.S.C. § 337(b) (1982 ed.), (repealed
1986) (see text box). AND: old § 337 applied to hypothetical sales under § 338.
•Thus, the acquiring corporation could obtain a stepped-up basis in target’s
assets without paying any income tax. Not surprisingly, purchasing
corporations would opt for a tax-free step up in the basis of the target’s
assets to the purchase price of target’s stock whenever the purchase price
of the target’s stock exceeded the bases of the target’s assets.
•Congress repealed the General Utilities doctrine in 1986. This changed the
landscape dramatically.
7. Now consider the following: Corporation B owns assets, and Corporation C wishes to
acquire all of them. We assume that the adjusted basis of Corporation B’s assets is less
than their fair market value. There are two ways Corporation C might go about a taxable
acquisition.
Option 1: Corporation C can buy all the stock of Corporation B so that Corporation
B becomes a wholly-owned subsidiary of Corporation C. The shareholders of
Corporation B would recognize gain/loss on the sale of their stock. Corporation B
would not recognize gain on the disposition of its assets as the corporation remains
intact. Corporation C can then liquidate Corporation B. Corporation C will own all

394

the assets that Corporation B formerly owned with the same basis that Corporation
B had when it owned the assets.
•Basis reduces income taxes in the future. More basis results in greater
future tax savings. An important determinant in those future tax savings is
the (remaining) cost recovery period of Corporation B’s assets.
•Of course, $1 saved today is worth more than $1 saved in the future.
•Therefore, as a general matter, Corporation
S
corporations:
Why
is
the
C should take into account the fact that it
generalization in note 7A more
takes Corporation B’s bases in its assets and
problematic in the case of an S
corporation target than in the case of a
that the bases are less than fair market value
C corporation target? Consider –
when establishing a purchase price for
•S corporation gain is subject to
Corporation B’s stock.
income tax only at the
shareholder level;
Option 2: Corporation C can buy all the
•the likely difference in purchase
assets of Corporation B from Corporation
price between a stock purchase
and an asset purchase;
B. Corporation B would recognize gain/loss
on the sale of each of its assets, as per
•the basis the acquiring
corporation gets in the assets it
Williams v. McGowan. Corporation B
receives in a stock purchase as
would no longer own any assets; it would
compared to an asset purchase;
have cash. Corporation C would have a cost
•the character of income to the
basis in the assets that it purchased from
shareholder in a stock purchase
Corporation B rather than a carryover basis.
rather than an asset purchase.
Corporation C’s cost recovery allowances
would be greater than they are under option
1.
•Corporation B could use its cash to acquire other assets – perhaps another
business.
•Or it could liquidate. If it liquidates, shareholders of Corporation
B would recognize gain/loss on the sale of their stock. In the event
of liquidation, there would be two levels of tax.
•Corporation C does not inherit Corporation B’s tax attributes, including
Corporation B’s earnings and profits.
•Under this option, every $1 of taxable gain to Corporation B is offset by
$1 of basis increase to Corporation C. Every $1 of taxable gain to
Corporation B will be subject to income tax to Corporation B and again to
Corporation B’s shareholders upon distribution.
•[Reminder: Section 168(k) changes the precise calculations herein
to Corporation C. To the extent it can exploit bonus depreciation,
potential tax reductions resulting from increased basis are realized
immediately.]
•Corporation B should take into account the fact that sale of its assets
followed by liquidation will trigger two levels of income tax – to the
detriment of its shareholders.
395

7A. Assuming the parties in these hypotheticals get the valuations right, there would seem
to be no reason to want to incur an immediate increase in tax liability. There would be two
levels of income tax. We would expect most taxable acquisition of assets to follow the
pattern of option 1.
7B. BUT suppose that –
1. The increase in the value of Corporation B’s stock value is more than the increase in
the value of Corporation B’s assets, and
2. Corporation B possesses tax attributes (aside from basis) that will reduce its income
tax liability in the future, e.g., net operating loss carryovers, capital loss carryovers.
These attributes will “eat” taxable income – if and when there is taxable income.
OR
3. The target possesses non-assignable assets such as licenses.
7C. If the first two conditions prevailed and Corporation C could “purchase” basis in
assets that it (or a newly-purchased subsidiary) owns by paying the income tax liability on
such an increase, Corporation C should be interested in such a “purchase” – so long as
applicable tax attributes swallow up at least some of the tax liability on such a basis
increase. The purchase of basis would accelerate use of tax-reducing attributes. Those taxreducing attributes of course reduce, if not eliminate, one level of income tax.
•“Basis is how we keep score with the
We have conveniently assumed that
government.” We simply want to increase
the acquiring corporation purchases
our score by paying income tax on a basis 100% of the target corporation’s
increase, AND
stock during the acquisition period.
•we want to do this without the shareholders But § 338 applies to a purchase of as
of Corporation B incurring additional income little as 80% of the stock of the
tax, as would occur under option 2.
target. Section 338’s technical rules
•Corporation C would have the same basis in treat “recently purchased stock” and
the assets that it acquired through its purchase non-recently
purchased
stock
The
acquiring
of Corporation B that it would have under differently.
option 2 (i.e., fmv) with an outlay of only the corporation may limit the basis steptax on the increase in basis – not an actual up to only the stock acquired during
the acquisition period. Implementing
outlay of that amount of income.
this limitation requires creation of
8. So: suppose that Corporation C has pursued terms and phrases as well as
arithmetic formulas. The acquiring
option 1 (purchase of stock from shareholders). It
corporation may also elect to step up
may or may not wish to liquidate Corporation B.
the basis of non-recently purchased
Because it paid more for the stock than the bases of
stock. This of course entails more
Corporation B’s assets, it may wish to obtain bases terminology and formulas.
in Corporation B’s assets equal to the price it paid for **Remaining text boxes in this
Corporation B’s stock.
chapter explain some of these
•§ 338 makes this possible, albeit at the cost
technicalities – and some may
of an immediate income tax liability.
choose to skip over them. **
396

•§ 338 gives a corporation the option of “buying” an increase in the bases of assets
that it acquires through a purchase of the stock of another corporation. The
corporation does this by paying the income tax on the basis increase.
•Moreover, whatever advantages there were in the old § 334(b)(2), § 338 provides
them without requiring that the subsidiary be liquidated.
9. The following provides an overview of the mechanics of “buying” an increase in basis
under § 338.
•Section 338(a) applies to a “qualified stock
The sales price: Actually, the sale price is
purchase.” A “qualified stock purchase” is
what the regulations call the “aggregate
one or more transactions occurring within a
deemed sale price” (ADSP). See Reg. §
12-month acquisition period whereby160 the
1.338-4(a). The ADSP is the sum of the
grossed-up price of the purchasing
purchasing corporation 161 acquires by
corporation’s recently purchased stock of
purchase at least 80% of the total voting
the target corporation plus the “old
power of the target corporation’s stock and
target’s” liabilities minus the selling
at least 80% of the total value of all the
shareholders’ selling costs. Regs. § 1.3384(b)(1), 1.338-4(c)(1)(iii). The “old
target corporation’s stock. § 338(d) (crosstarget’s” liabilities include the very tax
referencing
liability determined under § 338. Reg. §
§ 1504(a)(2)).162
1.3384(d)(1).
•The purchasing corporation’s “recently
•The “grossed-up” price (herein “G”) of
purchased stock” is the stock that it purchased
the purchasing corporation’s recently
during the 12-month acquisition period. §
purchased stock (herein “RPS”) is the
338(b)(6)(A). The remainder of the
amount realized on the sale of that stock
purchasing corporation’s stock that it owns in
divided by the percentage of stock
attributable to that purchase. Reg. §
the target corporation is “nonrecently
1.338-4(c)(1)(i and ii).
purchased stock.” § 338(b)(6)(B).
•So: “grossed up” price = RPS/(% of
•The “12-month acquisition period” is a
shares acquired during acquisition
twelve-month period that begins on the date
period)
of the first acquisition of stock that is
•Thus, the actual “amount realized” is
included in a “qualified stock purchase.” §
G + L + λ*(ADSP − AB),
338(h)(1). The “acquisition date” is the first
day on which there is a “qualified stock
where
purchase” with respect to the stock of the
λ = tax rate; AB = adjusted basis of
target corporation. § 338(h)(2).
assets; L = liabilities.

160 Section 338(d)(3) requires that the purchasing corporation actually acquire 80% of the target’s stock (vote and

value) during the 12-month acquisition period.
161 The purchaser must be a corporation, not an individual. Reg. § 1.338-3(b)(1).
162 If a § 336(e) election is made to treat the sale, exchange, or distribution of stock in a corporation as a distribution

of its assets, no election under 338 may be made. Reg. § 1.338-1(a)(1).

397

9A. (Note 9 continued): When a corporation makes a “qualified stock purchase” of a
“target corporation” and so elects, the target corporation (“old target”) is treated as
having sold all its assets at the
Fmv bases: The “new target” actually takes an
close of the acquisition date for
“adjusted grossed-up basis” (AGUB) in its assets.
the fair market value 163 of the
•AGUB is the sum of
assets and is then treated as a
•the “grossed-up” basis of the purchasing
new corporation (“new target”)
corporation’s recently purchased stock,
at the beginning of the day
•the purchasing corporation’s basis in its
following the acquisition date. §
nonrecently purchased stock, AND
338(a). The putative sale will
•the liabilities of the new target. § 338(b)(1
trigger an income tax liability
and 2); Reg. § 1.338-5(b)(1).
(i.e., a recognition event) on the
•ADSP and AGUB are not the same in that ADSP does
difference between the fmv of
not take account of the purchasing corporation’s
the target corporation’s assets
nonrecently purchased stock. The grossing up formula
and their bases.
for ADSP in essence treats the nonrecently purchased
•The “old target’s” earnings and
stock the same as recently purchased stock.
profits disappear.
•Bear in mind that ADSP is determined for the purpose
of determining taxable gain on a hypothetical sale of
•The “old target’s” tax liability
assets – not for the purpose of determining basis in
does not affect the income tax
assets that the purchaser purchased.
liability
of
the
former
•“Grossed-up basis:” “Grossing up” of the basis of the
shareholders of the target
purchasing corporation’s “recently purchased stock”
corporation who sold their shares
involves creation of a ratio. The purchasing
corporation must identify the percentage by value of
to the purchasing corporation.
all the target corporation’s stock that it owns as
However, the “new target” is
“recently purchased stock” (RPS) and as “nonrecently
responsible for the “old target’s”
purchased stock” (herein NPS). Cf. § 338(b)(4). The
income tax liabilities.
gross up ratio is –
Reg. § 1.338-1(b)(3)(i).
(100 − NPS)/RPS
•The “grossed-up basis” of the corporation’s “recently
purchased stock” is the basis of that stock multiplied
by this ratio. § 338(b)(4).
•Notice: if the purchasing corporation owns 100% of
the target corporation’s stock, whether or not recently
purchased, the ratio will equal 1, and AGUB will
simply be the sum of the corporation’s basis in its
nonrecently purchased stock plus its basis in its recently
purchased stock.

9B. (Note 9 continued): The
“new target” comes into
existence the day after the
“acquisition date.” § 338(a)(2).
The “new target” will have bases
in its assets equal to their fmv.
9C. The purchasing corporation
may also elect to gross up the
basis
of
its
nonrecently
purchased stock. § 338(b)(3)(A).

163 This is what the statute provides. However, the fair market value of assets is determined with reference to

the price of stock that the purchasing corporation purchased, no matter when it purchased that stock, plus the
liabilities of the target corporation.

398

This election requires recognition of the gain that it would recognize if it were to sell its
nonrecently purchased stock for a grossed-up amount. § 338(b)(3)(A).
10. The § 338 election is to be made in the manner prescribed by the Secretary of the
Treasury no later than the 15th day of the 9th month beginning after the month in which the
acquisition date occurs. § 338(g)(1 and 2). The purchasing corporation makes the election.
The election is irrevocable. § 338(g)(3).
11. Section 338(e) deems an election to have been made by the purchasing corporation if
at any time during the “consistency period” it procures any asset of the target corporation
unless the acquisition was in the ordinary course of the target’s (or an affiliate’s) trade or
business, or the purchasing corporation takes a carryover basis in the asset. § 338(e)(1 and
2).
11A. (Note 11 continued): The “consistency period” is the period beginning one year
before the 12-month acquisition period and ending
The relationship between ADSP and
one year (plus one day) after the end of the
AGUB: the ADSP and the AGUP
acquisition period. § 338(h)(4)(A). The Secretary
do not have to be the same. The
may include in the consistency period any time for
methodology of computing ADSP
which there was a plan in effect to make a “qualified
treats all the stock of the old
stock purchase” plus one or more stock purchases
target as “recently purchased.”
with respect to the target or an affiliate. §
The methodology of computing
338(h)(4)(B)
AGUP grosses up the purchase
•While § 338 makes Kimbell-Diamond treatment
price of “new target” corporation
nonrecently purchased stock as
elective rather than automatic, § 338(e) assures an
“recently purchased” only if the
arm’s-length relationship between the purchasing
purchasing corporation elects to
corporation and the target corporation during the
do so.
“consistency period.”
•The purchasing corporation may not pick and choose
the assets in which it wants a higher basis by purchasing them in transactions
separate from its purchase of stock.
Basis of non-recently purchased
stock if election is made: The
12. Section 338(h)(10) election: Section 338(h)(10) purchasing corporation determines
creates another election available in certain this amount by multiplying its
grossed-up basis in its recently
acquisitions. As contrasted with the election under purchased stock (supra) by the ratio
§§338(a, g), the election under § 338(h)(10) results in –
only one level of income tax.
NPS/(100 − NPS)
13. Suppose: parent corporation X is the parent of a
“consolidated group,” i.e., corporations linked to X Corporation through its 80%
ownership by vote and value of the shares of these corporations.
•A “consolidated group” may elect to file a “consolidated return.” As the terms
imply, the idea is to “consolidate” income and loss of the constituent entities. This
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is particularly advantageous if some of the subsidiaries have taxable income and
others have losses. One can be currently matched against the other.
13A. (Note 13 continued): Continue supposing: 164 one of the corporations that X
Corporation owns is T Corporation. P Corporation wants to purchase the assets of T
Corporation. How might it go about this?
•First alternative: T Corporation could sell all its assets directly to P Corporation,
a taxable event to T. T Corporation would then distribute after-tax proceeds to X
Corporation in a tax-free liquidation of a subsidiary, § 332. X Corporation would
retain all T Corporation’s tax attributes including earnings and profits. OR
•Second alternative: T Corporation could first liquidate and distribute all its assets
to X Corporation. No gain/loss would be recognized. X Corporation would take a
carryover basis. If X Corporation then sold those assets to P Corporation, X
Corporation would recognize gain on the sale of those assets. P Corporation would
take a cost basis in the assets presumably equal to their fair market value. X
Corporation would retain all the Target Corporation’s tax attributes, including its
earnings and profits. OR
•Third alternative: P Corporation wants (needs) to purchase stock, not assets. P
Corporation could purchase the stock of T Corporation from X Corporation. X
Corporation would incur the tax consequences of having sold stock. P Corporation
would own all the stock of T Corporation, which of course would retain all its tax
attributes, e.g., basis in assets, earnings and profits, loss carryovers.
•If the basis of T Corporation’s assets was low but their fair market value
was high – there would be a second layer of income tax when P Corporation
disposed of those assets. Similarly, cost recovery deductions for P
Corporation would be low – another way of “taxing” P Corporation on the
transaction.
•Furthermore, other members of X Corporation’s consolidated group might
have tax attributes that could – if allowed – swallow up gain to be
recognized on a step-up in basis of T corporation’s assets.
•Under either of the first two alternatives, there is one level of tax – and P obtains
a fmv basis in the assets that it purchased. Under the third alternative, there is one
level of tax and potentially a second level of tax when P disposes of the assets
and/or realizes very little advantage from cost recovery allowances.
•It might be advantageous for P Corporation to make a § 338 election.
13B. (Note 13 continued): Section 338(h)(10) provides that a corporation that sells the
target’s stock may elect jointly with the purchaser to treat the sale of the stock as an asset
sale in certain circumstances, namely if the purchasing corporation acquires the target from

164 Suggestion: diagram fact patterns as necessary.

400

–
•a selling “consolidated group,” i.e., a consolidated group of which the target is a
member;
•a selling “affiliate,” i.e., a corporation that owns 80% of the stock by vote and
value of the target but which does not file a consolidated return with the target; or
•an S corporation.
Reg. § 1.338(h)(10)-1(c).
13C. (Note 13 continued): It might be that the best outcome would be for T to recognize
gain on the disposition of its assets to P Corporation and for X Corporation not to recognize
gain on the disposition of stock – but to retain T’s tax attributes.
•Perhaps X Corporation’s built-in gain on its stock is more than T Corporation’s
built-in gain on its assets.
•Moreover, other members of the consolidated group might have losses that could
offset T Corporation’s gains on the sale of its assets.
14. The election made under § 338(g) is made by the purchasing corporation. But if –
•the target corporation was a member of a consolidated group (i.e., a subsidiary),
and
•the target corporation recognizes gain or loss with respect to the transaction as if
it sold all its assets in a single transaction,
•then –
the purchasing corporation and the target corporation may jointly (Reg. § 1.338(h)(10)1(c)(3)) elect to have the target corporation treated as a member of the selling
consolidated group with respect to the sale, and no gain or loss is recognized by members
of the selling consolidated group on the sale or exchange of the stock. § 338(h)(10)(A).
14A. (Note 14 continued): The consequences of a § 338(h)(10) election are –
•The purchasing corporation is deemed to have made a gain recognition election
for its nonrecently purchased stock, Reg. § 1.338(h)(10)-1(d)(1);
•The “new target” takes a grossed-up basis for its assets under the rules of § 338,
Reg. § 1.338(h)(10)-1(d)(2);
•The “old target” is treated as transferring all its assets to an unrelated person in
exchange for consideration that includes discharge of liabilities and so recognizes
all gain realized from a sale for ADSP, Reg. § 1.338(h)(10)-1(d)(3)(i);
•Immediately after the deemed sale of its assets, the “old target” is treated as if it
transferred all its assets to members of the consolidated group while still a member
of the selling consolidated group (or owned by the selling affiliate or by the S
corporation’s shareholders) – and ceased to exist. Reg. § 1.338(h)(10)-1(d)(4)(i).
The transfer will be treated for tax purposes as whatever an actual transfer would
401

be, often a liquidation to which either § 336 (non-subsidiary) or § 337 (subsidiary)
would apply. Reg. § 1.338(h)(10)-1(d)(4)(i).
•Thus, T’s tax attributes remain within the consolidated group.
14B. When the dust settles after a § 338(h)(10) election, there is no difference in tax
treatment between a purchase of stock and a purchase of assets.
15. Section 336(e): Section 336(e): Section 336(e) provides that a parent corporation that
sells, exchanges, or distributes stock of a subsidiary may elect to treat the sale, exchange,
or distribution as a disposition of the subsidiary’s assets. The tax consequences of such an
election will be the same as they are for an election made under § 338(h)(10).
•§ 336(e) applies to stock purchased by individuals as well as to stock purchased
by corporations.
•A § 338 (or § 338(h)(10)) election may not be made if a § 336(e) election is made.

IV. Introduction to Triangular Mergers: Forward and Reverse Cash Mergers
The discussion to this point has dealt with the basic aspects of taxable acquisitions, and
perhaps that is sufficient for the simplest of deals, e.g., where one closely held corporation
acquires another closely held corporation. The objectives of the parties to such transactions
are apt to be easily attained. For example, in Williams v. McGowan, the sole owner of a
hardware business, which was not even a corporation, sold his assets for cash to a
corporation. The “target” did not have to concern himself with his right to make such a sale
without putting the matter to the vote of shareholders, with the rights of dissenting
shareholders, or (evidently) with liabilities. But, when matters are not so simple, such nontax matters can derail a merger or acquisition.
A matter of utmost concern to Acquiring Corporation is
that it does not want its assets to be subject to the claims of
Target Corporation’s creditors – some of whom may not
even be known at the time of the acquisition. Furthermore,
Acquiring Corporation, especially a publicly held
corporation, may not want to incur the expense of a
shareholder vote. And, dissenting shareholders may have
appraisal rights, i.e., the right to have the corporation
purchase their shares for fair value.

When the media air a report
that one corporation is acquiring
another corporation in an “allcash deal,” it is fairly certain that
the acquisition is either a
“forward triangular” merger or
a “reverse triangular” merger. It
is quite unlikely that the deal is a
straight-forward acquisition of
one corporation by another for
cash.

The triangular merger has emerged to deal with such
matters, and we consider such a transaction in the next chapter. For now, we note that in a
triangular merger, Acquiring Corporation forms a subsidiary corporation to acquire (or be
acquired by) the Target Corporation – and hence the term “triangular.” The Acquiring
Corporation is insulated from the Target Corporation’s liabilities because it is the
402

subsidiary into which the Target Corporation has merged that assumes the liabilities of the
Target Corporation. Acquiring Corporation’s subsidiary also succeeds to all the rights that
Target Corporation had, e.g., contract rights. Shareholder voting rights on the merger,
particularly those of Target Corporation, must still be honored. See, e.g., DEL. GEN. CORP.
LAW 251(c); MODEL BUS. CORP. ACT (2016) § 11.04(b). However, shareholders of
Acquiring Corporation usually have more limited voting rights – or none at all. See, e.g.,
DEL. GEN. CORP. LAW 251(f) (voting rights only if Acquiring Corporation’s certificate of
incorporation is amended and Acquiring Corporation issues more than 20% of the number
of its outstanding shares of common stock in the merger). In such a “forward triangular
merger,” the Target Corporation will cease to exist.
Perhaps the Target Corporation possesses various assets that are not transferable, e.g.,
licenses, non-transferable contract rights such as franchises. The parties do not want the
Target Corporation to cease to exist. In that case, the merger may take the form of a
“reverse triangular merger.” In a reverse triangular merger, the Acquiring Corporation’s
newly formed subsidiary is merged into the Target Corporation so that Target Corporation
survives but is nevertheless controlled by Acquiring Corporation. Target Corporation
shareholders receive stock of Acquiring Corporation’s subsidiary – which they may
exchange for cash or Acquiring Corporation stock.
While triangular forward and reverse mergers dominate tax-deferred reorganizations, a
triangular merger can be structured as a taxable cash acquisition. Such a transaction would
be subject to the tax consequences described in this chapter, but such a transaction would
also give parties the non-tax advantages of triangular mergers.

403

Chapter 9: Reorganizations

I. Introduction
Several Code provisions work together to provide tax-deferred treatment 165 of certain
specifically-defined transactions that work a change in structure or ownership of one or
more corporations. Such transactions are “reorganizations.” The regulations state the
following purpose of the reorganization provisions of the Code:
The purpose of the reorganization provisions of the Code is to except from the
general rule [that exchanges are recognition events] certain specifically described
exchanges incident to such readjustments of corporate structures made in one of
the particular ways specified in the Code, as are required by business exigencies
and which effect only a readjustment of continuing interest in property under
modified corporate form.
Reg. § 1.368-1(b) (second sentence). Thus, reorganizations are non-recognition events that
involve an adjustment of the corporate structure in one of the ways that the Code specifies.
They result in a readjustment of a continuing interest in property in a modified corporate
form. Section 368(a)(1) names seven types of “reorganizations.” These are transactions
that are at least partially tax-free to shareholders and the corporations. Without these Code
provisions, such transactions would be recognition events.166 Failure to meet the Code’s
conditions of tax deferred reorganizations results in recognition of gain or loss.
The Code identifies and defines transactions that are different forms of a “reorganization”
in § 368(a)(1) – to which tax deferral principles can apply. The Code adds conditions of
tax deferral to some of these transactions in § 368(a)(2). In a rough sense, reorganizations
are transactions in which a corporation may accomplish one of three things, i.e. –
1. Acquire another corporation;
2. Divide itself into two or more corporations; and
3. Adjust its capital structure.
In addition to definitional requirements of § 368, certain common law requirements of tax
deferral have emerged that apply to all reorganizations. Irrespective of parties’ objectives,
they must structure their transaction in a manner that meets both common law and statutory
requirements.

165 Tax-deferred reorganizations are often referred to as “tax-free” reorganizations. This is not strictly accurate.
166 On the other hand, taxpayers who fulfill the conditions of a tax-deferred reorganization must accept the tax-

deferred treatment. Such treatment is not elective.

404

The Code provides tax-deferred treatment to reorganizations in §§ 354, 355, 356, and 361.
We can observe that reorganizations are transactions where stock of one or more
corporations is a medium of exchange. Receipt of money or other property is outside the
scope of a reorganization and so will either reduce the basis of what the recipient receives
or constitute immediately taxable income. Deferral of gain or loss recognition of
qualifying exchanges occurs through the transfer of basis from the property exchanged to
the property received. The Code states basis rules in §§ 358 and 362(b).
Section 368(a) defines “reorganization” and so the applicability of §§ 354, and 356 – which
describe the tax-deferral consequences (and their limits) of reorganizations. Section 355
describes the conditions when so-called divisive reorganizations167 result in tax-deferral.
The doctrines of “substance over form” and “step-transaction” also shape the law of
reorganizations.
There is a “seamless web” character to the Code provisions governing reorganizations. We
break into this “seamless web” by briefly describing in broad terms what the relevant Code
sections provide. The remainder of the chapter will provide some details of this broad
picture:
•§ 368: Section 368(a)(1) names seven types of transactions that constitute a
“reorganization.” Section 368(b) defines a “party to a reorganization.” Section
368(c) defines “control of a corporation.”
•§ 354: Section 354(a)(1) provides that “a party to [a] reorganization” does not
recognize gain or loss in an exchange “in pursuance of the plan of reorganization.”
There are conditions and limitations to such non-recognition treatment.
•§ 355: Section 355(a)(1) provides that gain or loss is not recognized on a
corporation’s distribution of all the stock or securities that it holds of a “controlled
corporation.” Section 355 applies to divisions of a corporation. The conditions and
limitations to non-recognition treatment should assure that such distributions are
not bailouts of corporate earnings or sales of corporate assets. The focus of § 355
is distributions, not reorganizations.
•§ 356: Section 356(a) provides that if §§ 354 or 355 would apply to an exchange
but for the receipt of boot, the boot or gain – whichever is less – must be
recognized. Section 356(b) provides that certain distributions are subject to the
dividend rules of § 301.
•§ 357(a): Section 357(a) provides that when § 361 provides non-recognition
treatment to a corporation that is a party to a reorganization, another’s assumption
of a liability is not to be treated as money received and does not prevent the
exchange from being accorded nonrecognition treatment under § 361.
•§ 358: Section 358(a) provides the same basis carryover rule applicable to
distributees in § 351 transactions to distributees in transactions to which §§ 354,
355, 356, or 361 apply. Moreover, §§ 357(c) and 358(d) provide that unloading a
167 Section 355 does not by its terms limit its applicability to “reorganizations.”

405

liability onto another party is not equivalent to receiving cash but rather reduces
the basis that the exchanging party takes in the property received – except that a
reduction to less $0 is taxable gain to that extent.
•§ 361: Section 361(a) provides that a corporation that “is a party to a
reorganization” that exchanges property for stock or securities in another
corporation “in pursuance of the plan of reorganization” does not recognize gain
or loss on the exchange. The corporation does not recognize gain or loss from the
receipt of boot if it distributes the boot in pursuance of the plan of reorganization.
§ 361(b)(1)(A). If the corporation does not distribute such boot, it must recognize
the amount of boot or gain, whichever is less. § 361(b)(1)(B). Section 361(c)
provides that a corporation that is a “party to a reorganization” that distributes
pursuant to “the plan of reorganization” its own stock, or the stock or obligation of
“another corporation which is a party to the reorganization” that it received in the
exchange, recognizes no gain or loss.
•§ 362: Section 362(b) provides that a corporation that receives property in
connection with a reorganization has the same basis that the transferor of the
property had.
•§ 381 provides that an acquiring corporation that acquires the assets of another
corporation pursuant to a reorganization to which § 361 applies succeeds – within
limits and conditions – to the tax attributes of the target corporation.
•§ 1032: Section 1032(a) provides that a corporation that receives money or
property in exchange for its stock does not recognize gain or loss on the exchange.
Now suppose – we want to “do a deal” that will involve two corporations.168 We may want
to merge one corporation into another169 or we may want to divide a corporation into two
or more corporations and distribute stock of one of those corporations to some or all
shareholders. The parties themselves must work out the terms of the deal, but their
discussions and negotiations will occur in the shadow of the rules we consider in the
remainder of this chapter.

II. Common Law Requirements
A cursory examination of § 368(a)(1) shows that the term “reorganization” applies to
transactions whereby

168 We defer until the end of the chapter discussion of so-called “one party reorganizations,” i.e., those that

involve such matters as alteration of the corporation’s capital structure or a change in the corporation’s “identity,
form, or place of organization.”
169 State statutes often treat mergers and “consolidations” in the same paragraph. A “consolidation” occurs when

two corporations consolidate to form a new corporation and then individually go out of existence. Nowadays,
one corporation will more likely simply merge into the other.

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•two corporations merge or consolidate into one, or one corporation acquires the
stock or assets of another corporation by exchanging its own stock – so-called
acquisitive reorganizations;
•a corporation divides itself into two or more separate entities – so-called divisive
reorganizations.
•a corporation adjusts its corporate structure, e.g., recapitalizes, changes its
identity, form, or place of incorporation – so-called non-acquisitive
reorganizations; or
From an early date, taxpayers found that they might structure a transaction to appear to be
one of the statutory reorganizations in form, but not in substance. Notable among such
transactions are payment of a dividend and sale of property. Furthermore, §368(a)(1)
includes a “statutory merger or consolidation” as a “reorganization” and so (potentially)
subject to tax-deferred treatment – even if a particular merger or consolidation is clearly
not the type of transaction to which Congress wished to accord such treatment, e.g., an all
cash acquisition by one corporation of another. To restrict tax deferral to the types of
transactions that Congress intended, the courts created certain requirements – apart from
statutory requirements – that apply to all reorganizations. Treasury has adopted and
embellished these common law requirements. Treasury has also proposed adoption of yet
another requirement. We examine these doctrines here.

A. Continuity of Business Enterprise (COBE)
The regulations governing reorganizations require that there be a “continuity of business
enterprise” between the acquiring corporation and the target corporation.
Continuity of business enterprise (COBE) requires that the issuing corporation (P)
... either continue the target corporation’s (T’s) historic business or use a
significant portion of T’s historic business assets in a business. ... The application
of this general rule to certain transactions, such as mergers of holding companies,
will depend on all facts and circumstances. The policy underlying this general rule,
which is to ensure that reorganizations are limited to readjustments of continuing
interests in property under modified corporate form, provides the guidance
necessary to make these facts and circumstances determinations.
Reg. § 1.368-1(d)(1) (emphasis added). See, e.g., Honbarrier v. Commissioner, 115 T.C.
300, 311-14 (2000) (transfer of valueless ICC operating license, tax-exempt bonds, and
tax-exempt funds met neither prong of COBE). COBE is met either through business
continuity or asset continuity. An issuing “corporation is treated as holding all of the
businesses and assets of all of the members of” a “qualified group,” Reg. § 1.3681(d)(4)(i), i.e., a group of corporations linked by 80% ownership of stock by vote and

407

value, Reg. § 1.368-1(d)(4)(ii). Hence parent corporation does not have to be the entity
that continues the business or uses the assets.

1. Business Continuity
The regulations do not specifically define what “business continuity” is, but rather offer
considerations and examples. “The continuity of business enterprise requirement is
satisfied if P continues T’s historic business. The fact that P is in the same line of business
as T tends to establish the requisite continuity, but is not alone sufficient.” Reg. § 1.3681(d)(2)(i). “In general, a corporation’s historic business is the business it has conducted
most recently.” Reg. § 1.368-1(d)(2)(iii). When target has more than one line of business,
“continuity of business enterprise requires only that P continues a significant line of
business.” Reg. § 1.368-1(d)(2)(ii). In determining whether the business P is continuing is
“significant,” all “facts and circumstances are considered[.]” Reg. § 1.368-1(d)(2)(iv).

Problems:
1. T conducts three lines of business: manufacture of synthetic resins, manufacture of
chemicals for the textile industry, and distribution of chemicals. The three lines of business
are approximately equal in value. On July 1, 20Y1, T sells the synthetic resin and
chemicals distribution businesses to a third party for cash and marketable securities. On
December 31, 20Y1, T transfers all its assets to P solely for P voting stock. P continues
the chemical manufacturing business without interruption. Does it matter that P continues
only one of T’s three roughly equal businesses? See Reg. § 1.368-1(d)(5), Example 1.
2. T is a manufacturer of boys’ and men’s trousers. On January 1, 2013, as part of a plan
of reorganization, T sold all its assets to a third party for cash and purchased a highly
diversified portfolio of stocks and bonds. As part of the plan T operates an investment
business until July 1, 2016. On that date, the plan of reorganization culminates in a transfer
by T of its assets to P, a regulated investment company, solely in exchange for P voting
stock. Has the COBE requirement been met because P uses T’s investment portfolio in its
business? Reg. § 1.3681(d)(5), Example 3.

2. Asset Continuity
COBE is met by P’s use of “a significant portion of T’s historic business assets in a
business.” Reg. § 1.368-1(d)(3)(i). “A corporation’s historic business assets are the assets
used in its historic business.” Reg. § 1.368-1(d)(3)(ii). Such assets “may include stock and
securities and intangible operating assets such as good will, patents, and trademarks,
whether or not they have a tax basis.” Reg. § 1.368-1(d)(3)(ii). Whether the portion of T’s
assets that P uses are “significant” is generally “based on the relative importance of the
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assets to operation of the business.” Reg. § 1.368-1(d)(3)(iii). The determination of
“significance” requires consideration of all “facts and circumstances, such as the net fair
market value of those assets[.]” Reg. § 1.3681(d)(3)(iii).

The intersection of the tax code and state
corporation laws: Incorporation occurs (for
our purposes) under state laws. State
statutes provide outer limits of a
corporation’s allocation of responsibilities
among shareholders, directors, and
officers. While boards of directors and
officers can make the decisions necessary
to
the
corporation’s
day-to-day
operation, shareholders have the final say
in deciding whether the corporation should
make a fundamental change. Among the
changes that are so fundamental that
shareholders should have the final say are
mergers, consolidations, and sales of all
the corporation’s assets. Certainly,
shareholders of a target corporation have
the right to vote on a merger, and in some
states shareholders of the acquiring
corporation also have that right. When a
shareholder vote is necessary to
implement the board’s recommendation of
a fundamental change, the corporation
must bear the expense of holding the vote.
This can be expensive and timeconsuming. A corporation will also have to
consider the rights of dissenting
shareholders.
A purpose of state corporation
laws governing mergers is protection of
shareholder interests. A merger resolution
may involve any consideration, including
money, that accommodates the interests of
different shareholders. This is not
necessarily consistent with the Internal
Revenue Code’s policies of providing taxdeferred treatment to reorganizations
that “effect only a readjustment of
continuing interest in property under
modified corporate form.”
Accommodation
of
state
corporation law and federal income tax
reorganization law has occurred through
the common law constraints on the taxdeferred treatment of reorganizations.

Problems:
1. P manufactures
computers
and
T manufactures components for computers. T
sells all its output to P. On January 1, 20Y1, P
decides to buy imported components only. On
March 1, 20Y1, T merges into P. P continues
buying imported components but retains T’s
equipment as a backup source of supply.
Should such use of T’s asset satisfy the COBE
requirement? See Reg. § 1.368-1(d)(5),
Example 2.
2. T manufactures children’s toys and P
distributes steel and allied products. On
January 1, 20Y1, T sells all its assets to a third
party for $100,000 cash and $900,000 in
notes. On March 1, 20Y1, T merges into P.
Should the use of the sales proceeds in P’s
business satisfy the COBE requirement? See
Reg. § 1.368-1(d)(5), Example 4.

B. Continuity of Proprietary Interest
(COPI)
The “continuity of proprietary interest”
(COPI) requires that “a substantial part of the
value of the proprietary interests in the target
corporation
be
preserved
in
the
reorganization.” Reg. § 1.368-1(e)(1)(i). The
purpose of the COPI requirement “is to
prevent transactions that resemble sales from
qualifying for nonrecognition of gain or loss
available to corporate reorganizations.” Id.
(emphasis added).
Shareholders as a whole who give up their
stock in a corporation must retain a sufficient
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proprietary interest in the acquiring corporation. Clearly the receipt of stock is the receipt
of a proprietary interest, and the receipt of cash is not. The consideration given in a
reorganization is usually not exclusively the same type of stock (e.g., voting common,
non-voting common, preferred) as the stock surrendered. The contours of the COPI test
have evolved.
The Supreme Court has determined that short-term notes170 and long-term bonds171 do not
constitute a sufficient proprietary interest to support a tax-deferred reorganization. On the
other hand, non-voting preferred stock is a sufficient proprietary interest.172 More than half
the consideration may be cash. 173 Reg. § 1.386-1(e)(2)(v), Examples 1, 2(ii), and 6
assumed that an exchange in which target shareholders receive 40% of their consideration
in the form of stock and 60% in the form of cash was sufficient to satisfy the COPI
requirement. Examples 2(i) and 4 assume that an exchange in which target shareholders
receive 25% of their consideration in the form of stock and 75% in the form of cash is not
sufficient to satisfy the COPI requirement.
Should the sufficiency of the equity interest be measured shareholder-by-shareholder or
by the overall transaction?

Rev. Rul. 66-224, 1966-2 C.B. 114
Corporation X was merged under state law into corporation Y. Corporation X had four
stockholders (A, B, C, D), each of whom owned 25 percent of its stock. Corporation Y
paid A and B each $50,000 in cash for their stock of corporation X, and C and D each
received corporation Y stock with a value of $50,000 in exchange for their stock of
corporation X. There are no other facts present that should be taken into account in
determining whether the continuity of interest requirement of § 1.368-1(b) of the Income
Tax Regulations has been satisfied, such as sales, redemptions or other dispositions of
stock prior to or subsequent to the exchange which were part of the plan of reorganization.
Held, the continuity of interest requirement of § 1.368-1(b) of the regulations has been
satisfied. It would also be satisfied if the facts were the same except corporation Y paid

170 See Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U.S. 462, 470 (1933) (cash plus notes consideration

for a sale).

171 See LeTulle v. Scofield, 308 U.S. 415, 420-21 (1940) (owner of bonds is creditor, not one with proprietary

interest).

172 See John A. Nelson Co. v. Helvering, 296 U.S. 374, 377 (1935) (“definite and substantial interest” in affairs of

corporation; “statute does not require participation in” management).

173 See Helvering v. Minnesota Tea Co., 296 U.S. 378, 385 (1935) (focus belongs on proprietary interest received,

not cash received; proprietary interest must be “substantial part” of “value of the thing transferred”).

410

each stockholder $25,000 in cash and each stockholder received corporation Y stock with
a value of $25,000.

Questions and comments:
1. The overall transaction is what matters. This is true even of a minority shareholder who
receives only shares in a transaction that otherwise is all-cash. See Kass v. Commissioner,
60 T.C. 218, 227 (1973), aff’d without opinion, 491 F.2d 749 (3d Cir. 1974).
2. The COPI requirement is applied by focusing only on the actual exchanges of
shareholders of the target with the acquirer. Sales or dispositions to unrelated parties
before or after such exchanges do not affect application of the COPI requirement. Reg. §
1.368-1(e)(1)(i) provides in part:
For purposes of the continuity of interest requirement, a mere disposition of stock
of the target corporation prior to a potential reorganization to persons not related
... to the target corporation or to persons not related ... to the issuing corporation is
disregarded and a mere disposition of stock of the issuing corporation received in
a potential reorganization to persons not related ... to the issuing corporation is
disregarded.
With stark simplicity, Treasury mooted litigation over the question of whether the
proprietary interests of previously cashed out shareholders mattered in meeting (or not
meeting 174 ) the continuity of proprietary interest standard; they do not. However,
preexchange or post-exchange dispositions to corporations within the same affiliated

174 In J.E. Seagram v. Commissioner, 104 T.C. (1995), Seagram, DuPont, and others made tender offers to gain

control of Conoco, Inc. Seagram purchased many shares that Conoco shareholders tendered to it. As part of its
tender offer, DuPont offered to exchange 1.6 (later 1.7) shares of DuPont stock for one share of Conoco stock.
Seagram lost its bid to take control of Conoco and tendered the shares it purchased to DuPont in exchange for
DuPont stock. Seagram sought to claim a loss on the exchange; this would require that the acquisition be treated
as taxable. Seagram argued that there was no continuity of proprietary interest because the shares it (and others)
– which amounted to 78% of Conoco’s stock – exchanged had been recently purchased for cash. The Tax Court
did not agree with Seagram’s contention, and said:
[W]e must look not to the identity of the target's shareholders, but rather to what the shares represented
when the reorganization was completed. In this case, a majority of the old shares of Conoco were
converted to shares of DuPont in the reorganization, so that in the sense, at least, that a majority of
the consideration was the acquiring corporation's stock, the test of continuity was met. In this aspect
of the case step transaction and continuity questions would have arisen only had there been some
preexisting intention or arrangement for the disposal of the newly acquired DuPont shares, but there
were none.
Id. at 103. While 78% of Conoco stock had been recently purchased, 54% remained in corporate solution –
certainly enough to satisfy the continuity of proprietary interest standard. But see Yoc Heating Corp. v. Commissioner,
61 T.C. 168, 177-78 (1973) (comparing ownership of target immediately before and after transfer of assets; no
reorganization).

411

group of either the target or the acquirer are treated as sales to related persons, so those
shares will not count in determining compliance with the COPI requirement. For example,
the acquiring corporation stock that a target shareholder receives does not count towards
the 40% threshold if the target shareholder sells the acquiring corporation stock to a
member of the acquiring corporation’s affiliated group or the acquiring corporation
redeems the stock. Reg. § 1.368-1(e)(4)(A). The same is true if the purchase of one
corporation’s stock by another corporation would fall within § 304(a)(2) (acquiring
corporation’s purchase of stock of issuing corporation from shareholder where issuing
corporation controls of acquiring corporation). Reg. § 1.368-1(e)(4)(B).
3. Non-qualified preferred stock of course resembles debt in many respects. Nevertheless,
while § 351(g) treats non-qualified stock as boot, Congress intended that it be treated as
stock for other purposes. See H.R. CONF. REP. NO. 105-220, at 544 (1997) (“Until
regulations are issued, preferred stock that is subject to the proposal shall continue to be
treated as stock under other provisions of the Code.”).

Problems:
1. Corporation X was merged under state law into Corporation Y. Corporation X had four
stockholders (A, B, C, and D), each of whom owned 25% of its stock. Has the COPI
requirement been met if Corporation Y –
A. paid A and B each $50,000 in cash for their stock of Corporation X, and transferred to
C and D Y Corporation non-qualified preferred stock with a value of $50,000 in exchange
for their stock of Corporation X.
B. Same as A, except that C and D received $10,000 cash and non-qualified preferred stock
with a value of $40,000 in exchange for their stock of Corporation X.

C. Business Purpose
Gregory v. Helvering, 293 U.S. 465 (1935)
Certiorari to review a judgment reversing a decision of the Board of Tax Appeals, 27
B.T.A. 223, which set aside an order of the Commissioner determining a deficiency in
income tax.
Justice SUTHERLAND delivered the opinion of the Court.
Petitioner, in 1928, was the owner of all the stock of United Mortgage Corporation. That
corporation held among its assets 1,000 shares of the Monitor Securities Corporation. For
the sole purpose of procuring a transfer of these shares to herself in order to sell them for
412

her individual profit, and at the same time, diminish the amount of income tax which would
result from a direct transfer by way of dividend, she sought to bring about a
“reorganization” under § 112(g) of the Revenue Act of 1928, c. 852, 45 Stat. 791, 816,
818, set forth later in this opinion. To that end, she caused the Averill Corporation to be
organized under the laws of Delaware on September 18, 1928. Three days later, the United
Mortgage Corporation transferred to the Averill Corporation the 1,000 shares of Monitor
stock, for which all the shares of the Averill Corporation were issued to the petitioner. On
September 24, the Averill Corporation was dissolved, and liquidated by distributing all its
assets, namely, the Monitor shares, to the petitioner. No other business was ever
transacted, or intended to be transacted, by that company. Petitioner immediately sold the
Monitor shares for $133,333.33. She returned for taxation, as capital net gain, the sum of
$76,007.88, based upon an apportioned cost of $57,325.45. Further details are
unnecessary. It is not disputed that, if the interposition of the so-called reorganization was
ineffective, petitioner became liable for a much larger tax as a result of the transaction.
The Commissioner of Internal Revenue, being of opinion that the reorganization attempted
was without substance and must be disregarded, held that petitioner was liable for a tax as
though the United corporation had paid her a dividend consisting of the amount realized
from the sale of the Monitor shares. In a proceeding before the Board of Tax Appeals, that
body rejected the commissioner’s view and upheld that of petitioner. 27 B.T.A. 223. Upon
a review of the latter decision, the Circuit Court of Appeals sustained the commissioner
and reversed the board, holding that there had been no “reorganization” within the
meaning of the statute. 69 F.2d 809. Petitioner applied to this Court for a writ of certiorari,
which the government, considering the question one of importance, did not oppose. We
granted the writ.
Section 112 of the Revenue Act of 1928 deals with the subject of gain or loss resulting
from the sale or exchange of property. Such gain or loss is to be recognized in computing
the tax, except as provided in that section. The provisions of the section, so far as they are
pertinent to the question here presented, follow:
“Sec. 112(g) Distribution of Stock on Reorganization. If there is distributed, in
pursuance of a plan of reorganization, to a shareholder in a corporation a party to
the reorganization, stock or securities in such corporation or in another corporation
a party to the reorganization, without the surrender by such shareholder of stock or
securities in such a corporation, no gain to the distributee from the receipt of such
stock of securities shall be recognized. ...”
“(i) Definition of Reorganization. – As used in this section . . .”
“(1) The term ‘reorganization’ means ... (B) a transfer by a
corporation of all or a part of its assets to another corporation if
immediately after the transfer the transferor or its stockholders or
413

both are in control of the corporation to which the assets are
transferred. ...”
It is earnestly contended on behalf of the taxpayer that, since every element required by
the foregoing subdivision (B) is to be found in what was done, a statutory reorganization
was effected, and that the motive of the taxpayer thereby to escape payment of a tax will
not alter the result or make unlawful what the statute allows. It is quite true that, if a
reorganization in reality was effected within the meaning of subdivision (B), the ulterior
purpose mentioned will be disregarded. The legal right of a taxpayer to decrease the
amount of what otherwise would be his taxes, or altogether avoid them, by means which
the law permits, cannot be doubted. United States v. Isham, 17 Wall. 496, 84 U.S. 506;
Superior Oil Co. v. Mississippi, 280 U.S. 390, 395-396; Jones v. Helvering, 63 App. D.C.
204, 71 F.2d 214, 217. But the question for determination is whether what was done, apart
from the tax motive, was the thing which the statute intended. The reasoning of the court
below in justification of a negative answer leaves little to be said.
When subdivision (B) speaks of a transfer of assets by one corporation to another, it means
a transfer made “in pursuance of a plan of reorganization” [§ 112(g)] of corporate business,
and not a transfer of assets by one corporation to another in pursuance of a plan having no
relation to the business of either, as plainly is the case here. Putting aside, then, the question
of motive in respect of taxation altogether, and fixing the character of the proceeding by
what actually occurred, what do we find? Simply an operation having no business or
corporate purpose – a mere device which put on the form of a corporate reorganization as
a disguise for concealing its real character, and the sole object and accomplishment of
which was the consummation of a preconceived plan, not to reorganize a business or any
part of a business, but to transfer a parcel of corporate shares to the petitioner. No doubt,
a new and valid corporation was created. But that corporation was nothing more than a
contrivance to the end last described. It was brought into existence for no other purpose;
it performed, as it was intended from the beginning it should perform, no other function.
When that limited function had been exercised, it immediately was put to death.
In these circumstances, the facts speak for themselves, and are susceptible of but one
interpretation. The whole undertaking, though conducted according to the terms of
subdivision (B), was in fact an elaborate and devious form of conveyance masquerading
as a corporate reorganization, and nothing else. The rule which excludes from
consideration the motive of tax avoidance is not pertinent to the situation, because the
transaction, upon its face, lies outside the plain intent of the statute. To hold otherwise
would be to exalt artifice above reality and to deprive the statutory provision in question
of all serious purpose.
Judgment affirmed.

414

Questions and comments:
1. In its consideration of this case, the United States Court of Appeals for the Second
Circuit provided the language that is perhaps the most-quoted in all of tax law:
We agree with the Board and the taxpayer that a transaction, otherwise within an
exception of the tax law, does not lose its immunity, because it is actuated by a
desire to avoid, or, if one choose, to evade, taxation. Any one may so arrange his
affairs that his taxes shall be as low as possible; he is not bound to choose that
pattern which will best pay the Treasury; there is not even a patriotic duty to
increase one’s taxes.
69 F.2d 809, 810 (2d Cir. 1934) (Hand, J.). Of course, a taxpayer must still fulfill the
Code’s requirements, and the taxpayer lost this case.
2. In the second-to-last paragraph of the Supreme Court’s opinion, the Court weighed in
explicitly or implicitly on “plan of reorganization,” business purpose, device, and step
transaction.
3. Reorganizations are not tax-free if they lack “business or corporate purpose.”
Transferring property from a corporation to a shareholder in a manner that taxpayer elects
solely because it reduces federal income tax is not a valid business purpose.
•Distribution of Monitor Corporation stock would have been a dividend. The fair
market value of the Monitor stock – not reduced by basis – would be subject to
income tax as ordinary income.
4. The Court applied a step-transaction approach – without specifically calling it the “step
transaction” doctrine.
5. While an inquiry into motive may be outside the scope of a reorganization, isn’t it
motive that made these transactions fail to constitute a “reorganization?”
6. The “business purpose” of which the Court spoke in Gregory is now embodied in
regulations prescribing that a tax-free reorganization depends upon the existence of a “plan
of reorganization.” Reg. § 1.368-1(c) (tax deferral provisions governing reorganizations
inapplicable “unless there is a plan of reorganization”). The regulations offer little in the
way of guidance on what constitutes a “plan of reorganization” other than to make
continuance of the business of a corporation the touchstone of relevance.
[T]he transaction, or series of transactions, embraced in a plan of reorganization
must not only come within the specific language of § 368(a), but the readjustments
involved in the exchanges or distributions effected in the consummation thereof
must be undertaken for reasons germane to the continuance of the business of a
415

corporation a party to the reorganization. Section 368(a) contemplates genuine
corporate reorganizations which are designed to effect a readjustment of
continuing interests under modified corporate forms.
Reg. § 1.368-2(g). At another place, the Regulations provide that –
A plan of reorganization must contemplate the bona fide execution of one of the
transactions specifically described as a reorganization in § 368(a) and for the bona
fide consummation of each of the requisite acts under which nonrecognition of
gain is claimed. Such transaction and such acts must be an ordinary and necessary
incident of the conduct of the enterprise and must provide for a continuation of the
enterprise. A scheme, which involves an abrupt departure from normal
reorganization procedure in connection with a transaction on which the imposition
of tax is imminent, such as a mere device that puts on the form of a corporate
reorganization as a disguise for concealing its real character, and the object and
accomplishment of which is the consummation of a preconceived plan having no
business or corporate purpose, is not a plan of reorganization.
Reg. § 1.368-1(c). Naturally, the step-transaction doctrine will have a prominent role in
“business purpose” cases as the existence of a “disguise” will only emerge by its
application.
7. Should a valid “business purpose” be neither more nor less than a non-tax purpose?
Should a valid business purpose be a purpose that can only be accomplished through a taxdeferred reorganization?
•A corporation that structures an acquisition of or merger with a corporation
unrelated to it surely has a business purpose for doing so. “Business purpose” is
not apt to be a significant constraint on mergers and acquisitions between unrelated
parties.
•More problematic are cases resulting in distributions to shareholders – as occurred
in Gregory. Section 355 is the successor to § 112(g), the Code provision upon
which Mrs. Gregory relied. When § 355 controls such distributions, § 355’s
conditions of tax deferral include a business purpose. See chapter 9-IV infra
(discussion of “device” in § 355).

III. Acquisitive Reorganizations
One purpose for which corporate taxpayers may engage in reorganizations is to acquire
another corporation, whether through acquisition, merger, or otherwise. In chapter 8, we
examined taxable acquisitions. We now examine the rudiments of how one corporation
may acquire another in a tax-deferred transaction. In any tax-deferred acquisition, there
416

are interests that must be accommodated within the statutory and common law rules.175
This may be more difficult than it is with taxable acquisitions. It doesn’t require any great
foresight to see that there may be –
•shareholders, whether of the acquiring corporation or of the target corporation,
who oppose any acquisition;
•shareholders who do not oppose the acquisition but want to terminate their interest
and be bought out;
•shareholders who want to pass their shares on to the next generation and get a
stepped-up basis under § 1014;
•shareholders who do not want to incur tax liability and wish to keep an ownership
interest in a going concern;
•and so on.
Furthermore, an acquiring and target corporation must consider –
•who will assume the target’s liabilities;
•whether there are licenses, contractual rights, permits, etc. that cannot easily be
transferred to a different corporation;
•whether shareholders should have a right to vote on the acquisition;
•whether certain securities laws will apply;
•whether shareholders of the target corporation should be able to participate in
corporate affairs of the acquiring or merged corporation;
•whether the acquiring corporation wants all of the target’s assets – or are there
some assets it does not want;
•whether the target corporation is to survive or to dissolve;
•whether shareholders of the target want stock of the acquiring corporation, the
acquiring corporation’s parent, or the acquiring corporation’s subsidiary;
•and so on.
A so-called triangular reorganization might enable the interested parties to achieve the
results and personally disparate outcomes they desire. A triangular reorganization, as the
name implies, involves three corporations – one of which is formed as a subsidiary
corporation for the occasion. Upon its formation, the new corporation can be used to
perform any number of functions, e.g. –
•assume the liabilities of the target corporation and thereby insulate the acquiring
corporation from the liabilities of the target;
•separately continue a business and separately hold rights and properties;
•allow target shareholders to receive what may be more desirable stock of the
parent rather than of the subsidiary that their corporation will become;

175 Recall that in INDOPCO, the shareholders of the target corporation had different wishes. The parties incurred

hefty, non-deductible fees in order the give the different parties what they wanted.

417

•allow acquired assets to be placed in an operating subsidiary without giving any
control to (former) shareholders of the target corporation;
•and so on.
A triangular acquisitive reorganization can be “forward,” i.e., target into subsidiary, or
“reverse,” (subsidiary into target). Code provisions that permit the use of stock of a
corporation other than that of the acquiring corporation to acquire another corporation or
its assets contemplate triangular reorganizations. After introducing A, B, C, and G
acquisitive reorganizations, we consider triangular acquisitions. See chapter 9:III:E, infra.
Rules governing triangular reorganizations depend upon parts of § 368 that Congress
enacted to address the holding of the Supreme Court in particular cases.
Section 368(a)(1) contemplates several different means by which one corporation may
acquire another without payment of income tax on gain. Each offers certain advantages as
well as naming conditions. We consider each:

A. “A” Reorganizations
An “A” reorganization is a “statutory” merger or consolidation. § 368(a)(1)(A). In a
merger, one corporation merges into another. In a consolidation, two (or more)
corporations consolidate into a newly created corporation. The old corporations disappear.
The new corporation assumes the liabilities of the old corporations. The statutory merger
or consolidation occurs under state (or other, Reg. § 1.368-2(b)(ii)) corporate law. Thus,
the corporation statutes of a state which may have as their focus the protection of the
interests of shareholders, officers, directors, fiduciaries, the corporation itself, and others
– dictate the necessary, but not sufficient, conditions of tax-deferred treatment of a merger
or consolidation. Under state law, the shareholders of the target corporation and perhaps
of the acquiring corporation176 must approve the merger or consolidation. See, e.g. MODEL
BUS. CORP. ACT § 11.04(b) (AM. BAR ASS’N 2020) (approval of shareholders of “party to
a merger or the acquired entity”).
The “A” reorganization is not a congressional abdication of Congress’s taxing power to
state legislatures. State corporation laws governing mergers and consolidations are not
generally permissive and free-wheeling. The MBCA of 2020, § 11.07(a), provides that
certain events occur upon the occasion of a merger. Among them are (1) a designated
corporate entity survives the merger, (2) the separate existence of all other corporations or
entities that are parties(-y) to the merger ceases, (3) the property and contract rights of all
corporations or entities that are parties(-y) to the merger become the property or contract

But cf. MODEL BUS. CORP. ACT § 11.04(h)(1) (AM. BAR ASS’N 2020) (“Unless the articles of incorporation
otherwise provide, approval by the corporation’s shareholder’s of a plan of merger is not required if: (i) the
corporation will survive the merger”).

176

418

rights of the survivor, and (4) the debts, obligations, or other liabilities of all corporations
or entities that are parties(-y) to the merger become the debts, obligations, or other
liabilities of the survivor. As Professor Bank observed:
Policymakers believed that mergers conducted pursuant to state law were subject
to many limitations, including an automatic continuity of shareholder interest and
a protection of dissenters and creditors, the aggregate effect of which would be to
ensure that the aims of the [Code’s] reorganization provisions were achieved.
Thus, Congress did not subject statutory mergers to the same restriction that were
imposed on transactions that only resembled mergers or consolidations.
Steven A. Bank, Federalizing the Tax-Free Merger: Toward an End to the Anachronistic
Reliance on State Corporation Laws, 77 U. N.C. L. REV. 1307, 1312 (1999).
A significant advantage of an A reorganization is that it is not subject to conditions that
apply to other reorganization forms. There is greater flexibility in structuring an A
reorganization than there is in structuring another type of reorganization. State law may
permit a transfer of some consideration that is not a proprietary interest in a corporation.
An A reorganization is not subject to the “substantially all” or the “voting stock”
requirements of the other reorganization forms – see chapter 9-IIIC and IIID – at least
when the reorganization is not a triangular reorganization. It is in such cases that the
common law requirements noted in chapter 9-II supra have their greatest significance. The
continuity of proprietary interest that these doctrines prescribe might otherwise be lost
because state laws may permit consideration other than stock (or some other proprietary
interest) to effectuate the acquisition.
In addition to meeting the requirements of a merger statute, Reg. § 1.368-2(b)(1)(ii) names
certain requirements of any A merger. By operation of law, the following must occur:
•the assets and liabilities of all members of the “combining unit” “become the
assets and liabilities of one or more members of one other combining unit (the
transferee unit);
•the “combining entity” (i.e., corporation) of each transferor unit ceases its separate
legal existence for all purposes – except that it may act or be acted against in
connection with activities that arose prior to the transactions.

Rev. Rul. 2000-5, 2000-1 C.B. 436
Application of § 368(a)(1)(A) to divisive mergers. The ruling holds that a state law merger
will not qualify as a reorganization under § 368(a)(1)(A) of the Code if the merger does
not result in one corporation acquiring the assets of a target corporation and the target
corporation ceasing to exist.

419

ISSUES:
Whether a transaction in which (1) a target corporation “merges” under state law with and
into an acquiring corporation and the target corporation does not go out of existence, or
(2) a target corporation “merges” under state law with and into two or more acquiring
corporations and the target corporation goes out of existence, qualifies as a reorganization
under § 368(a)(1)(A) of the Internal Revenue Code?
FACTS:
Situation (1). A target corporation transfers some of its assets and liabilities to an acquiring
corporation, retains the remainder of its assets and liabilities, and remains in existence
following the transaction. The target corporation’s shareholders receive stock in the
acquiring corporation in exchange for part of their target corporation stock and they retain
their remaining target corporation stock. The transaction qualifies as a merger under state
X corporate law.
Situation (2). A target corporation transfers some of its assets and liabilities to each of two
acquiring corporations. The target corporation liquidates and the target corporation’s
shareholders receive stock in each of the two acquiring corporations in exchange for their
target corporation stock. The transaction qualifies as a merger under state X corporate law.
DISCUSSION:
The purpose of the reorganization provisions of the Code is to provide tax-free treatment
to certain exchanges incident to readjustments of corporate structures made in one of the
specified ways described in the Code. Reg. § 1.368-1(b). In 1921, Congress defined a
reorganization as including “... a merger or consolidation (including the acquisition by one
corporation ... of substantially all the properties of another corporation).” In 1934,
Congress separated this rule into two distinct provisions. In the predecessor of current §
368(a)(1)(C), an “acquisition by one corporation ... of substantially all the properties of
another corporation” continued to be a reorganization where payment was effectuated with
the acquiror’s voting stock. In the predecessor of current § 368(a)(1)(A), the terms “merger
or consolidation” were qualified by requiring that they be “statutory” mergers and
consolidations. The word “statutory” was added to the definition of a reorganization so
that the definition “will conform more closely to the general requirements of [state]
corporation law.” See H.R. REP. NO. 704, 73d Cong., 2d Sess. 14 (1934).
Historically, corporate law merger statutes have operated to ensure that “[a] merger
ordinarily is an absorption by one corporation of the properties and franchises of another
whose stock it has acquired. The merged corporation ceases to exist, and the merging
corporation alone survives.” Cortland Specialty Co. v. Commissioner, 60 F.2d 937, 939
(2d Cir. 1932), cert. denied, 288 U.S. 599 (1933); for other cases that describe mergers as
requiring that the target corporation transfer its assets and cease to exist, see, e.g., Vulcan
Materials Company v. U.S., 446 F.2d 690, 694 (5th Cir. 1971), cert. denied, 404 U.S. 942
(1971); Fisher v. Commissioner, 108 F.2d 707, 709 (6th Cir. 1939), cert. denied, 310 U.S.
420

627 (1939). Thus, unlike § 368(a)(1)(C), in which Congress included a “substantially all
the properties” requirement, it was not necessary for Congress to explicitly include a
similar requirement in § 368(a)(1)(A) because corporate law merger statutes contemplated
an acquisition of the target corporation’s assets by the surviving corporation by operation
of law.
Compliance with a corporate law merger statute does not by itself qualify a transaction as
a reorganization. See, e.g., Southwest Natural Gas Co. v. Commissioner, 189 F.2d 332 (5th
Cir. 1951), cert. denied, 342 U.S. 860 (1951) (holding that a state law merger was not a
reorganization under § 368(a)(1)(A)); Roebling v. Commissioner, 143 F.2d 810 (3d Cir.
1944), cert. denied, 323 U.S. 773 (1944) (same holding). In addition to satisfying the
requirements of business purpose, continuity of business enterprise and continuity of
interest, in order to qualify as a reorganization under § 368(a)(1)(A), a transaction
effectuated under a corporate law merger statute must have the result that one corporation
acquires the assets of the target corporation by operation of the corporate law merger
statute and the target corporation ceases to exist. The transactions described in Situations
(1) and (2) do not have the result that one corporation acquires the assets of the target
corporation by operation of the corporate law merger statute and the target corporation
ceases to exist. Therefore, these transactions do not qualify as reorganizations under §
368(a)(1)(A).
In contrast with the operation of corporate law merger statutes, a divisive transaction is
one in which a corporation’s assets are divided among two or more corporations. Section
355 provides tax-free treatment for certain divisive transactions, but only if a number of
specific requirements are satisfied. Congress intended that § 355 be the sole means under
which divisive transactions will be afforded tax-free status and, thus, specifically required
the liquidation of the acquired corporation in reorganizations under both §§ 368(a)(1)(C)
and 368(a)(1)(D) in order to prevent these reorganizations from being used in divisive
transactions that did not satisfy § 355. See S. REP. NO. 1622, 83d Cong., 2d Sess. 274
(1954); S. REP. NO. 169, 98th Cong., 2d Sess. 204 (1984). No specific liquidation
requirement was necessary for statutory mergers because corporate law merger statutes
contemplated that only one corporation survived a merger. The transaction described in
Situation (1) is divisive because, after the transaction, the target corporation’s assets and
liabilities are held by both the target corporation and acquiring corporation and the target
corporation’s shareholders hold stock in both the target corporation and acquiring
corporation. The transaction described in Situation (2) is divisive because, after the
transaction, the target corporation’s assets and liabilities are held by each of the two
acquiring corporations and the target corporation’s shareholders hold stock in each of the
two acquiring corporations.

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HOLDING:
The transactions described in Situations (1) and (2) do not qualify as reorganizations under
§ 368(a)(1)(A). However, the transactions described in Situations (1) and (2) possibly may
qualify for tax-free treatment under other provisions of the Code.

Questions and comments:
1. What purpose is served by requiring that the target corporation cease to exist?
2. Why did the acquisition in Situation (1) fail as an A reorganization?
3. Why did the acquisition in Situation (2) fail as an A reorganization?
4. An A reorganization cannot be a divisive reorganization. As the IRS explained:
Congress intended that § 355 be the sole means under which divisive transactions
will be afforded tax-free status and, thus, specifically required the liquidation of
the acquired corporation in reorganizations under both §§ 368(a)(1)(C) and
368(a)(1)(D) in order to prevent these reorganizations from being used in divisive
transactions that did not satisfy § 355.
See § IV infra (“divisive D reorganizations).
5. Disregarded Entities: The IRS in Rev. Rul. 2000-5 stated that state “corporate law
merger statutes have operated to ensure that ‘[a] merger ordinarily is an absorption by one
corporation of the properties and franchises of another whose stock it has acquired. The
merged corporation ceases to exist, and the merging corporation alone survives.’”
(citations omitted).
The attractiveness of the limited liability company (LLC) as a business entity has raised
the question whether it can be a party to an acquisitive reorganization. An LLC is not a
“corporation” and is not taxed as one. Its existence is disregarded for income tax purposes,
and its owners are subject to the tax consequences of the LLC’s activities. A corporation
can own an LLC, and an LLC can own a corporation. These points may provide some
benefits under state law, but they do not change the tax liabilities of the LLC’s owners.
For example, an acquiring corporation might set up a wholly-owned LLC into which a
target might merge and thereby avoid the expense of obtaining approval of many
shareholders. The liabilities of the target might be placed in the LLC. The acquiring
corporation seeks state law treatment of its LLC merger and federal tax law treatment of
its reorganization. See Steven A. Bank, Federalizing the Tax-Free Merger: Toward an
End to the Anachronistic Reliance on State Corporation Law, 77 U. N.C. L. REV. 1307,
1368 (1999).
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The regulations now permit the merger of a target corporation into an LLC. See Reg. §
1.368-2(b)(1). There are conditions to such a merger, which regulations establish in part
through definitions and in part through requirements of what state merger statutes must
provide.
•A combining entity is a corporation. Reg. § 1.368-2(b)(1)(i)(B).
•A combining unit is a combining entity and all disregarded entities whose assets
are treated as owned by the combining entity.
•The merger or consolidation occurs pursuant to state statute(s), and the following
occur by operation of those merger or consolidation statutes: all assets and
liabilities of each combining unit (i.e., transferor unit), with limited exceptions,
become the assets and liabilities of one or more members of “one other combining
unit,” i.e., the transferee unit, Reg. § 1.368-2(b)(1)(ii)(A), and the combining entity
of each transferor ceases its separate legal existence, Reg. § 1.368-2(b)(1)(ii)(B).
•A merger involving an LLC can only be an A reorganization. We shall see that a
B, C, or D reorganization requires transactions between “corporations.”
•The regulations contemplate that the acquiring corporation will own the LLC into
which the target will merge. The target corporation will not be related to the
acquiring corporation. The acquiring corporation will transfer consideration to the
target corporation (or its shareholders), which the target corporation will distribute
to its shareholders upon its liquidation. The target corporation will merge into the
LLC that is a part of the acquiring corporation’s “combining unit.” When the dust
settles, the acquiring corporation will have acquired the target corporation’s assets.
See generally Reg. § 1.368-2(b)(1)(iii) (examples).
6. Preview to Triangular A Reorganizations:
•Section 368(a)(2)(C) permits the acquiring corporation to transfer the stock or
assets that it acquired to a corporation that it controls, i.e., to drop down assets.
•Forward Triangular A Acquisition: Section 368(a)(2)(D) permits use of a
corporate parent’s stock to acquire “substantially all” the properties of another
corporation so long as no stock of the acquiring subsidiary corporation is used in
the transaction and the transaction would otherwise have qualified as an A merger
if the other corporation had merged into the parent.
•Reverse Triangular A Acquisition: Section 368(a)(2)(E) permits the use of a parent
corporation’s stock to merge a subsidiary corporation into another corporation so
long as (i) the corporation surviving the merger holds “substantially all” its
properties and the properties of the merged corporation (other than the parent
corporation’s stock) and (ii) shareholders of the surviving corporation exchanged
sufficient stock constituting control of the surviving corporation for voting stock of
the parent corporation.
7. Notice the occasions when the statutory merger must result in acquisition of
“substantially all” the assets of another corporation. Notice also the use of the same phrase
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in § 368(a)(1)(C). Do you expect the phrase to have the same meaning in both contexts?
See Reg. § 1.368-2(b)(2).
•If Target Corporation sells 50% of its assets immediately prior to an acquisitive A
reorganization, can Acquiring Corporation successfully execute a triangular A
reorganization?
8. As between A, B, and C reorganizations, notice which ones require use of “voting”
stock and which ones do not.
9. Suppose that Acquiring Corporation owns some stock of Target Corporation that it
acquired many years ago for cash. Now it wants to acquire Target Corporation through an
acquisitive A reorganization. Should the “old and cold” stock of Target Acquiring already
owns count against it when determining whether it meets the continuity of proprietary
interest standard?
10. Tax Consequences of Reorganizations (first cut):
•§ 354(a): provides for non-recognition of gain/loss and applies to “a party to a
reorganization.”
•§ 356(a)(1): references § 354 and states the familiar boot recognition rule, i.e.,
recognize boot or gain, whichever is less; no recognition of loss is allowed. § 356(c).
•§ 358(a): references § 354 and states familiar rules of basis substitution.
•§ 358(d): for basis purposes, reduce basis by the amount of liability assumed by
another party to the exchange.
•§ 361(a): A corporation that is a party to a reorganization recognizes no gain/loss if
exchanges of property are “solely” for stock or securities in another corporation.
•§ 361(b)(1, 2): If a corporation receiving property distributes it to shareholders “in
pursuance of the plan of reorganization,” no gain/loss to the corporation is
recognized.
•§ 357: references § 361 and states familiar rule that assumption of liability by a
party to an exchange is not treated as “money or other property” received by the
other party, except to the extent that the amount of liability exceeds the adjusted
basis of the property transferred.

Problems:
1. Z is a C corporation and X is a disregarded entity separate and owned by Y. Under
State W law, Z transfers some of its assets and liabilities to Y, retains the remainder of its
assets and liabilities, and remains in existence for Federal income tax purposes following
the transaction. The transaction qualifies as a merger under State W corporate law. What
will be the federal income tax treatment of Z’s transfer of some of its assets and liabilities
to Y? See Reg. §1.368-2(b)(1)(iii), Example 1.

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2. Z is a C corporation. X is a domestic LLC and wholly owned by Y, a C corporation.
Under State W law, Z merges into X. Pursuant to W state corporation law, the following
events occur simultaneously at the effective time of the transaction: all the assets and
liabilities of Z become the assets and liabilities of X and Z's separate legal existence ceases
for all purposes. In the merger, the Z shareholders exchange their stock of Z for stock of
Y. What will be the federal income tax treatment of Z Corporation, of Y Corporation, of
Z’s shareholders, and of Y’s shareholders? See Reg. § 1.368-2(b)(1)(iii), Example 2.
3. Y Corporation and Z Corporation are C corporations. Z operates two unrelated
businesses, Business P and Business Q, each of which represents 50% of the value of the
assets of Z. Y desires to acquire and continue operating Business P, but does not want to
acquire Business Q. Pursuant to a single plan, Z sells Business Q for cash to parties
unrelated to Z and Y in a taxable transaction, and then distributes the proceeds of the sale
pro rata to its shareholders. Then, pursuant to W state corporation law, Z merges into Y.
Pursuant to W state corporation law, the following events occur simultaneously at the
effective time of the transaction: all the assets and liabilities of Z related to Business P
become the assets and liabilities of Y and Z’s separate legal existence ceases for all
purposes. In the merger, the Z shareholders exchange their Z stock for Y stock. What are
the federal income tax consequences to Z Corporation, Z Corporation’s shareholders, and
to Y Corporation? See Reg. § 1.368-2(b)(iii), Example 8.

Review the basic rules of §§ 356, 357, 361, and 381. Then:

Do the CALI exercise:
Corporate Taxation: Reorganizations: A Reorganizations: Definition.

Do the CALI exercise:
Corporate Taxation: Reorganizations: Tax Consequences of A Reorganizations.
•As always, do not be afraid of learning something when doing these exercises.

B. “B” Reorganizations
A “B” reorganization is a “voting stock-for-stock” acquisition. The acquiring corporation
must exchange solely voting stock of itself or its parent for the stock of the target
corporation – and immediately after the exchange have control of the target, i.e., ownership
of at least 80% of the total combined voting power of all the classes of stock entitled to
vote and of at least 80% of the total number of shares of each and every other class of nonvoting stock of the corporation. §§ 368(a)(1)(b), 368(c). This includes non-qualified
preferred stock. Only voting stock may be used in a B acquisition, so a B reorganization
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will involve dilution of the voting interest of existing shareholders of the acquiring
corporation. “If, for example, corporation X in one transaction exchanges nonvoting
preferred stock or bonds in addition to all or a part of its voting stock in the acquisition of
stock corporation Y, the transaction is not a reorganization under § 368(a)(1)(B).” Reg. §
1.368-2(c). And while the acquiring corporation may exchange the stock of its parent,
when it does so it must exchange solely stock of its parent. “[I]f stock is acquired in
exchange for voting stock both of the acquiring corporation and of a corporation which is
in control of the acquiring corporation,” the acquisition is not a B reorganization. Id.
There may be more than one exchange of stock-for-stock, but the exchanges themselves
must take “place over a relatively short period of time such as 12 months.” Id. The
acquiring corporation may execute a B reorganization to acquire control of a corporation
in which it already owns (a not insubstantial) amount of stock, a so-called “creeping
acquisition.” See id. Stock that is “old and cold” may count towards “control” – even when
acquired for consideration other than voting stock.
Since the acquiring corporation may not use boot to acquire the target corporation,177 the
statutory requirements of a B reorganization themselves assure that there will be a
sufficient continuity of proprietary interest. There must also be a “continuity of business
enterprise” (COBE).
Notice that the target corporation does not exchange anything, i.e., the exchanges all occur
at shareholder levels. However, the acquiring corporation and the target corporation may
have dealings independent of the exchanges of stock. The target corporation continues to
exist, so the rights of creditors are not affected by a B reorganization. Target shareholders
may sell their stock in target prior to the exchange or sell their acquiring stock immediately
after the exchange. Cf. Reg. § 1.368-1(e)(i) (continuity of proprietary interest not lost;
proprietary interests in corporation preserved as such and not sold to the acquiring
corporation). In like manner, the target corporation may adjust its holdings – perhaps
distributing assets to shareholders that the acquiring corporation does not want.

177 The “solely for stock” requirement is still met when shareholders of the target who receive fractional shares

may either top up their holdings by purchasing the complementary fraction or sell the fractional share. If the
acquiring corporation pays cash to target shareholders to redeem fractional shares, the cash payment is treated
as a redemption and the acquisition still qualifies for §§ 368(a)(1)(B) and 354(a)(1) treatment. See Rev. Rul. 66365, 1966-2 C.B. 116.

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Chapman v. Commissioner, 618 F.2d 856 (1st Cir. 1980)
Opinion by: CAMPBELL
… We must decide whether the requirement of § 368(a)(1)(B) that the acquisition of stock
in one corporation by another be solely in exchange for voting stock of the acquiring
corporation is met where, in related transactions, the acquiring corporation first acquires
8% of the acquiree’s stock for cash and then acquires more than 80% of the acquiree in an
exchange of stock for voting stock. The Tax Court agreed with the taxpayers that the latter
exchange constituted a valid tax-free reorganization.
The Facts
Appellees were among the more than 17,000 shareholders of the Hartford Fire Insurance
Company who exchanged their Hartford stock for shares of the voting stock of
International Telephone and Telegraph Corporation pursuant to a formal exchange offer
from ITT dated May 26, 1970. [footnote omitted]. On their 1970 tax returns, appellees did
not report any gain or loss from these exchanges. Subsequently, the Internal Revenue
Service assessed deficiencies in the amounts of $15,452.93 (Chapman), $43,962.66
(Harry), $55,778.45 (Harwood), and $4,851.72 (Ladd). Appellees petitioned the Tax Court
for redetermination of these deficiencies … The Tax Court, with five judges dissenting,
[footnote omitted] granted appellees’ motion for summary judgment, and the
Commissioner of Internal Revenue filed this appeal.
The events giving rise to this dispute began in 1968, when the management of ITT, a large
multinational corporation, became interested in acquiring Hartford as part of a program of
diversification. In October 1968, ITT executives approached Hartford about the possibility
of merging the two corporations. This proposal was spurned by Hartford, which at the time
was considering acquisitions of its own. In November 1968, ITT learned that
approximately 1.3 million shares of Hartford, representing some 6% of Hartford’s voting
stock, were available for purchase from a mutual fund. After assuring Hartford’s directors
that ITT would not attempt to acquire Hartford against its will, ITT consummated the $63.7
million purchase from the mutual fund with Hartford’s blessing. From November 13, 1968
to January 10, 1969, ITT also made a series of purchases on the open market totalling
458,000 shares which it acquired for approximately $24.4 million. A further purchase of
400 shares from an ITT subsidiary in March 1969 brought ITT’s holdings to about 8% of
Hartford’s outstanding stock, all of which had been bought for cash.
... [O]n April 9, 1969 a provisional plan and agreement of merger was executed by the two
corporations. ...
... By private letter ruling, the Service notified the parties on October 13, 1969 that the
proposed merger would constitute a nontaxable reorganization, provided ITT
unconditionally sold its 8% interest in Hartford to a third party before Hartford’s
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shareholders voted to approve or disapprove the proposal. On October 21, the Service
ruled that a proposed sale of the stock to Mediobanca, an Italian bank, would satisfy this
condition, and such a sale was made on November 9.
On November 10, 1969, the shareholders of Hartford approved the merger, which had
already won the support of ITT’s shareholders in June. On December 13, 1969, however,
the merger plan ground to a halt, as the Connecticut Insurance Commissioner refused to
endorse the arrangement. ITT then proposed to proceed with a voluntary exchange offer
to the shareholders of Hartford on essentially the same terms they would have obtained
under the merger plan.178 After public hearings and the imposition of certain requirements
on the post-acquisition operation of Hartford, the insurance commissioner approved the
exchange offer on May 23, 1970, and three days later ITT submitted the exchange offer to
all Hartford shareholders. More than 95% of Hartford’s outstanding stock was exchanged
for shares of ITT’s $2.25 cumulative convertible voting preferred stock. The Italian bank
to which ITT had conveyed its original 8% interest was among those tendering shares, as
were the taxpayers in this case.
In March 1974, the Internal Revenue Service retroactively revoked its ruling approving
the sale of Hartford stock to Mediobanca, on the ground that the request on which the
ruling was based had misrepresented the nature of the proposed sale. Concluding that the
entire transaction no longer constituted a nontaxable reorganization, the Service assessed
tax deficiencies against a number of former Hartford shareholders who had accepted the
exchange offer. Appellees, along with other taxpayers, contested this action in the Tax
Court, where the case was decided on appellees’ motion for summary judgment. ... The
taxpayers ... conceded, solely for purposes of their motion for summary judgment, that the
initial cash purchases of Hartford stock had been made for the purpose of furthering ITT’s
efforts to acquire Hartford.
The Issue
Taxpayers advanced two arguments in support of their motion for summary judgment.
Their first argument related to the severability of the cash purchases from the 1970
exchange offer. Because 14 months had elapsed between the last of the cash purchases and
the effective date of the exchange offer, and because the cash purchases were not part of
the formal plan of reorganization entered into by ITT and Hartford, the taxpayers argued
that the 1970 exchange offer should be examined in isolation to determine whether it
satisfied the terms of § 368(a)(1)(B) ... The Service countered that the two sets of
transactions – the cash purchases and the exchange offer – were linked by a common
acquisitive purpose, and that they should be considered together for the purpose of
determining whether the arrangement met the statutory requirement that the stock of the
acquired corporation be exchanged “solely for ... voting stock” of the acquiring
178 Apparently, the insurance commissioner was concerned, among other things, about the rights of dissenting

shareholders, who could have been forced to exchange their Hartford shares under the merger plan. ...

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corporation. The Tax Court did not reach this argument; in granting summary judgment it
relied entirely on the taxpayers’ second argument.
For purposes of the second argument, the taxpayers conceded arguendo that the 1968 and
1969 cash purchases should be considered “parts of the 1970 exchange offer
reorganization.” Even so, they insisted upon a right to judgment on the basis that the 1970
exchange of stock for stock satisfied the statutory requirements for a reorganization
without regard to the presence of related cash purchases. The Tax Court agreed with the
taxpayers, holding that the 1970 exchange in which ITT acquired more than 80% of
Hartford’s single class of stock for ITT voting stock satisfied the requirements of §
368(a)(1)(B), so that no gain or loss need be recognized on the exchange under § 354(a)(1).
The sole issue on appeal is whether the Tax Court was correct in so holding. [footnote
omitted].
I.
We turn first to the statutory scheme under which this case arose. [footnote omitted]. The
basic rule governing exchanges was imported from § 1002 of the 1954 Code, 26 U.S.C. §
1002. Section 1002 stated that, except as otherwise provided, gain or loss on the exchange
of property should be recognized and taken into account in computing a taxpayer’s taxable
income. [footnote omitted]. One exception to that rule appears in § 354(a)(1), which
provides that gain or loss shall not be recognized if stock or securities in a corporation are,
in pursuance of the plan of reorganization, exchanged solely for stock or securities in
another corporation which is a party to the reorganization. [footnote omitted]. ... Section
354(a)(1) does not apply to an exchange unless the exchange falls within one of the six
categories of “reorganization” defined in Section 368(a)(1). [footnote omitted]. The
category relevant to the transactions involved in this case is defined in § 368(a)(1)(B):
[T]he term “reorganization’ means
(B) the acquisition by one corporation, in exchange solely for all or a part
of its voting stock ... of stock of another corporation if, immediately after
the acquisition, the acquiring corporation has control of such other
corporation (whether or not such acquiring corporation had control
immediately before the acquisition). [footnote omitted].
The concept of “control” is defined in § 368(c) as “the ownership of stock possessing at
least 80% of the total combined voting power of all classes of stock entitled to vote and at
least 80% of the total number of shares of all other classes of stock of the corporation.”179
Subsection (B) thus establishes two basic requirements for a valid, tax-free stock-for-stock
reorganization. First, “the acquisition” of another’s stock must be “solely for ... voting

179 The parties do not contest the fact that ITT had control of Hartford, as defined by § 368(c), immediately after

the 1970 exchange, whether or not the cash purchases were included in ITT’s holdings.

429

stock.” Second, the acquiring corporation must have control over the other corporation
immediately after the acquisition.
The single issue raised on this appeal is whether “the acquisition” in this case complied
with the requirement that it be “solely for ... voting stock.” It is well settled that the “solely”
requirement is mandatory; if any part of “the acquisition” includes a form of consideration
other than voting stock, the transaction will not qualify as a (B) reorganization. See
Helvering v. Southwest Consolidated Corp., 315 U.S. 194, 198 (1942) (“‘Solely’ leaves
no leeway. Voting stock plus some other consideration does not meet the statutory
requirement”). The precise issue before us is thus how broadly to read the term
“acquisition.” The Internal Revenue Service argues that “the acquisition ... of stock of
another corporation” must be understood to encompass the 1968-69 cash purchases as well
as the 1970 exchange offer. If the IRS is correct, “the acquisition” here fails as a (B)
reorganization. The taxpayers, on the other hand, would limit “the acquisition” to the part
of a sequential transaction of this nature which meets the requirements of subsection (B).
They argue that the 1970 exchange of stock for stock was itself an “acquisition” by ITT of
stock in Hartford solely in exchange for ITT’s voting stock, such that after the exchange
took place ITT controlled Hartford. Taxpayers contend that the earlier cash purchases of
8%, even if conceded to be part of the same acquisitive plan, are essentially irrelevant to
the tax-free reorganization otherwise effected.
The Tax Court ... plurality opinion stated its “narrow” holding as follows:
We hold that where, as is the case herein, 80% or more of the stock of a corporation
is acquired in one transaction, [footnote omitted] in exchange for which only voting
stock is furnished as consideration, the “solely for voting stock” requirement of §
368(a)(1)(B) is satisfied.
The plurality treated as “irrelevant” the 8% of Hartford’s stock purchased for cash …
II.
For reasons set forth extensively in section III of this opinion, we do not accept the position
adopted by the Tax Court. [footnote omitted]. Instead we side with the Commissioner on
the narrow issue presented in this appeal, that is, the correctness of taxpayers’ so-called
“second” argument premised on an assumed relationship between the cash and stock
transactions. As explained below, we find a strong implication in the language of the
statute, in the legislative history, in the regulations, and in the decisions of other courts
that cash purchases which are concededly “parts of” a stock-for-stock exchange must be
considered constituent elements of the “acquisition” for purposes of applying the “solely
for ... voting stock” requirement of § 368(a)(1)(B). We believe the presence of non-stock
consideration in such an acquisition, regardless of whether such consideration is necessary
to the gaining of control, is inconsistent with treatment of the acquisition as a nontaxable
reorganization. It follows for purposes of taxpayers’ second argument which was premised
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on the assumption that the cash transactions were part of the 1970 exchange offer
reorganization that the stock transfers in question would not qualify for nonrecognition of
gain or loss.
Our decision will not, unfortunately, end this case. The Tax Court has yet to rule on
taxpayers’ “first” argument. … The question of what factors should determine, for
purposes of § 368(a)(1)(B), whether a given cash purchase is truly “related” to a later
exchange of stock requires further consideration by the Tax Court, as does the question of
the application of those factors in the present case. We therefore will remand this case to
the Tax Court for further proceedings on the question raised by the taxpayers’ first
argument in support of their motion for summary judgment.
We view the Tax Court’s options on remand as threefold. It can hold that the cash and
stock transactions here in question are related as a matter of law – the position urged by
the Commissioner – in which case, under our present holding, there would not be a valid
(B) reorganization. On the other hand, the Tax Court may find that the transactions are as
a matter of law unrelated, so that the 1970 exchange offer was simply the final, nontaxable
step in a permissible creeping acquisition. Finally, the court may decide that, under the
legal standard it adopts, material factual issues remain to be decided, so that a grant of
summary judgment would be inappropriate at this time. [footnote omitted].
III.
A.
Having summarized in advance our holding, and its intended scope, we shall now revert
to the beginning of our analysis, and, in the remainder of this opinion, describe the thinking
by which we reached the result just announced. We begin with the words of the statute
itself. The reorganization definitions contained in § 368(a)(1) are precise, technical, and
comprehensive. They were intended to define the exclusive means by which nontaxable
corporate reorganizations could be effected. See Treas. Reg. § 1.368-1 (1960); 3 J.
MERTENS, THE LAW OF FEDERAL INCOME TAXATION § 20.86 at 364 (1972). In examining
the language of the (B) provision, [footnote omitted] we discern two possible meanings.
On the one hand, the statute could be read to say that a successful reorganization occurs
whenever Corporation X exchanges its own voting stock for stock in Corporation Y, and,
immediately after the transaction, Corporation X controls more than 80% of Y’s stock. On
this reading, purchases of shares for which any part of the consideration takes the form of
“boot” should be ignored, since the definition is only concerned with transactions which
meet the statutory requirements as to consideration and control. To take an example, if
Corporation X bought 50% of the shares of Y, and then almost immediately exchanged
part of its voting stock for the remaining 50% of Y’s stock, the question would arise
whether the second transaction was a (B) reorganization. Arguably, the statute can be read
to support such a finding. In the second transaction, X exchanged only stock for stock
(meeting the “solely” requirement), and after the transaction was completed X owned Y
(meeting the “control” requirement).
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The alternative reading of the statute – the one which we are persuaded to adopt – treats
the (B) definition as prescriptive, rather than merely descriptive. We read the statute to
mean that the entire transaction which constitutes “the acquisition” must not contain any
nonstock consideration if the transaction is to qualify as a (B) reorganization. In the
example given above, where X acquired 100% of Y’s stock, half for cash and half for
voting stock, we would interpret “the acquisition” as referring to the entire transaction, so
that the “solely for ... voting stock” requirement would not be met. We believe if Congress
had intended the statute to be read as merely descriptive, this intent would have been more
clearly spelled out in the statutory language. [footnote omitted].
We recognize that the Tax Court adopted neither of these two readings. For reasons to be
discussed in connection with the legislative history which follows, the Tax Court purported
to limit its holding to cases, such as this one, where more than 80% of the stock of
Corporation Y passes to Corporation X in exchange solely for voting stock. The Tax Court
presumably would assert that the 50/50 hypothetical posited above can be distinguished
from this case, and that its holding implies no view as to the hypothetical. The plurality
opinion recognized that the position it adopted creates no small problem with respect to
the proper reading of “the acquisition” in the statutory definition. In order to distinguish
the 80% case from the 50% case, it is necessary to read “the acquisition” as referring to at
least the amount of stock constituting “control” (80%) where related cash purchases are
present. Yet the Tax Court recognized that “the acquisition” cannot always refer to the
conveyance of an 80% bloc of stock in one transaction, since to do so would frustrate the
intent of the 1954 amendments to permit so-called “creeping acquisitions.”180
The Tax Court’s interpretation of the statute suffers from a more fundamental defect, as
well. In order to justify the limitation of its holding to transactions involving 80% or more
of the acquiree’s stock, the Tax Court focused on the passage of control as the primary
requirement of the (B) provision. This focus is misplaced. Under the present version of the
statute, the passage of control is entirely irrelevant; the only material requirement is that
the acquiring corporation have control immediately after the acquisition. As the statute
explicitly states, it does not matter if the acquiring corporation already has control before
the transaction begins, so long as such control exists at the completion of the
reorganization. Whatever talismanic quality may have attached to the acquisition of
control under previous versions of the Code, see Part III B infra, is altogether absent from
the version we must apply to this case. In our view, the statute should be read to mean that
180 In the typical creeping acquisition situation, Corporation X acquires a portion of Corporation Y’s stock, let

us say 40%, for cash or other nonstock consideration. If (B) reorganizations were limited to those encompassing
80% or more of Y’s stock in one transaction, X would thereafter be barred, as a practical matter, from acquiring
the remainder of Y’s shares in a tax-free (B) reorganization. The 1954 Code, however, clearly permits X to trade
voting stock for 40% or more of Y’s remaining stock so long as the stock acquisition is sufficiently separated
from the prior cash purchase. See 1954 Senate Report, supra note 17 at 273. In these circumstances, therefore,
“the acquisition” must be interpreted as referring to an amount of stock less than 80%. [citation omitted].

432

the related transactions that constitute “the acquisition,” whatever percentage of stock they
may represent, must meet both the “solely for voting stock” and the “control immediately
after” requirements of § 368(a)(1)(B). Neither the reading given the statute by the Tax
Court, nor that proposed as the first alternative above, adequately corresponds to the
careful language Congress employed in this section of the Code.
B.
The 1924 Code defined reorganization, in part, as “a merger or consolidation (including
the acquisition by one corporation of at least a majority of the voting stock and at least a
majority of the total number of shares of all other classes of stock of another corporation,
or substantially all the properties of another corporation).” Pub. L. No. 68-176, c. 234, §
203(h)(1), 43 Stat. 257. Although the statute did not specifically limit the consideration
that could be given in exchange for stock or assets, courts eventually developed the socalled “continuity of interest” doctrine, which held that exchanges that did not include
some quantum of stock as consideration were ineligible for reorganization treatment for
lack of a continuing property interest on the part of the acquiree’s shareholders. See, e.g.,
Cortland Specialty Co. v. Commissioner, 60 F.2d 937, 939-40 (2d Cir. 1932), cert. denied,
288 U.S. 599 (1933); Pinellas Ice Co. v. Commissioner, 287 U.S. 462, 470 (1933).
Despite this judicial development, sentiment was widespread in Congress that the
reorganization provisions lent themselves to abuse, particularly in the form of so-called
“disguised sales.” See, e.g., “Prevention of Tax Avoidance,” REPORT OF SUBCOMM. OF
HOUSE COMM. ON WAYS AND MEANS, 73d Cong., 2d Sess. (Dec. 4, 1933). In 1934, the
House Ways and Means Committee proposed abolition of the stock-acquisition and assetacquisition reorganizations which had appeared in the parenthetical section of the 1924
Act quoted above. See H.R. REP. NO. 704, 73d Cong., 2d Sess. 12-14 (1939-1 Cum. Bull.
(Part 2) 554, 563-65). The Senate Finance Committee countered with a proposal to retain
these provisions, but with “restrictions designed to prevent tax avoidance.” S. REP. NO.
558, 73d Cong., 2d Sess. 15 (1939-1 Cum. Bull. (Part 2) 586, 598). 181 One of these
restrictions was the requirement that the acquiring corporation obtain at least 80%, rather
than a bare majority, of the stock of the acquiree. The second requirement was stated in
the Senate Report as follows: “the acquisition, whether of stock or of substantially all the
properties, must be in exchange solely for the voting stock of the acquiring corporation.”
Id. at 17. The Senate amendments were enacted as § 112(g)(1) of the Revenue Act of 1934,
48 Stat. 680, which provided in pertinent part:
(1) The term “reorganization’ means (A) a statutory merger or consolidation, or
(B) the acquisition by one corporation in exchange solely for all or a part of its
voting stock: of at least 80 per centum of the voting stock and at least 80 per centum
181 The Senate’s purpose in retaining these provisions was apparently to make available an alternative to statutory

merger or consolidation in those states where merger statutes were overly restrictive or nonexistent. See Howard
v. Commissioner, 238 F.2d 943, 946 (7th Cir. 1956).

433

of the total number of shares of all other classes of stock of another corporation; or
of substantially all the properties of another corporation ....
Congress revised this definition in 1939 in response to the Supreme Court’s decision in
United States v. Hendler, 303 U.S. 564 (1938), which held that an acquiring corporation’s
assumption of the acquiree’s liabilities in an asset-acquisition was equivalent to the receipt
of “boot” by the acquiree. Since virtually all asset-acquisition reorganizations necessarily
involve the assumption of the acquiree’s liabilities, a literal application of the “solely for
... voting stock” requirement would have effectively abolished this form of tax-free
reorganization. In the Revenue Act of 1939, Congress separated the stock-acquisition and
asset-acquisition provisions in order to exempt the assumption of liabilities in the latter
category of cases from the “solely for ... voting stock” requirement. [footnote omitted].
Section 112(g)(1) of the revised statute then read, in pertinent part, as follows:
(1) the term “reorganization’ means (A) a statutory merger or consolidation, or (B)
the acquisition by one corporation, in exchange solely for all or a part of its voting
stock, of at least 80 per centum of the voting stock and at least 80 per centum of
the total number of shares of all other classes of stock of another corporation, or
(C) the acquisition by one corporation, in exchange solely for all or a part of its
voting stock, of substantially all the properties of another corporation, but in
determining whether the exchange is solely for voting stock the assumption by the
acquiring corporation of a liability of the other, or the fact that property acquired
is subject to liability, shall be disregarded ....
The next major change in this provision occurred in 1954. In that year, the House Bill,
H.R. 8300, would have drastically altered the corporate reorganization sections of the Tax
Code, permitting, for example, both stock and “boot” as consideration in a corporate
acquisition, with gain recognized only to the extent of the “boot.” See H.R. REP. NO. 1337,
83d Cong., 2d Sess. A118-A119, A132-A134, reprinted in (1954) U.S. CODE CONG. &
ADMIN. NEWS, pp. 4017, 4256-4257, 4269-4271. The Senate Finance Committee, in order
to preserve the familiar terminology and structure of the 1939 Code, proposed a new
version of § 112(g)(1), which would retain the “solely for ... voting stock” requirement,
but alter the existing control requirement to permit so-called “creeping acquisitions.”
Under the Senate Bill, it would no longer be necessary for the acquiring corporation to
obtain 80% or more of the acquiree’s stock in one “reorganization.” The Senate’s proposal
permitted an acquisition to occur in stages; a bloc of shares representing less than 80%
could be added to earlier acquisitions, regardless of the consideration given earlier, to meet
the control requirement. The Report of the Senate Finance Committee gave this example
of the operation of the creeping acquisition amendment:
Corporation A purchased 30% of the common stock of corporation W (the only
class of stock outstanding) for cash in 1939. On March 1, 1955, corporation A
offers to exchange its own voting stock, for all the stock of corporation W tendered
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within 6 months from the date of the offer. Within the 6 months period corporation
A acquires an additional 60% of the stock of W for its own voting stock. As a result
of the 1955 transactions, corporation A will own 90% of all of corporation W’s
stock. No gain or loss is recognized with respect to the exchanges of the A stock
for the W stock.
1954 SENATE REPORT, supra note 17, at 273, U.S. CODE CONG. & ADMIN. NEWS 1954, p.
4911. See also Treas. Reg. § 1.368-2(c) (1960).
At the same time the Senate was revising the (B) provision, (while leaving intact the
“solely for ... voting stock” requirement), it was also rewriting the (C) provision to
explicitly permit up to 20% of the consideration in an asset acquisition to take the form of
money or other nonstock property. See 26 U.S.C. § 368(a)(2)(B). The Senate revisions of
subsections (B) and (C) were ultimately passed, and have remained largely unchanged
since 1954. ... Proposals for altering the (B) provision to allow “boot” as consideration
have been made, but none has been enacted. [footnote omitted].
As this history shows, Congress has had conflicting aims in this complex and difficult area.
On the one hand, the 1934 Act evidences a strong intention to limit the reorganization
provisions to prevent forms of tax avoidance that had proliferated under the earlier revenue
acts. This intention arguably has been carried forward in the current versions through
retention of the “solely for ... voting stock” requirement in (B), even while the (C)
provision was being loosened. On the other hand, both the 1939 and 1954 revisions
represented attempts to make the reorganization procedures more accessible and practical
in both the (B) and (C) areas. In light of the conflicting purposes, we can discern no clear
Congressional mandate in the present structure of the (B) provision, either in terms of the
abuses sought to be remedied or the beneficial transactions sought to be facilitated. At
best, we think Congress has drawn somewhat arbitrary lines separating those transactions
that resemble mere changes in form of ownership and those that contain elements of a sale
or purchase arrangement. In such circumstances we believe it is more appropriate to
examine the specific rules and requirements Congress enacted, rather than some
questionably delineated “purpose” or “policy,” to determine whether a particular
transaction qualifies for favorable tax treatment.
To the extent there is any indication in the legislative history of Congress’ intent with
respect to the meaning of “acquisition” in the (B) provision, we believe the intent plainly
was to apply the “solely” requirement to all related transactions. In those statutes where
Congress intended to permit cash or other property to be used as consideration, it made
explicit provision therefor. See, e.g., 26 U.S.C. § 368(a)(2)(B). It is argued that in a (B)
reorganization the statute can be satisfied where only 80% of the acquiree’s stock is
obtained solely for voting stock, so that additional acquisitions are irrelevant and need not
be considered. In light of Congress’ repeated, and increasingly sophisticated, enactments
in this area, we are unpersuaded that such an important question would have been left
435

unaddressed had Congress intended to leave open such a possibility. We are not prepared
to believe that Congress intended either when it enacted the 1934, the 1939, or the 1954
statutes to permit a corporation to exchange stock tax-free for 80% of the stock of another
and in a related transaction to purchase the remaining 20% for cash. The only question we
see clearly left open by the legislative history is the degree of separation required between
the two transactions before they can qualify as a creeping acquisition under the 1954
amendments. This is precisely the issue the Tax Court chose not to address, and it is the
issue we now remand to the Tax Court for consideration.
C.
Besides finding support for the IRS position both in the design of the statute and in the
legislative history, we find support in the regulations adopted by the Treasury Department
construing these statutory provisions. …
....
D.
Finally, we turn to the body of case law that has developed concerning (B) reorganizations
to determine how previous courts have dealt with this question. Of the seven prior cases
in this area, all to a greater or lesser degree support the result we have reached, and none
supports the result reached by the Tax Court. We recognize that the Tax Court purported
to distinguish these precedents from the case before it, and that reasonable persons may
differ on the extent to which some of these cases directly control the question raised here.
Nevertheless, after carefully reviewing the precedents, we are satisfied that the decision of
the Tax Court represents a sharp break with the previous judicial constructions of this
statute, and a departure from the usual rule of stare decisis, which applies with special
force in the tax field where uncertainty and variety are ordinarily to be avoided.
....
IV.
We have stated our ruling, and the reasons that support it. In conclusion, we would like to
respond briefly to the arguments raised by the Tax Court, the District Court of Delaware,
and the taxpayers in this case against the rule we have reaffirmed today. The principal
argument, repeated again and again, concerns the supposed lack of policy behind the rule
forbidding cash in a (B) reorganization where the control requirement is met solely for
voting stock. It is true that the Service has not pointed to tax loopholes that would be
opened were the rule to be relaxed as appellees request. We also recognize, as the Tax
Court and others have highlighted, that the rule may produce results which some would
view as anomalous. For example, if Corporation X acquires 80% of Corporation Y’s stock
solely for voting stock, and is content to leave the remaining 20% outstanding, no one
would question that a valid (B) reorganization has taken place. If Corporation X then

436

decides to purchase stock from the remaining shareholders, the Howard rule[182] might
result in loss of nontaxable treatment for the stock acquisition if the two transactions were
found to be related. The Tax Court asserted that there is no conceivable Congressional
policy that would justify such a result. Further, it argued, Congress could not have felt that
prior cash purchases would forever ban a later successful (B) reorganization since the 1954
amendments, as the legislative history makes clear, specifically provided that prior cash
purchases would not prevent a creeping acquisition. [footnote omitted].
While not without force, this line of argument does not in the end persuade us. First of all,
as already discussed, the language of the statute, and the longstanding interpretation given
it by the courts, are persuasive reasons for our holding even in the absence of any clear
policy behind Congress’ expression of its will. Furthermore, we perceive statutory
anomalies of another sort which the Tax Court’s rule would only magnify. It is clear from
the regulations, for example, that a corporation which already owned as much as 80% of
another’s stock, acquired solely for cash, could in some circumstances acquire all or a part
of the remainder solely for voting stock as a valid (B) reorganization. [footnote omitted].
Why, then, could not as little as 10% of an acquisition constitute a (B) reorganization, if
made solely for voting stock, even though the remaining transactions totaling more than
80% were made for nonstock consideration? If it is true that Congress did not view related
cash transactions as tainting a stock-acquisition reorganization, why would it enact a
“solely for ... voting stock” requirement at all, except to the extent necessary to prevent
mixed consideration of the sort employed in the “disguised sales” of the twenties?
Possibly, Congress’ insertion of the “solely for ... voting stock” requirement into the 1934
Act was, as one commentator has suggested, an overreaction to a problem which could
have been dealt with through more precise and discriminating measures.183 But we do not
think it appropriate for a court to tell Congress how to do its job in an area such as this. If
a more refined statutory scheme would be appropriate, such changes should be sought
from the body empowered to make them. While we adhere to the general practice of
construing statutes so as to further their demonstrated policies, we have no license to
rework whole statutory schemes in pursuit of policy goals which Congress has nowhere
articulated. Appellees have not shown us any reason to believe that reaffirmation of the
settled rule in this area will frustrate the Congressional purpose of making the (B)
reorganization provision generally available to those who comply with the statutory
requirements. [footnote omitted].
A second major argument, advanced primarily by the district court in Pierson [v. United
States, 472 F. Supp. 957 (D. Del. 1979)], is that the previous cases construing this statute
182 [The court reviewed Howard v. Commissioner, 238 F.2d 943 (7th Cir. 1956), rev’g, 24 T.C. 792 (1955), a case

supporting the Commissioner’s view, in part IIID of its opinion.]
183 See Dailey, The Voting Stock Requirement of B and C Reorganizations, 26 TAX L. REV. 725, 731 (1971); Pierson v.

United States, 472 F. Supp. 957, 968 n.37 (D. Del. 1979).

437

are suspect because they did not give proper weight to the changes wrought by the 1954
amendments. In particular, the court argued the liberalization of the “boot” allowance in
(C) reorganizations and the allowance of creeping (B) acquisitions showed that Congress
had no intent or desire to forbid “boot” of up to 20% in a (B) reorganization. As we have
discussed earlier, we draw the opposite conclusion from the legislative history.
Liberalization of the (C) provision shows only that Congress, when it wished to do so,
could grant explicit leeway in the reorganization rules. Nor do the creeping acquisition
rules mark such a departure from a strict reading of the “solely” requirement as to persuade
us that Congress intended to weaken it with respect to related transactions. One has only
to look at the illustration given in the legislative history, with its separation of 16 years
between the cash and stock transactions, to see that Congress did not indicate positive
approval of the type of acquisition covered by the district court’s holding. [footnote
omitted].
A third argument asserts that reliance on the literal language of the 1954 Code, and in
particular a focus on the interpretation of “acquisition,” is unjustified because the 1954
Code was not intended to alter the status of (B) reorganizations under the 1934 and 1939
Codes. According to this argument, the acquisition of at least 80% of the acquiree’s stock
solely for voting stock was allowed under the pre-1954 version, and must still be allowed
even though the present statute refers only to “the acquisition ... of stock” with no
percentage specified. This argument assumes the answer to the question that is asked. As
Howard and Southwest Consolidated 184 illustrate, it has been the undeviating
understanding of courts, until now, that the pre-1954 statutes did not allow cash or other
“boot” in a (B) reorganization. It cannot be inferred that Congress left intact a rule which
never existed by enacting language inconsistent with such a rule.
Finally, we see no merit at all in the suggestion that we should permit “boot” in a (B)
reorganization simply because “boot” is permitted in some instances in (A) and (C)
reorganizations. Congress has never indicated that these three distinct categories of
transactions are to be interpreted in pari materia. In fact, striking differences in the
treatment of the three subsections have been evident in the history of the reorganization
statutes. [footnote omitted]. We see no reason to believe a difference in the treatment of
“boot” in these transactions is impermissible or irrational.
Accordingly, we vacate the judgment of the Tax Court insofar as it rests on a holding that
taxpayers were entitled to summary judgment irrespective of whether the cash purchases
in this case were related by purpose or timing to the stock exchange offer of 1970. The
case will be remanded to the Tax Court for further proceedings consistent with this
opinion.

184 [Helvering v. Southwest Consolidated Corp., 315 U.S. 194 (1942).]

438

Vacated and remanded.

Questions and comments:
1. The court’s opinion provides a very good statement of the law of B reorganizations –
complete with illustrative hypotheticals.
2. What is a “creeping acquisition?” How does § 368(a)(1)(B) apply to “creeping
acquisitions?” See the third footnote of the court’s opinion.
3. The court also accounted for the relative leniency of “C” reorganizations with respect
to the use of boot.
4. In the last paragraph of part IIIB, the court states its view of what Congress intended.
What is it?
5. N.B. A B reorganization is, of course, the acquisition solely of stock solely for voting
stock. The exchange is between the acquiring corporation and the shareholders of the target
corporation. The target corporation does not itself participate. Section 354(a)(a) accords a
B reorganization tax-free (i.e., tax-deferred) treatment. Section 358(a)(1) provides that the
target corporation shareholders take the same basis in their acquiring corporation voting
stock that they had in their target corporation stock.
6. In a B reorganization, the target corporation survives completely intact. Section
368(a)(1)(B) requires that the acquiring corporation have “control” of the target corporation
immediately after the acquisition. Section 368(c) defines “control” to be ownership of “at
least 80% of the total combined voting power of all classes of stock entitled to vote and at
least 80% of the total number of shares of all other classes of stock of the corporation.”
Non-qualified preferred stock, defined in § 351(g)(2)(A), is a class of stock, so the 80%
ownership requirement applies to it. However, § 354(a)(2)(C)(i) provides that non-qualified
preferred stock is not to be treated as “stock or securities” for purposes of according taxfree treatment to its receipt. Its receipt is taxed according to the rules of boot recognition. §
356(e).
7. In light of the relatively permissive nature of A reorganizations and C reorganizations,
infra, with respect to matters of boot, do you think that the relative rigidity of B
reorganizations is warranted?
8. In light of this holding, do you think that in planning a B reorganizations, target
corporations should be permitted to make themselves into the corporation that the
acquiring corporation wants?

439

•For example, the target corporation might redeem the shares of dissenting
shareholders prior to the exchange of voting stock for stock.
•Or the target corporation might distribute assets that the acquiring corporation
does not want to its shareholders.

Rev. Rul. 79-4, 1979-1 C.B. 150
….
ISSUE
Is the “solely for *** voting stock” requirement of §368 (a)(1)(B) of the Internal Revenue
Code of 1954 violated in the situation described below where an acquired corporation’s
debt that is treated for federal income tax purposes as a debt of its guarantor-shareholder
is repaid by the acquired corporation with funds furnished to it by the acquiring
corporation?
FACTS
A, an individual, was the sole shareholder of corporation Y, and was the guarantor on an
unsecured note of Y in the principal amount of 200x dollars issued to Z, an unrelated party,
in exchange for a loan. Because of Y’s inadequate capitalization, Z required that A
guarantee the note as to principal and interest. The facts and circumstances, including but
not limited to Y’s thin capitalization, resulted in Z being treated for federal income tax
purposes as having made the loan to A rather than Y and A being treated as having made
a capital contribution of the 200x dollar loan proceeds to Y. A’s initial basis in A’s Y stock
(100x dollars) was therefore increased to 300x dollars pursuant to § 1.118-1 of the Income
Tax Regulations. Payments of principal and interest by Y to Z with respect to the loan
were treated as discharging A’s obligation to Z, and such amounts were taxable to A as
constructive distributions under § 301 of the Code. In addition, Y’s interest payments on
the loan were considered as having been made by A. See Plantation Patterns, Inc. v.
Commissioner, 462 F.2d 712 (1972), aff’g T.C.M. 1970-182. For financial accounting
purposes, however, the loan was considered as made to Y and listed among its liabilities.
At the time of the situation described below, Y had made all previous principal and interest
payments on the loan as they became due.
In accordance with an agreement and plan of reorganization, X acquired all of the
outstanding stock of Y from A in exchange for voting stock of X. The fair market value of
the Y stock was calculated at 400x dollars with the 180x dollar remaining indebtedness on
the Z loan being included in such calculation as an indebtedness of Y. A received 390x
dollars of X stock, an amount equal to the 400x dollar fair market value of the Y stock at
the date of the exchange less 10x dollars consideration for X’s agreement to contribute
180x dollars to Y to satisfy the indebtedness to Z. The satisfaction of such indebtedness
would eliminate A’s potential liability as guarantor and would improve A’s borrowing
440

ability. X was willing to satisfy the indebtedness immediately to strengthen Y’s financial
position and to prevent a suit for reimbursement that would have arisen if A, as guarantor,
had been required to pay the indebtedness on Y’s default.
LAW AND ANALYSIS
Because the contribution of cash by X to Y and the repayment by Y of the indebtedness
plus accrued interest was a condition for the exchange of the Y stock for the X stock, such
contribution and repayment constitute additional consideration for the Y stock within the
meaning of § 1.368-2(c) of the regulations and the “solely for * * * voting stock”
requirement contained in § 368(a)(1)(B) of the Code is not satisfied. Consequently, the
nonrecognition provisions of § 354(a)(1) are inapplicable and gain or loss realized on the
exchange is recognized under § 1001.
In addition, because under Plantation Patterns, the indebtedness of Y to Z is considered
as indebtedness of A to Z despite Y’s timely payment of principal and interest to Z, and
because the repayment of the outstanding indebtedness by Y was a condition for exchange
of stock, A has received income in the amount of such repayment. [citations omitted].
Therefore, pursuant to § 1001, A will realize and recognize a gain on the exchange to the
extent such income and the fair market value of the X stock received exceeds A’s basis in
the Y stock:
income from Y’s repayment of indebtedness 180x
fair market value of X stock received
390x
Total
570x
Less A’s basis in Y stock
300x
gain realized by and recognized to A
270x
A will therefore realize and recognize a gain of 270x dollars on the exchange, and A’s
basis in the X stock received will be 400x dollars, its cost in Y stock exchanged. Section
1012 of the Code.
HOLDING
The “solely for *** voting stock” requirement of § 368(a)(1)(B) of the Code is violated
when the debt of Y (which is treated for federal income tax purposes as the debt of A) is
repaid by Y with funds furnished by X, if such repayment is a condition for the exchange
of the X and Y stock.

Questions and comments:
1. On how much income must taxpayer pay income tax? What is its character? Account
for all of the numbers in the revenue ruling’s table, especially the $400X basis A has in
the X Corporation stock.
441

2. What if the liability were not made the obligation of shareholder A because of the rule
of Plantation Patterns and repayment of the acquired corporation’s liability were not a
condition of the acquisition? As part of the plan, the acquiring corporation contributes cash
to the acquired corporation to discharge the corporation’s indebtedness to a third party that
a shareholder had guaranteed. HELD: §§ 368(a)(1)(B) and 354(a)(1) apply. Gain or loss
on exchange is not recognized. See Rev. Rul. 79-89, 1979-1 C.B. 152.
•What facts are critical to the difference in result?
•Payment of the obligation may not have been a condition of the reorganization,
but what might make the guarantor-shareholder insist on such a condition?

Rev. Rul. 98-10, 1998-1 C.B. 643
ISSUE
Where a stock for stock acquisition otherwise qualifying under § 368(a)(1)(B) of the
Internal Revenue Code is accompanied by an exchange of securities, how should the
transaction be treated?
FACTS
....
Corporation X acquires all of the outstanding capital stock of Corporation Y in exchange
for voting stock of X. Corporation Y is a solvent corporation. Prior to the exchange, Y has
an issue of six percent fifteen-year debentures outstanding. Pursuant to the plan of
reorganization, X acquires all the outstanding debentures of Y in exchange for an equal
principal amount of new six percent fifteen-year debentures of X. Some of the debentures
of Y are held by its shareholders, but a substantial proportion of the Y debentures are held
by persons who own no stock.
X is in control of Y immediately after the acquisition of the Y stock. The X and Y
debentures constitute “securities” within the meaning of § 354(a)(1) and, thus, do not
represent an equity interest. Disregarding the exchange of debentures, the transaction
meets the requirements of § 368(a)(1)(B).
LAW AND ANALYSIS
Section 368(a)(1)(B) provides that a reorganization includes the acquisition by one
corporation, in exchange solely for all or a part of its voting stock, of stock of another
corporation if, immediately after the acquisition, the acquiring corporation has control of
such other corporation.
Section 1.368-2(c) of the Income Tax Regulations provides:

442

In order to qualify as a “reorganization” under § 368(a)(1)(B), the acquisition by
the acquiring corporation of stock of another corporation must be in exchange
solely for all or a part of the voting stock of the acquiring corporation ..., and the
acquiring corporation must be in control of the other corporation immediately after
the transaction. If, for example, preferred stock or bonds in addition to all or a part
of its voting stock or bonds in addition to all or a part of its voting stock in the
acquisition of stock of Corporation Y, the transaction is not a reorganization under
§ 368(a)(1)(B).
Section 354(a)(1) provides that no gain or loss will 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 another corporation a party to a reorganization.
In the circumstances set forth above, the Y shareholders receive exclusively voting stock
of X as consideration for the exchange of their Y stock. The fact that a substantial
proportion of the Y debentures is held by bondholders who own no stock in Y has the
effect of ensuring that the value of the debentures issued by X in exchange for the
debentures of Y realistically reflects the value of the Y debentures alone and does not
constitute indirect nonqualifying consideration for the Y stock. Because the Y
shareholders, in their capacity as shareholders, receive only X voting stock, the transaction
constitutes a reorganization within the meaning of § 368(a)(1)(B).
Although the acquisition by X of the debentures of Y in exchange for debentures of X
occurs as part of the overall transaction, it is not a part of the stock-for-stock exchange
which qualifies as a reorganization. It is, however, an exchange of securities in parties to
a reorganization which occurs in pursuance of the plan of reorganization, and, therefore,
meets all the conditions of § 354(a)(1). Accordingly, any gain or loss realized by the
debenture holders of Y as a result of their exchange of their Y debentures for an equal
principal amount of debentures of X will not be recognized. § 354(a)(1). If, under different
facts, the principal amount of the debentures of X was greater than the principal amount
of the debentures of Y, §§ 354(a)(2) and 356(d) would apply to require the debenture
holders of Y to recognize some or all of any gain realized.
HOLDING
The exchange of Y stock for X stock is a reorganization described in § 368(a)(1)(B); and
any gain or loss realized by the shareholders of Y as a result of the exchange will not be
recognized. § 354(a)(1).
The separate exchange of Y debentures for X debentures is an exchange in pursuance of
the plan of reorganization described in § 368(a)(1)(B). Thus, any gain or loss realized by
the debenture holders of Y as a result of their exchange of their Y debentures for an equal
principal amount of debentures of X will not be recognized. § 354(a)(1).

443

In certain cases, rights to acquire stock of a party to a reorganization are “securities” for
purposes of § 354. See § 1.354-1(e) (as amended by T.D. 8752, 1998-9 I.R.B. 4, effective
for exchanges occurring on or after March 9, 1998). An exchange of such rights, although
separate from a § 368 exchange, may also be in pursuance of the plan of reorganization.
In such cases, any gain or loss realized by the holder of such rights as a result of the
exchange will not be recognized. § 354(a)(1).
EFFECT ON OTHER REVENUE RULINGS
....
Rev. Rul. 70-41, 1970-1 C.B. 77, deals with a stock-for-stock exchange accompanied by
an exchange of Acquired debentures for Acquiring stock. It is modified such that § 354
applies to the exchange of debentures for stock.
Rev. Rul. 78-408, 1978-2 C.B. 203, deals with a stock-for-stock exchange accompanied
by a warrant-for-warrant exchange. It is modified such that § 354 applies to the exchange
of warrants provided that the warrants constitute securities. See § 1.354-1(e).
Rev. Ruls. 68-637, 1968-2 C.B. 158, and 70-269, 1970-1 C.B. 82, similarly deals [sic]
with reorganization exchanges accompanied by exchanges of warrants or options. Each is
amplified such that § 354 applies to the exchange of warrants or options, provided that, as
in Rev. Rul. 78-408 above, the warrants or options constitute securities.
....

Questions and comments:
1. In Rev. Rul. 98-10, there was a stock-for-stock exchange and a debenture-for-debenture
exchange.
2. Read § 354(a)(2)(A) and § 356(d)(2)(B). What do these sections mean? In the last
paragraph of “LAW and ANALYSIS” of the revenue ruling, the IRS hypothesized an
exchange of securities in which the “principal amount” of securities received exceeds the
“principal amount” of securities surrendered. Why should such an exchange be a
recognition event? If one party to such an exchange has a gain, the other party must have a
loss. How is it treated? See § 356(c).
3. Section 368(a)(2)(C) permits the acquiring corporation in a B reorganization to drop
down the stock of the target corporation’s stock to another corporation that the parent
controls. See, e.g., Reg. § 1.368-2(k)(2), Example 4.
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Problems:
1. Corporation X entered into an agreement with the shareholders of corporation Y to
acquire all of the stock of Y in exchange solely for voting stock of X. Corporation X also
agreed with O, an insurance company, which did not own any of the stock of Y, to purchase
for cash an entire issue of convertible debentures of Y that O held. The debentures are
convertible at any time into the common stock of Y until their due date in 1982. The
debentures, which have all the indicia of valid indebtedness, confer upon the holder no
rights or liabilities as a shareholder of Y unless and until the holder exercises the
conversion privilege. Pursuant to agreement between X and O, O will not exercise the
conversion privilege of the debentures prior to the actual purchase by X. Such purchase is
conditioned upon the simultaneous acquisition by X of all the stock of Y. After the date of
purchase, X intends to hold the debentures until their maturity. Is this a tax-free exchange?
See Rev. Rul. 69-91, 1969-1 C.B. 106.
2. Corporation X procures 80% of the stock of Corporation Y by exchanging voting stock
with the shareholders of Corporation Y. As part of the plan, Corporation X procures the
other 20% of the stock of Corporation Y by purchasing it from Corporation Y
shareholders. Corporation X procured control of Corporation X “solely for voting stock.”
HELD: This is not a tax-free reorganization pursuant to § 368(a)(1)(B). Why not? See Rev.
Rul. 75-123, 1975-1 C.B. 11.
3. Corporation X acquired all of the outstanding stock of Y corporation from the
shareholders of Y in exchange for voting stock of X. X was in control of Y immediately
after the exchange within the meaning of § 368(c) of the Code. Y was a solvent corporation
but had need of additional working capital for expansion purposes. At the time of the
exchange of the Y stock for X stock, and as part of the overall plan, X purchased authorized
but unissued shares of Y stock for cash as a means of providing additional capital to Y.
None of the cash received by Y was distributed or otherwise paid out to its former
shareholders. Is this a tax-free exchange under §§ 368(a)(1)(B) and 354(a)(1)? What did
the shareholders of Corporation Y receive? See Rev. Rul. 72-522, 1972-2 C.B. 215.
4. Corporation P and Corporation Y are publicly owned corporations. Y had outstanding
various classes of preferred stock and 9,000,000 shares of common stock of which 300,000
shares were owned by Corporation P. P had purchased its Y stock for cash, on the open
market, within a short period of time before the transactions described below. P wished to
acquire the stock of Y in a transaction that would qualify as a reorganization defined in §
368(a)(1)(B). Because of its prior purchase of Y stock, P wished to preclude the possibility
that such purchase, and the subsequent exchange of Y stock for voting stock of P, would
be treated as a single transaction which would violate the “solely for voting stock”
requirement of § 368(a)(1)(B). Prior to the offer by P to the shareholders of Y to exchange
their Y stock for voting stock of P, P unconditionally sold for cash all of its Y stock to X,
an unrelated third party. P had no agreement or other arrangement to reacquire the stock
of Y. P thereafter acquired all of the outstanding stock of Y, which was sufficient to gain
445

control of Corporation Y, in exchange for voting stock of P. HELD: The prior purchase
for cash by Corporation P of the shares of Corporation Y will not violate the “solely for
voting stock” requirement of § 368(a)(1)(B), since such stock was unconditionally sold to
an unrelated third party prior to the offer by Corporation P to the shareholders of
Corporation Y. Rev. Rul. 72-354, 1972-2 C.B. 216.
•How is this different from Chapman?
Voting Stock: In B and C
reorganizations, the acquiring
5. Corporation X wants to acquire all of the stock of corporation may exchange
Corporation Y in a stock-for-stock B acquisition. solely voting stock. This means
Shareholders owning 25% of the outstanding stock of the voting interest of existing
Corporation Y elect not to participate. Corporation Y shareholders will be diluted. The
establishes an escrow account and provides enough funds acquiring
corporation
can
to pay the shareholders of Corporation Y who wish not execute an A reorganization
to participate in the exchange. Corporation X made no with exchanges of other forms of
payments to Corporation Y or to the shareholders of equity.
Corporation Y. Is this a tax-free exchange under §§
368(a)(1)(B) and 354(a)(1)? See Rev. Rul. 68285, 1968-1 C.B. 147.
•What if Corporation X had funded the escrow account? See id.

Do the CALI exercise:
Corporate Taxation: Reorganizations: B Reorganizations: Definition.

Do the CALI exercise:
Corporate Taxation: Reorganizations: Tax Consequences of B Reorganizations.

C. “C” Reorganizations
A “C” reorganization, § 368(a)(1)(C), occurs when the acquiring corporation acquires
“solely” for its (or its parent’s) voting stock “substantially all” the target corporation’s
properties. In contrast to a B reorganization, i.e., voting stock-for-stock, a C reorganization
is a voting stock-for-assets acquisition. The acquiring corporation’s assumption of a
liability “shall be disregarded.” The court in Chapman gave us some background of how
C reorganizations emerged in their current form. The focus of a C reorganization is the
acquisition of assets.185

185 By contrast, the focus of a “D” reorganization is “control” of the transferee corporation.

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The target corporation parts with assets and acquires stock. Lest it retain that stock and
realize gain without payment of income tax, § 368(a)(2)(G)(i) requires the acquired
corporation to distribute “the stock, securities, and other properties it receives, as well as
its other properties, in pursuance of the plan of reorganization.”
•Any distribution to creditors in connection with a liquidation which is pursuant to
the plan of reorganization is treated as “pursuant to the plan of reorganization.” §
368(a)(2)(G)(i).
•The Secretary may waive this distribution requirement upon conditions that she
may prescribe. § 368(a)(2)(G)(ii).
“Substantially all” is hardly a precise standard. The phrase appears elsewhere in the
reorganization rules. The Service has issued a revenue procedure that sets forth a litmus
test of what constitutes “substantially all” of a corporation’s assets for purposes of
receiving an advance ruling. Rev. Proc. 77-37, 1977-2 C.B. 568 provides at 3.01:
The “substantially all” requirement of §§ 354(b)(1)(A), 368(a)(1)(C),
368(a)(2)(B)(i), 368(a)(2)(D), and 368(a)(2)(E)(i) of the Code is satisfied if there
is a transfer (and in the case of a surviving corporation under § 368(a)(2)(E)(i), the
retention) of assets representing at least 90 percent of the fair market value of the
net assets and at least 70 percent of the fair market value of the gross assets held
by the corporation immediately prior to the transfer. All payments to dissenters and
all redemptions and distributions (except for regular, normal distributions) made
by the corporation immediately preceding the transfer and which are part of the
plan of reorganization will be considered as assets held by the corporation
immediately prior to the transfer. [emphasis added].
•note that: (fmv of assets, i.e., gross assets) − liabilities = (net assets)
With adequate information of the value of a target’s assets, cash, and liabilities, an
acquiring corporation can mechanically determine the minimum value of assets that it
must acquire in exchange for voting stock to effectuate a C reorganization.186 For example,
if Target Corporation owns assets with a fair market value of $500,000 that are subject to
liabilities of $150,000, 70% of the gross value of its assets is $350,000 and 90% of the net
value of its assets is $315,000. To satisfy the Service’s guidelines, an acquiring corporation
must acquire at least $350,000 worth of Target’s assets for voting stock.
•Now suppose that Target Corporation’s assets are subject to liabilities of
$100,000. To satisfy the Service’s guidelines, an acquiring corporation must
acquire at least $360,000 of Target Corporation’s assets for stock. $360,000 >
350,000.
•Question: Can you make any generalizations concerning meeting Rev. Proc. 7737's requirements and the amount of the target’s debt that the acquiring corporation
186 The same is true of an acquisitive “D” reorganization or a “G” reorganization. Note the inclusion of §

354(b)(1)(A) in the first sentence of the quoted excerpt of the revenue procedure.

447

may assume? At some point, doesn’t assumption of debt look more like a purchase
than a mere “readjustment of corporate structure?”

Problems:
1. Suppose Acquiring Corporation exchanged $750K worth of voting stock for Target
Corporation’s assets worth $850K and subject to $100K of liabilities. Immediately prior
to this exchange, Target had exchanged $50K for the stock of dissenting shareholders.
•What were Target’s gross assets and net assets immediately prior to Target’s
distributions to its dissenting shareholders?
•Under the guidelines of Rev. Proc. 77-37, would the exchange be treated as a C
reorganization? Note the last sentence of the quoted excerpt of Rev. Proc. 77-37.
2. Same as #1, but the value of the voting stock exchanged was $890K, and immediately
prior to the exchange Target exchanged $10K for the stock of dissenting shareholders.
3. Same as #2, but Acquiring Corporation exchanges $700K worth of voting stock for
certain assets of Target Corporation worth $800K and subject to the same liabilities and
subsequent to the same distribution to dissenting shareholders.
Note: The purchase of stock from a shareholder of the target or from the corporation itself
for money property (i.e., boot) is treated as giving money or property as consideration for
acquiring the target corporation’s properties. Reg. § 1.368-2(d)(4)(i). It is treated for the
“substantially all” determination the same as an assumption of liabilities. Such treatment
of purchases of stock from minority shareholders inhibits an acquiring corporation’s
acquisition of substantially all of the target corporation’s assets solely for voting stock.

Rev. Rul. 70-107, 1970-1 C.B. 78
The “solely for voting stock” requirement of § 368(a)(1)(C) of the Code is not met where
a wholly-owned subsidiary acquires the assets of an unrelated corporation in exchange for
voting stock of its parent that assumed part of the liabilities of the acquired corporation.
Corporation X owned all of the stock of corporation Y. Pursuant to a plan of reorganization
intended to meet the requirements of § 368(a)(1)(C) of the Internal Revenue Code of 1954,
Y directly acquired all the assets of corporation Z using voting stock of X previously
transferred to it. Part of the liabilities of Z were assumed by Y and part were assumed by
X.
Held, in view of the assumption by X of some of Z’s liabilities, the exchange does not
meet the “solely for voting stock” requirement of § 368(a)(1)(C) of the Code because that
section provides in part that in determining whether the exchange is solely for voting stock
448

the assumption by the acquiring corporation of a liability of the other shall be disregarded.
Since X (the parent of Y) is not the acquiring corporation, its assumption of Z’s liabilities
will not be disregarded.

Questions and comments:
1. By this point, you should have read most of § 354 and § 358. Perhaps you notice the
seemingly permissive statement in § 368(a)(2)(C), i.e., “shall not be disqualified.” The
revenue ruling should serve as a reminder that the definitions of “reorganization” in §
368(a)(1) are not to be read too expansively. The phrase “acquiring corporation” is not
synonymous with the phrase “party to a reorganization.”
2. The acquiring corporation may transfer some or all of the assets it acquires from the
target corporation to a subsidiary that it controls, i.e., a drop-down. § 368(a)(2)(C). But as
the revenue ruling states, the parent and the drop-down may not share the target
corporation’s liabilities.
3. Read § 368(a)(1)(D) and § 368(a)(2)(A). D reorganizations (infra) also involve
transfers of stock in exchange for assets. Section 368(b)(2)(A) provides that a
reorganization described both by § 368(a)(1)(C) and § 368(a)(1)(D) is to be treated only
as described by § 368(a)(1)(D). This provision is important in the context of divisive “D”
reorganizations (rather than acquisitive “D” reorganizations). This is made clear in Rev.
Rul. 88-48, infra.
4. Section 368(a)(1)(C) provides that in a C reorganization, when determining whether
the exchange is solely for stock, the acquiring corporation’s assumption of the target
corporation’s liabilities is to be disregarded.
•However, § 368(a)(2)(B) permits the acquiring corporation to transfer boot
(“money or other property”) to the target provided that voting stock is exchanged
for property that has a fair market value equal to 80% of more of the fair market
value of all of the target’s properties. When making the 80% determination,
liabilities are not disregarded and are to be treated as money paid for the property.
§ 368(a)(2)(B) (carryout ¶).
Thus: Section 368(a)(1)(C) and § 368(a)(2)(B) establish two tracks for a C reorganization.
The difference between these “tracks” turns on the nature of the boot. Section
368(a)(2)(B) creates a distinction between “non-liability boot” (“money or other
property”) and “liability boot.”
•If the target corporation receives no boot other than relief from liabilities
(“liability boot”), the analysis never moves past § 368(a)(1)(C). The only limitation
on such a C reorganization is the “substantially all” limitation.

449

•Section 368(a)(2)(B) states the rule when boot other than relief from liabilities
(“nonliability boot”) is included in the exchange. In such cases, relief from
liabilities is not disregarded, but rather treated as money paid. Boot that includes
“non-liability boot” cannot amount to 20% of the fair market value of all of the
target’s property. Stated differently, the acquiring corporation must acquire at least
80% of the fair market value of the target’s properties “solely” for voting stock.
•Thus: analysis under § 368(a)(2)(B) requires that we count the assumption
of liabilities in making the 80%-determination when non-liabilityassumption boot is included in the exchange.
•Illustration: Reg. 1.368-2(d)(3) provides in part: “[I]f the properties of
Corporation A worth $100,000, were subject to $50,000 in liabilities, an
acquisition of all the properties, subject to the liabilities, for any consideration
other than solely voting stock would not qualify as a reorganization under this
section since the liabilities alone are in excess of 20% of the fair market value of
the properties.”
5. Too much liability?: Reg. § 1.368-2(d)(1) provides that while an assumption of the
target’s liabilities may still be an exchange of assets “solely for voting stock,” “it may in
some cases ... so alter the character of the transaction as to place the transaction outside
the purposes and assumptions of the reorganization provisions. Section 368(a)(1)(C) does
not prevent consideration of the effect of an assumption of liabilities on the general
character of the transaction but merely provides that the requirement that the exchange be
solely for voting stock is satisfied if the only additional consideration is an assumption of
liabilities.”
6. Reg. § 1.368-2(d)(2) provides that the stock of both parent and subsidiary may not be
exchanged for the assets of the target corporation.

Rev. Rul. 88-48, 1988-1 C.B. 117
ISSUE
If a transferor corporation sold 50% of its historic assets to unrelated parties for cash and
immediately afterwards transferred to an acquiring corporation all of its assets (including
the cash from the sale), did the subsequent transfer meet the “substantially all” requirement
of § 368(a)(1)(C) of the Internal Revenue Code?
FACTS
X and Y were unrelated corporations that for many years were engaged in the hardware
business. X operated two significant lines of business, a retail hardware business and a
wholesale plumbing supply business. Y desired to acquire and continue to operate X’s
hardware business but did not desire to acquire the other business. Accordingly, pursuant
to an overall plan, the following steps were taken. First, in a taxable transaction, X sold its
450

entire interest in the plumbing supply business (constituting 50% of its total historic
business assets) to purchasers unrelated to either X or Y or their shareholders. Second, X
transferred all of its assets, including the cash proceeds from the sale, to Y solely for Y
voting stock and the assumption of X’s liabilities. Finally, in pursuance of the plan of
reorganization, X distributed the Y stock (the sole asset X then held) to the X shareholders
in complete liquidation.
Except for the issue relating to the “substantially all” requirement, the transfer of assets
form [sic from] X to Y constituted a corporate reorganization within the meaning of §
368(a)(1)(C) of the Code.
LAW AND ANALYSIS
Section 368(a)(1)(C) of the Code defines a corporate reorganization to include the
acquisition by one corporation, in exchange solely for all or part of its voting stock, of
substantially all the properties of another corporation.
Section 368(a)(1)(C) of the Code is intended to accommodate transactions that are, in
effect, mergers, but which fail to meet the statutory requirements that would bring them
within § 368(a)(1)(A). See S. REP. NO. 558, 73d Cong., 2d Sess. 16, 17, (1939), 1939-1
C.B. (Pt. 2) 586, 598.
Congress intended that transactions that are divisive in nature not qualify under §
368(a)(1)(C) of the Code, but, instead, be subject to the tests under § 368(a)(1)(D). See S.
REP. NO. 1622, 83d Cong., 2d Sess. 274 (1954). The enactment of § 368(a)(2)(G) indicates
the continuing interest in furthering this underlying objective of preventing divisive C
reorganizations.
Rev. Rul. 57-518, 1957-2 C.B. 253, concerns whether, in a C reorganization, assets may
be retained to pay liabilities. The ruling states that what constitutes “substantially all” for
purposes of § 368(a)(1)(C) of the Code depends on the facts and circumstances in each
case. Rev. Rul. 57-518 exemplifies the Service’s longstanding position that where some
assets are transferred to the acquiring corporation and other assets retained, then the
transaction may be divisive and so fail to meet the “substantially all” requirement of §
368(a)(1)(C). See also Rev. Rul. 78-47, 1978-1 C.B. 113.
In the present situation, 50% of the X assets acquired by Y consisted of cash from the sale
of one of X’s significant historic businesses. Although Y acquired substantially all the
assets X held at the time of transfer, the prior sale prevented Y from acquiring substantially
all of X historic business assets. The transaction here at issue, however, was not divisive.
The sale proceeds were not retained by the transferor corporation or its shareholders, but
were transferred to the acquiring corporation. Moreover, the prior sale of the historic assets
was to unrelated purchasers, and the X shareholders retained no interest, direct or indirect,

451

in these assets. Under these circumstance, the “substantially all” requirement of §
368(a)(1)(C) was met because all of the assets of X were transferred to Y.
HOLDING
The transfer of all of its assets by X to Y met the “substantially all” requirement of §
368(a)(1)(C) of the Code, even though immediately prior to the transfer X sold 50% of its
historic business assets to unrelated parties for cash and transferred that cash to Y instead
of the historic assets.

Questions and comments:
1. Did the C reorganization in this ruling violate any of the policies we expect to be
pursued in a reorganization?
•Do you think it significant that X sold its interest in the plumbing supply business
in a taxable transaction rather than a tax-deferred transaction? Or was it more
important that the target distributed to its shareholders everything it received from
Y Corporation, retained nothing, and liquidated?
•Do you think that the IRS would have issued a favorable private letter ruling in
the case? See Rev. Proc. 77-37, 1977-2 C.B. 568, supra?
2. What requirement does § 368(a)(2)(G) prescribe? Compare § 368(a)(2)(G) with the last
clause of § 368(a)(1)(D).
3. Cash used by the target corporation “to pay the regular quarterly dividend prior to the
reorganization exchange is not taken into account in determining whether [the acquiring
corporation] acquired ‘substantially all of the properties’ of [the target corporation] within
the meaning of § 368(a)(1)(C) ... However, if payment of the dividend occurs after the
reorganization exchange, both the cash to pay the dividend and the amount of the liability
for payment of the dividend will be taken into account in determining whether [the
acquiring corporation] acquired ‘substantially all the properties’ of [the target
corporation].” Rev. Rul. 74-457, 1974-2 C.B. 122.
4. Creeping C reorganization: The regulations now specify that a creeping C
reorganization does not fail the “solely for voting stock” requirement so long as –
1. money and other property distributed to target shareholders – counting neither
distributions of money or property to the acquiring corporation nor to creditors of
the target, PLUS
2. liabilities of the target corporation that the acquiring corporation acquires do not
exceed 20% of the value of the target’s assets. Reg. § 1.368-2(d)(4)(i).

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Problems:
1. Corporation P (P) holds 60% of the Corporation T (T) stock that P purchased several
years ago in an unrelated transaction. T has 100 shares of stock outstanding. The other
40% of the T stock is owned by Corporation X (X), an unrelated corporation. T has
properties with a fair market value of $110 and liabilities of $10. T transfers all of its
properties to P. In exchange, P assumes the $10 of liabilities, and transfers to T $30 of P
voting stock and $10 of cash. T distributes the P voting stock and $10 of cash to X and
liquidates. Is this a C reorganization? See Reg. § 1.368-2(d)(4)(ii), Example 1.
2. Same as #1, except that P purchased the 60 shares of T for $60 in cash in connection
with the acquisition of T’s assets. Is this a C reorganization? See Reg. § 1.368-2(d)(4)(ii),
Example 2.

Do the CALI exercise:
Corporate Taxation: Reorganizations: C Reorganizations: Definition.

Do the CALI exercise:
Corporate Taxation: Reorganizations: Tax Consequences of C Reorganizations.

D. Bankruptcy: G Reorganizations
If your edited copy of the Code and Regulations does not have § 368(a)(3), you should find
it online and print a copy.
A “transfer by a corporation of all or a part of its assets to another corporation in a title 11
or similar case ... if, in pursuance of the plan, stock or securities of the corporation to which
the assets are transferred are distributed in a transaction which qualifies under § 354, 355,
or 356” is a reorganization. § 368(a)(1)(G). A case “similar to” is a “receivership,
foreclosure, or similar proceeding” in a federal or state court. § 368(a)(3)(A)(ii). A G
reorganization is tax-free (i.e., deferred) so long as the transferee of assets acquires
“substantially all” such of the assets of the transferor, and the transferor distributes to its
shareholders the stock, securities, and other properties it receives as well as other
properties “in pursuance of the plan of reorganization.” § 354(b)(1). In these
circumstances, a drop down may follow the G reorganization. § 368(a)(2)(C). A G
reorganization can be divisive or non-divisive. § 368(a)(1)(G) (referencing § 355). Section
368(a)(3)(C) provides that a transaction qualifying as a G reorganization and as any other
type of reorganization – or tax-deferred under § 351 or § 332 – is governed by the rules
governing “G” reorganizations. A forward triangular acquisition is not disqualified from
being a G reorganization so long as no stock of the acquiring corporation is used in the
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transaction. § 368(a)(2)(D)(i). A reverse triangular reorganization is not disqualified from
being a G reorganization so long as “no former shareholder of the surviving corporation
receive[s] any consideration for his stock,” and former creditors of the surviving
corporation exchange debt of 80% or more of the “fair market value of the debt of the
surviving corporation for voting stock of the controlling corporation.” § 368(a)(3)(E).

Do the CALI exercise:
Corporate Taxation: Reorganizations: G Reorganizations: Definition.

E. Triangular Reorganizations
The A, B, C, and G acquisitive reorganizations suffer from their susceptibility to
considerations of state corporate laws and of other non-federal income tax considerations.
The liabilities of a target corporation do not disappear when the target corporation is
acquired, and an acquiring corporation may not be anxious to assume those liabilities. This
is particularly true of unknown liabilities – which describes a lot of products liability and
environmental liability. The complete disappearance of the target corporation may not be
something that the acquiring corporation desires, as when the target corporation owns such
non-transferable assets as state licenses, franchises, non-compete covenants, or other
contract rights. State corporation laws may require shareholder approval of a corporate
acquisition, both of the acquiring corporation and of the target corporation; obtaining such
approval can be (prohibitively) costly.
The triangular reorganization emerged to handle at least some of these matters. The
acquiring corporation forms a subsidiary corporation. The subsidiary corporation will
become the acquiring corporation or the acquired corporation. A triangular reorganization,
as the name implies, involves three parties, viz., the parent corporation that wants to make
the acquisition, the parent corporation’s subsidiary, and the target corporation. The parties
can transfer stock and assets between themselves.
•The target corporation can merge into the subsidiary corporation. The parent
corporation or the subsidiary corporation (not both) can transfer stock to the target
corporation or its shareholders. The target corporation or its shareholders can
transfer assets or stock to the parent corporation or to the subsidiary corporation.
If the target corporation transfers assets to the parent corporation, the parent
corporation can “drop them down” to the subsidiary corporation. The merger must
fit within the rules of an A, B, or C reorganization.
•IMPORTANTLY: The subsidiary corporation can assume the target
corporation’s liabilities, thereby insulating the acquiring corporation from
those liabilities.
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•This form, where the parent’s subsidiary merges into the target corporation
is a forward triangular merger.
Or
•The subsidiary corporation can merge into the target. The target corporation
becomes the acquiring corporation. Again, there is a transfer of stock and assets
between the corporations and their shareholders. This merger form is governed by
§ 368(a)(2)(D and E). That section applies only to A (and G in the case of §
368(a)(2)(D)) reorganizations.
•IMPORTANTLY: The target corporation continues to exist. The target
corporation continues to own its non-transferable assets, but is subject to
the control of the parent corporation.
•This form, where the target merges into the parent corporation’s
subsidiary, is a reverse triangular merger.
Moreover
•The parent corporation is the only shareholder of its subsidiary. Hence,
shareholder approval of a corporate subsidiary will not be difficult to obtain. This
is particularly useful when the parent corporation is a large, publicly traded
corporation. Only the cost of obtaining approval of the target’s shareholders must
still be incurred.
•Eliminating the expense of a shareholder vote at the level of the acquiring
corporation would be quite beneficial if the acquiring corporation is a large,
publicly traded corporation and the target corporation is a more closelyheld corporation.
Before there was § 368(a)(2)(C, D, and E), the Supreme Court held in Bashford and
Groman (discussed in Rev. Rul. 2002-85, infra) that in the absence of receiving something
in an exchange, a transferor was not a “party to a reorganization.” Thus, there could not
be a tax-deferred triangular merger in which a parent transfers its stock to a target
corporation or its shareholders if the parent received nothing in return. The whole point of
the triangular reorganization was to place assets into the subsidiary corporation rather than
the parent corporation. The target corporation or its shareholders likely will insist on
receiving stock of the parent corporation rather than stock of the subsidiary.
Since 1938, Congress responded incrementally by enacting § 368(a)(2)(C, D, and E). See
Stephanie Hoffer & Dale A. Osterle, Tax-Free Reorganizations: The Evolution and
Revolution of Triangular Mergers, 108 NW. U. L. REV. 1083, 1086-95 (2014) (recounting
history of congressional amendments to § 368(a)(2) and triangular mergers). Treasury has
also participated in liberalizing the availability of triangular reorganizations. Triangular
reorganizations can now occur under any of the reorganization types we have examined to
this point. In addition, Reg. § 1.368-2(k)(1) provides that transfers of stock or property
subsequent to a reorganization do not disqualify the reorganization, so long as the
nonstatutory (i.e., “common law”) requirements are met and there is a distribution to
455

shareholders. “Drop-downs” and “push-ups” can be tax-deferred, sometimes with reliance
upon § 351 instead of § 368, as parties to a reorganization move stocks and assets between
themselves.

1. B Triangular Reorganizations
A B reorganization is a voting stock for stock exchange. The target corporation does not
go out of existence, and there is not strictly speaking a merger.
•The acquiring corporation does not assume the liabilities of the target corporation.
•The applicability of state statutes governing mergers is avoided.
•There can be no boot.
•The strict construction that the court in Chapman, supra, gave § 368(a)(1)(B)
applies.
•Solely the voting stock of the parent or solely the voting stock of the subsidiary
may be used, but not both. Reg. § 1.368-2(c).
•The target corporation may redeem shares of its dissenting shareholders, so long
as the funds do not come from the parent.
If a triangular structure is used and the subsidiary acts as the acquiring corporation, the
parent will own a subsidiary and a subsidiary of a subsidiary. Section 368(a)(2)(C) and §
368(b)(2) (carryout ¶; acquiring corporation a “party to a reorganization” in straight B or
triangular B) permits the parent corporation to exchange its voting stock for voting stock
of the target corporation and then to transfer the voting stock of the target corporation to a
corporation that it controls, i.e., a subsidiary. The effect of this arrangement is the same as
it is for a straight B reorganization and no second-tier subsidiary is created.

2. C Triangular Reorganization
A C reorganization is a voting stock for “substantially all” assets exchange.
•The exchange must be of solely the voting stock of the parent or solely the voting
stock of the subsidiary, but not both. Reg. § 1.368-2(d)(1).
•Boot may be used. The mix of non-liability boot and liability boot is as discussed
supra.
•The target must go out of existence and distribute the stock, securities, and other
properties that it receives to its shareholders. § 368(a)(2)(G).
Section 368(a)(2)(C) and § 368(b)(2) (carryout ¶; acquiring corporation a “party to a
reorganization” in straight C or triangular C) permits the parent corporation to exchange
its voting stock for “substantially all of the properties” of the target corporation and then
to transfer the properties of the target corporation to a corporation that it controls, i.e., a
subsidiary.
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3. Forward A or G Triangular Reorganizations: § 368(a)(2)(D)
Section 368(a)(2)(D) and § 368(b)(2) (carryout ¶, third sentence) permit a forward
triangular merger through the exchange of the stock of the parent of the acquiring
corporation for “substantially all of the properties of” the target corporation.
•The parent does not assume the liabilities of the target corporation.
•Non-statutory rules of proprietary interest apply, so up to 60% of the consideration
given may be boot.
•The merger qualifies as an A reorganization only if a merger of the target
corporation into the parent corporation would have qualified as an A
reorganization. § 368(a)(2)(D)(i). COBE, COPI, and business purpose are
relevant to this determination – not state or federal corporate law. See Reg. §
1.368-2(b)(2).
•The acquiring corporation must acquire “substantially all” the properties of the
target corporation in exchange for the parent corporation’s stock. § 368(a)(2)(D).
The phrase “substantially all” has the same meaning that it has in § 368(a)(1)(C),
infra. Reg. § 1.368-2(b)(2).
•If less than “substantially all” the properties are acquired in the exchange, the
transaction may be divisive in nature, and divisive reorganizations are the exclusive
domain of § 355. See Rev. Rul. 2000-5, 2000-1 C.B. 436, infra.
•The step transaction doctrine may render a pre-reorganization divestment of some
of the target corporation’s properties together with the reorganization itself a single
integrated transaction – thereby precluding an acquisition of “substantially all” the
target’s properties in exchange for stock. But see Rev. Rul. 88-48, 198801 C.B.
117, infra.
•While § 368(a)(2)(1)(i) disallows use of the acquiring corporation’s stock, the
regulations provide that only the COPI regulations limit the use of the acquiring
corporation’s other property such as cash, securities, assumption of the acquired
corporation’s liabilities, etc. Reg. § 1.368-2(b)(2).
•State laws governing mergers, are by definition, applicable.

Problem:
1. V Corporation, Y Corporation, and Z Corporation are C corporations. X is a domestic
LLC and is wholly owned by Y Corporation. V owns 100 percent of the outstanding stock
of Y Corporation. Under State W law, Z merges into X. Pursuant to W state corporation
law, the following events occur simultaneously at the effective time of the transaction: all
of the assets and liabilities of Z become the assets and liabilities of X and Z’s separate
legal existence ceases for all purposes. In the merger, the Z shareholders exchange their
stock of Z Corporation for stock of V Corporation. What is the federal income tax
treatment of Z Corporation, of V Corporation, of Z Corporation shareholders, and of V
Corporation shareholders? See Reg. § 1.368-2(b)(1)(iii), Example 4; § 368(a)(2)(D).
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4. Reverse A Triangular Reorganizations: § 368(a)(2)(E)
Section 368(a)(2)(E) and § 368(b)(2) (carryout ¶, fourth sentence) permit a reverse
triangular merger through the exchange of the voting stock of the parent of the merged
corporation so long as (1) the corporation surviving the merger holds both substantially all
of its properties and substantially of the properties of the merged corporation, and (2)
former shareholders of the surviving corporation exchange sufficient stock to constitute
control of the surviving corporation for voting stock of the parent. Thus, the parent
corporation will control the surviving corporation. The number of shares constituting
“control” is measured before the transaction. Reg. § 1.368-2(j)(3)(i). The parent’s
subsidiary, i.e., the merged corporation, does not survive the reorganization.
•While boot may be used, the use of the parent’s voting stock to acquire sufficient
stock to constitute control of the surviving corporation provides a built-in
limitation on the amount of boot that may be used.
•Notice that in form, this reorganization is a stock for stock reorganization with
some boot permitted.
•The target corporation survives.
•The exchange must be of a sufficient number of shares to constitute control. Thus,
the parent must acquire by vote and value 80% or more of each and every class of
stock of the target’s stock. If the parent already owned 20% of any class of stock
of the target corporation, this form of reverse triangular is not permitted.

Problems:
1. P Corporation owns all the stock of S Corporation. T Corporation has 1000 shares of
common stock outstanding. P owns no T stock. On January 1, 2018, S merges into T. In
the merger, T’s shareholders surrender 950 shares of common stock in exchange for P
voting stock. The holders of the other 50 shares (who dissent from the merger) are paid in
cash with funds supplied by P. After the transaction, T holds all its own assets and all of
S’s assets. What are the income tax consequences to P Corporation, to T Corporation, and
to the T shareholders who were paid cash for their shares? See Reg. § 1.368-2(j)(6),
Example 1.
2. Same as #1, except that holders of 100 shares in corporation T, who dissented from the
merger, are paid in cash with funds supplied by T (and not by P or S) and in the merger,
T’s remaining shareholders surrender 720 shares of common stock in exchange for P
voting stock and 180 shares of common stock for cash supplied by P. What are the tax
consequences to P Corporation, to T Corporation, and to the T shareholders who were paid
cash for their shares? See Reg. § 1.368-2(j)(6), Example 2.
3. P Corporation owns all the stock of S Corporation. T Corporation has 1000 shares of
common stock outstanding. On January 1, 2008, P purchased 201 shares of T’s stock. On
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January 1, 2018 S merges into T. In the merger, T’s shareholders (other than P) surrender
799 shares of T stock in exchange for P voting stock. What are the tax consequences to P
Corporation, to T Corporation, and T Corporation’s shareholders? See Reg. § 1.3682(j)(6),
Example 4.
•How difficult would it be to make the acquisition into a B reorganization?
4. P Corporation owns all the stock of S Corporation. The stock of T Corporation has a
value of $75,000. On January 1, 2018, S merges into T. In the merger, T’s shareholders
surrender all their T stock in exchange for P voting stock. As part of the transaction, P
contributes $25,000 to T in exchange for new shares of T stock. None of the cash received
by T is distributed or otherwise paid out to former T shareholders. After the transaction, T
holds all its own assets and all of S’s assets. What are the income tax consequences to P
Corporation and to T Corporation? See Reg. § 1.368-2(j)(6), Example 7.
5. Same facts as #4, except that R Corporation (a C corporation) contributed the $25,000
to T Corporation in exchange for T stock. What are the tax consequences to P Corporation
and to T Corporation? See Reg. § 1.368-2(j)(6), Example 8.

F. Acquisitive “D” Reorganizations
Read § 354(a)(1)(D) and § 354(a, b).
A “D” Reorganization can effectuate a corporate acquisition. 187 An acquisitive D
reorganization is subject to the strictures of § 354. A D reorganization occurs when a
corporation transfers “all or a part of its assets to another corporation if immediately after
the transfer the transferor, one or more of its shareholders (including persons who were
shareholders immediately before the transfer), or any combination thereof, is in control of
the corporation to which the assets are transferred[.]” § 368(a)(1)(D).188 “Control” means
at least 50% stock ownership by vote or by value. § 368(a)(2)(H)(i) (cross-referencing §
304(c)). Recall that § 304(c) enlarges the relationships among which there is attribution of
ownership.
•The stock or securities of the corporate transferee of assets must be distributed in
a transaction qualifying under §§ 354, 355, or 356. § 368(a)(1)(D). [We defer
discussion of distributions that qualify for tax-deferred treatment under § 355. Such
distributions occur in the context of divisive reorganizations. Section 356 states
boot rules about which we initially have some intuition].

187 It can also effectuate a division of a single corporation into two or more corporations – a matter considered

infra.

188 In contrast to this focus on “control,” the focus of C reorganizations is the acquisition of “substantially all” the

target’s assets “solely for voting stock.”

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•Sections 354(b)(1) and 356 apply to D reorganizations and assure a continuity of
proprietary interest, even when substantial amounts of boot are involved. Section
354(b) requires that the transferor transfer “substantially all” of its assets to the
transferee and that the transferor distribute to its shareholders whatever it received
from the transferee as well as its “other properties.” Thus, the transferor is left
with nothing other than what it needs to satisfy existing liabilities incurred in the
ordinary course of business before the reorganization. Reg. § 1.354-1(a)(2). The
transferee will retain the assets it owned prior to the transfer plus the assets the
transferor transferred to it. Section 356 prescribes rules for income taxation of boot
in excess of gain realized, infra.
The phrase “all or a part” in § 368(a)(1)(D) when referring to the assets that must be
transferred generally has the same meaning as “substantially all” as used in § 368(a)(1)(C).
Thus, for private letter ruling purposes, the guidelines of Rev. Proc. 77-37 apply to
acquisitive D reorganizations as well as to C reorganizations. Section 354(b)(1)(A) uses
the phrase “substantially all” of the assets when conditioning tax-deferred treatment of
acquisitive reorganizations.
In A, B, or C reorganizations, shareholders of the target corporation typically surrender
their shares and therefore surrender control of the target corporation. Section 368(a)(1)(D),
by contrast, does not require an “exchange” and does not specify the type of consideration
(e.g., voting stock) that must be given. Section
De minimis variations in shareholder
368(a)(1)(D) requires only a “transfer” of “assets,”
identity or proportionality of
not an “exchange” of stock. A continuity of ownership are not taken into account.
proprietary interest is assured by the requirement Reg. § 1.368-2(l)(2)(iii).
that the transferor corporation or one or more of its
shareholders “control” the transferee corporation. As noted above, the “control”
requirement of D reorganizations is met by only 50% ownership of the target corporation’s
stock by vote or value. The acquisitive D reorganization offers complete flexibility insofar
as the consideration given in exchange for assets is concerned – whether property, money,
assumption of liabilities, or stock (voting or otherwise). In fact, an all-cash D
reorganization is possible.
An acquisitive D reorganization is useful when an acquisition occurs among affiliated
corporations, e.g., a parent acquiring a subsidiary, a subsidiary acquiring a parent, a brother
acquiring a sister. Indeed, these are the relationships among corporations that make
possible the transfer of assets by one corporation to another where the transferor has
control of the transferee immediately after the transfer.189

189

When the transferee corporation does not actually issue stock and/or securities, so long as person(s) own
the stock of the transferor corporation and the transferee corporation in identical proportions, the transferee
corporation will be treated as if it issued stock with a value equal to the fair market value of the assets received
minus the value of the consideration the transferor actually received. Reg. § 1.368-2(l)(2)(i). If the fair market
value of what the transferee received is equal to the value of the consideration that the transferor received, the

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The IRS has used the non-divisive D reorganization to attack taxpayer efforts to recognize
losses without disposing of assets.
•Before repeal of the General Utilities rule, corporations paid no income tax on
their distribution of property to their shareholders. Suppose –
•Corporation X has substantial e&p and appreciated assets. Corporation X
could liquidate and distribute its appreciated assets to its shareholders.
Corporation X would pay no income tax. Corporation X’s shareholders
would pay income tax at capital gain rates on the difference between their
bases in their stock and the fmv of the assets that they received. Corporation
X’s e&p would be wiped clean. Corporation X’s shareholders could then
transfer the assets that they received to a newly formed corporation,
Corporation Y.
•Shareholders would have a stepped-up basis in their Corporation
Y stock. Corporation Y would have a stepped-up basis in its assets
with a fresh depreciation schedule.
•Without e&p, Corporation Y’s distributions to shareholders would
not be subject at the shareholder level to income tax at ordinary
income rates.
•In essence, there had been a bailout of the corporation’s e&p.
•Corporation Y could issue preferred stock proportionately to
holders of common stock, and the preferred stock would not be §
306 stock because the corporation had no e&p.
•If shareholders did not retransfer all of the assets they received in
the liquidation, they effectively received a dividend of the retained
assets upon which they paid income tax at only capital gain rates.
Or suppose –
•Corporation X owns assets whose fmv is less than the
shareholders’ bases in their stock. Corporation X could liquidate.
Corporation X would recognize losses on its distribution of assets
in a liquidation. Shareholders would also recognize losses.
Shareholders could then transfer the assets to a new corporation Y
in a § 351 transaction.
Repeal of the General Utilities doctrine eliminated at least some, but not all, of these tax
avoidance possibilities. The IRS could (can) characterize the substance of these
transactions as D reorganizations. The 50% vote-or-value threshold of control, coupled
with attribution under § 318, makes this easier. Nevertheless, there remains a role for non-

transferee corporation is deemed to issue a nominal share of stock to the transferor corporation (in addition to
other consideration) that the transferor corporation is deemed to distribute to its shareholders. Id.

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divisive D reorganizations. When you read Rev. Rul. 2002-85, pay very close attention to
the summaries of the Groman and Bashford cases – and congressional reaction to those
cases. The United States Supreme Court decided those cases in 1937 and 1938 – before
there was § 368(a)(2)(C).

Rev. Rul. 2002-85, 2002-2 C.B. 986
SECTION 368(a)(1)(D) REORGANIZATION
Section 368. – Definitions Relating to Corporate Reorganizations, 26 CFR § 1.368-1,
Purpose and scope of exception for reorganization exchanges.
....
ISSUE
Whether an acquiring corporation’s transfer of a target corporation’s assets to a subsidiary
controlled by the acquiring corporation as part of a plan of reorganization will prevent a
transaction that otherwise qualifies as a reorganization under § 368(a)(1)(D) of the Internal
Revenue Code from so qualifying.
FACTS
A, an individual, owns 100% of T, a state X corporation. A also owns 100% of P, a state
Y corporation. For valid business reasons and pursuant to a plan of reorganization, (i) T
transfers all of its assets to P in exchange for consideration consisting of 70% P voting
stock and 30% cash, (ii) T then liquidates, distributing the P voting stock and cash to A,
and (iii) P subsequently transfers all of the T assets to S, a preexisting, wholly owned state
X subsidiary of P, in exchange for stock of S. S will continue T’s historic business after
the transfer and P will retain the S stock. Without regard to P’s transfer of all the T assets
to S, the transaction qualifies as a reorganization under § 368(a)(1)(D).
LAW
Section 368(a)(1)(D) provides that the term reorganization means a transfer by a
corporation of all or a part of its assets to another corporation if immediately after the
transfer the transferor, or one or more of its shareholders (including persons who were
shareholders immediately before the transfer), or any combination thereof, is in control of
the corporation to which the assets are transferred; but only if, in pursuance of the plan,
stock or securities of the corporation to which the assets are transferred are distributed in
a transaction which qualifies under §§ 354, 355, or 356.
Section 354(a) provides that, 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
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corporation a party to the reorganization. Section 354(b)(1) provides that § 354(a) shall
not apply to an exchange in pursuance of a plan of reorganization within the meaning of
subparagraph (D) or (G) of § 368(a)(1) unless (A) the corporation to which the assets are
transferred acquires substantially all of the assets of the transferor of such assets; and (B)
the stock, securities, and other properties received by such transferor, as well as the other
properties of such transferor, are distributed in pursuance of the plan of reorganization.
Section 368(a)(2)(A) provides that if a transaction is described in both §§ 368(a)(1)(C) and
368(a)(1)(D), then, for purposes of subchapter C (other than for purposes of §
368(a)(2)(C)), such transaction shall be treated as described only in § 368(a)(1)(D).
Section 368(a)(2)(C) provides that a transaction otherwise qualifying under §
368(a)(1)(A), (B), (C), or (G) shall not be disqualified by reason of the fact that part or all
of the assets or stock which were acquired in the transaction are transferred to a corporation
controlled (as defined in § 368(c)) by the corporation acquiring such assets or stock.
Section 368(b) provides that the term “a party to a reorganization” includes a corporation
resulting from a reorganization, and both corporations in the case of a reorganization
resulting from the acquisition by one corporation of the properties of another.
Congress enacted § 368(a)(2)(C) in response to the Supreme Court decisions in Groman
v. Commissioner, 302 U.S. 82 (1937), and Helvering v. Bashford, 302 U.S. 454 (1938). In
Groman, the shareholders of one corporation (Target) entered into an agreement with
another corporation (Parent) pursuant to which Target would merge into Parent’s newly
formed subsidiary (Sub). In the transaction, the Target shareholders transferred their
Target shares to Sub in exchange for shares of Parent, shares of Sub, and cash, and Target
liquidated. The Court concluded that, even though the statutory definition of “party to a
reorganization” was not exclusive, Parent was not a party to the reorganization because it
received nothing in the exchange. The Court then stated that an exchange that is pursuant
to a plan of reorganization is not taxable to the extent the interest of the stockholders of a
corporation continue to be definitely represented in substantial measure in a new or
different corporation. The stock of Parent, however, did not represent a continued
substantial interest in the assets conveyed to Sub. Because Parent was not a party to the
reorganization, the Court held that the receipt of the stock of Parent was taxable.
In Bashford, a corporation (Parent) wished to acquire three competitors (Targets). Pursuant
to a plan, Parent formed a new corporation (Sub) and acquired all the preferred shares and
a majority of the common shares of Sub. Sub became the owner of the stock and assets of
the Targets. The former stockholders of the Targets exchanged their shares in the Targets
for shares of Sub, shares of Parent, and cash. Because any direct ownership by Parent of
the Targets was transitory and without real substance, the Court saw no significant
distinction between this transaction and the transaction in Groman. Therefore, the Court
concluded that Parent was not a party to the reorganization. Hence, the Parent stock
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received by the shareholders of the Targets did not confer the requisite continuity of
interest.
In 1954, Congress enacted § 368(a)(2)(C) in response to Groman and Bashford. See S.
REP. NO. 1622, 83d Cong., 2d Sess. 52, 273, 275 (1954). As originally enacted, §
368(a)(2)(C) applied only to reorganizations under §§ 368(a)(1)(A) and 368(a)(1)(C), but
Congress has since amended the statute to apply to other reorganizations. Specifically,
Congress amended § 368(a)(2)(C) in 1964 to apply to reorganizations under §
368(a)(1)(B), and, in 1980, to reorganizations under § 368(a)(1)(G).
Section 1.368-2(k)(1) of the Income Tax Regulations restates the general rule of §
368(a)(2)(C) but permits the assets or stock acquired in certain types of reorganizations to
be successively transferred to one or more corporations controlled (as defined in § 368(c))
in each transfer by the transferor corporation without disqualifying the reorganization.
Section 1.368-2(f) provides that, if a transaction otherwise qualifies as a reorganization, a
corporation remains a party to the reorganization even though the stock or assets acquired
in the reorganization are transferred in a transaction described in § 1.368-2(k).
To qualify as a reorganization under § 368, a transaction must satisfy the continuity of
business enterprise (COBE) requirement. The COBE requirement is intended to ensure
that reorganizations are limited to readjustments of continuing interests in property under
modified corporate form. § 1.368-1(d)(1). Section 1.368-1(d)(1) provides that COBE
requires the issuing corporation (generally the acquiring corporation) in a potential
reorganization to either continue the target corporation’s historic business or use a
significant portion of the target’s historic business assets in a business. Pursuant to § 1.3681(d)(4)(i), the issuing corporation is treated as holding all of the businesses and assets of
all members of its qualified group. Section 1.368-1(d)(4)(ii) defines a qualified group as
one or more chains of corporations connected through stock ownership with the issuing
corporation, but only if the issuing corporation owns directly stock meeting the
requirements of § 368(c) in at least one other corporation, and stock meeting the
requirements of § 368(c) in each of the corporations (except the issuing corporation) is
owned directly by one of the other corporations.
In Rev. Rul. 88-48, 1988-1 C.B. 117, in a taxable transaction, corporation X sold 50% of
its historic business assets to unrelated purchasers for cash. Immediately afterwards,
pursuant to an overall plan, X transferred to corporation Y, a corporation unrelated to X
and the purchasers, all of its assets, including the cash from the sale. The ruling holds that
X’s transfer of assets to Y satisfied the substantially all requirement of § 368(a)(1)(C).
In Rev. Rul. 2001-25, 2001-1 C.B. 1291, pursuant to a plan, corporation S, a wholly owned
subsidiary of corporation P, merged with and into corporation T in a state law merger.
Immediately after the merger and as part of a plan that included the merger, T sold 50%
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of its operating assets for cash to an unrelated corporation. After the sale of the assets to
corporation X, T retained the sales proceeds. Without regard to the requirement that T hold
substantially all of the assets of T and S immediately after the merger, the merger satisfied
all the other requirements applicable to reorganizations under §§ 368(a)(1)(A) and
368(a)(2)(E). The Service ruled that even though T’s post-merger sale of 50% of its
operating assets prevented T from holding substantially all of its historic business assets
immediately after the merger, because the sales proceeds continued to be held by T, the
merger did not violate the requirement of § 368(a)(2)(E) that the surviving corporation
hold substantially all of its properties after the transaction.
In Rev. Rul. 2001-24, 2001-1 C.B. 1290, corporation X merged with and into corporation
S, a newly organized, wholly owned subsidiary of corporation P, in a transaction intended
to qualify as a reorganization under §§ 368(a)(1)(A) and 368(a)(2)(D). S continued the
historic business of X following the merger. Following the merger and as part of the plan
of reorganization, P transferred the S stock to corporation S1, a preexisting, wholly owned
subsidiary of P. The Service ruled that the transaction satisfied the continuity of business
enterprise requirement of § 1.368-1(d). Analyzing whether P’s transfer of the S stock to
S1 caused P to fail to control S for purposes of § 368(a)(2)(D) and caused P to fail to be a
party to the reorganization, the Service noted that the legislative history of § 368(a)(2)(E)
suggests that forward and reverse triangular mergers should be treated similarly. Section
1.368-2(k)(2) permits the transfer of stock or assets to a controlled corporation following
a reverse triangular merger under §§ 368(a)(1)(A) and 368(a)(2)(E), which supports
permitting P to transfer the S stock to S1 without causing the transaction to fail to qualify
as a reorganization under §§ 368(a)(1)(A) and 368(a)(2)(D). Furthermore, although §§
368(a)(2)(C) and 1.368-2(k) do not specifically address P’s transfer of S stock to S1
following a reorganization under §§ 368(a)(1)(A) and 368(a)(2)(D), § 368(a)(2)(C) is
permissive rather than exclusive or restrictive. Accordingly, the Service concluded that the
transfer of the S stock to S1 would not cause P to be treated as not in control of S for
purposes of § 368(a)(2)(D) and would not cause P to fail to be treated as a party to the
reorganization.
ANALYSIS
Neither § 368(a)(2)(C) nor § 368(a)(2)(A) indicates that an acquiring corporation’s
transfer of assets to a controlled subsidiary necessarily prevents a transaction that
otherwise qualifies as a reorganization under § 368(a)(1)(D) from so qualifying. Because
§ 368(a)(2)(C) is permissive and not exclusive or restrictive, the absence of § 368(a)(1)(D)
from § 368(a)(2)(C) does not indicate that such a transfer following a transaction that
otherwise qualifies as a reorganization under § 368(a)(1)(D) will prevent the transaction
from qualifying as such. Furthermore, although § 368(a)(2)(A) contains the parenthetical
exception “other than for purposes of [§ 368(a)(2)(C)],” that exception appears to have
been provided in the same spirit as § 368(a)(2)(C), i.e., to resolve doubts about the
qualification of transactions as reorganizations, and does not indicate that the transfer of

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assets to a controlled subsidiary necessarily prevents a transaction from qualifying as a
reorganization under § 368(a)(1)(D). See S. REP. NO. 313, 99th Cong., 2d Sess. 914 (1986).
Accordingly, an acquiring corporation’s transfer of assets to a controlled subsidiary
following a transaction that otherwise qualifies as a reorganization under § 368(a)(1)(D)
will not cause a transaction to fail to qualify as such, provided that the original transferee
is treated as acquiring substantially all of the assets of the target corporation, the
transaction satisfies the COBE requirement and does not fail under the remote continuity
principle of Groman and Bashford, and the transfer of assets to a controlled corporation
does not prevent the original transferee from being a “party to the reorganization.”
Section 354(b)(1)(A) requires that, in a reorganization under § 368(a)(1)(D), the
corporation to which the assets are transferred acquire substantially all of the assets of the
transferor of such assets. In this case, the requirement that P acquire substantially all of
T’s assets is satisfied because P retains the stock of S. See Rev. Rul. 2001-24; Rev. Rul.
88-48.
To qualify as a reorganization under § 368(a)(1)(D), a transaction must satisfy the COBE
requirement of § 1.368-1(d). In the present transaction, P and S constitute a qualified
group, and S will continue T’s historic business after the transfer. Therefore, the
transaction satisfies the COBE requirement.
As described above, Congress enacted § 368(a)(2)(C) in response to the Supreme Court’s
holdings in Groman and Bashford. After the enactment of § 368(a)(2)(C), however, the
Service continued to apply the principles of Groman and Bashford to transactions that
otherwise qualified as reorganizations under § 368(a)(1)(B). See Rev. Rul. 63-234, 19632
C.B. 148. In response to this position, Congress expanded the scope of § 368(a)(2)(C) to
include reorganizations under § 368(a)(1)(B). Congress’ response to the application of the
principles of Groman and Bashford has been to limit the application of those principles.
Implicit in Congress’ enactment and expansion of § 368(a)(2)(C) is a rejection of the
principle that the transfer of acquired stock or assets to a controlled subsidiary of the
acquiring corporation creates a remote continuity problem that causes a transaction that
otherwise qualifies as a reorganization to fail to so qualify. See H.R. REP. NO. 1337, 83d
Cong., 2d Sess. A134 (1954) (stating, after citing Groman and Bashford in reference to
proposed legislation that ultimately became § 368(a)(2)(C), “a corporation may not
acquire assets with the intention of transferring them to a stranger”).
Under the COBE regulations, stock or assets acquired in transactions that satisfy certain
provisions of § 368(a)(1) may be transferred without limitation to successive lower-tier
controlled subsidiaries within a qualified group. The Preamble to the final COBE
regulations states that “the IRS and Treasury believe the COBE requirements adequately
address the issues raised in Groman and Bashford and their progeny. Thus, [the final
COBE regulations] do not separately articulate rules addressing remote continuity of
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interest.” T.D. 8760, 1998-1 C.B. 803, Supplementary Information (Explanation of
Provisions). Accordingly, a transfer of acquired stock or assets will not cause a transaction
to fail for remote continuity if it satisfies the COBE requirement.
Under the facts described above, P’s transfer of the T assets to S pursuant to the plan of
reorganization satisfies the COBE requirement. Therefore, the transaction does not fail for
remote continuity.
Section 368(b) provides that the term “a party to a reorganization” includes a corporation
resulting from a reorganization, and both corporations in the case of a reorganization
resulting from the acquisition by one corporation of the properties of another. The use of
the word “includes” in § 368(b) indicates that the definition of “party to a reorganization”
is not exclusive. See § 7701(c); Groman, supra, at 86 (stating that “when an exclusive
definition is intended the word ‘means’ is employed … whereas [in the definition of “party
to a reorganization”] the word used is ‘includes”’). Furthermore, § 1.368-2(f), which
interprets § 368(b), provides that, if a transaction otherwise qualifies as a reorganization,
a corporation remains a party to a reorganization even though the stock or assets acquired
in the reorganization are transferred in a transaction described in § 1.368-2(k). Section
1.368-2(k) does not reference § 368(a)(1)(D). Nonetheless, because § 1.368-2(k) restates
and interprets § 368(a)(2)(C), which is a permissive and not an exclusive or restrictive
provision, § 1.368-2(k) also should be viewed as permissive and not exclusive or
restrictive. Therefore, because §§ 368(b), 1.368-2(f), and 1.368-2(k) are not exclusive or
restrictive provisions, the absence of § 368(a)(1)(D) from § 1.368-2(k) does not prevent a
corporation from remaining a party to a reorganization even if the acquired stock or assets
are transferred to a controlled subsidiary.
Reorganizations under § 368(a)(1)(D), like reorganizations under §§ 368(a)(1)(A) and
368(a)(1)(C), are asset reorganizations. In reorganizations under §§ 368(a)(1)(A) and
368(a)(1)(C), the original transferee is treated as a party to a reorganization, even if the
acquired assets are transferred to a controlled subsidiary of the original transferee. The
differences between reorganizations under § 368(a)(1)(D) on the one hand and
reorganizations under §§ 368(a)(1)(A) and 368(a)(1)(C) on the other hand do not warrant
treating the original transferee in a transaction that otherwise satisfies the requirements of
a reorganization under § 368(a)(1)(D) differently from the original transferee in a
reorganization under § 368(a)(1)(A) or 368(a)(1)(C) for purposes of § 368(b). Therefore,
the original transferee in a transaction that otherwise satisfies the requirements of a
reorganization under § 368(a)(1)(D) is treated as a party to the reorganization,
notwithstanding the original transferee’s transfer of acquired assets to a controlled
subsidiary of the original transferee.
For the reasons set forth above, P’s transfer of the T assets to S will not prevent P’s
acquisition of those assets from T in exchange for P voting stock and cash from qualifying
as a reorganization under § 368(a)(1)(D).
467

HOLDING
An acquiring corporation’s transfer of the target corporation’s assets to a subsidiary
controlled by the acquiring corporation as part of a plan of reorganization will not prevent
a transaction that otherwise qualifies as a reorganization under § 368(a)(1)(D) from so
qualifying.

Questions and comments:
1. Notice: T Corporation liquidated.
2. In your copy of the Code, you may pencil in (1)(D) to § 368(a)(2)(C).
3. The revenue ruling offers both a statement of the IRS’s position on certain acquisitions
and an attitude. Note the summaries of several revenue rulings. Cumulatively, you get
some idea of the many directions in which reorganizations may go in order to
accommodate the wishes of interested parties.
4. The IRS took the position that § 368(a)(2)(C) includes D reorganizations – even though
Congress did not so provide. It seems that the scope of triangular D reorganization will be
defined by COBE rules.
5. Section 368(a)(2)(A) provides that when both § 368(a)(1)(C) and § 368(a)(1)(D)
describe a reorganization, § 368(a)(1)(D) applies. This will make § 355 applicable to such
situations, except when the requirements of § 354(b)(1) are met – in which case the D
reorganization strongly resembles a C reorganization.
6. Under the facts of Rev. Rul. 2002-85, why was a D reorganization superior to a C
reorganization?
7. Section 368(a)(1)(D) does not name the type of consideration that must be given in the
exchange, i.e., it does not require an exchange of stock or securities. An all-cash D
reorganization is therefore possible. Nevertheless, compliance with § 354(b)(2) is
necessary, i.e., that “the stock, securities, and other properties received by such transferor,
as well as the other properties of such transferor, are distributed in pursuance of the plan
of reorganization.” § 354(b)(1)(B). So long as the “same persons own, directly or
indirectly, all the stock of the transferor and transferee corporation in identical
proportions,” (Reg. § 1.368-2(l)(2)(i)), the transaction will be deemed to satisfy the
requirements of § 368(a)(1)(D) and § 354(b)(1)(B). Family members under the attribution
rule of §318(a)(1) are treated as one individual. Reg. § 1.368-2(l)(2)(ii). Examples 1 and
2 from Reg. § 1.368-2(l)(3) are reprinted here:

468

Example 1. A owns all the stock of T and S. The T stock has a fair market value of $100x.
T sells all of its assets to S in exchange for $100x of cash and immediately liquidates.
Because there is complete shareholder identity and proportionality of ownership in T and
S, under ¶ (l)(2)(i) of this section, the requirements of §§ 368(a)(1)(D) and 354(b)(1)(B)
are treated as satisfied notwithstanding the fact that no S stock is issued. Pursuant to ¶
(l)(2)(i) of this section, S will be deemed to issue a nominal share of S stock to T in addition
to the $100x of cash actually exchanged for the T assets, and T will be deemed to distribute
all such consideration to A. The transaction qualifies as a reorganization described in §
368(a)(1)(D).
Example 2. The facts are the same as in Example 1 except that C, A’s son, owns all of the
stock of S. Under ¶ (l)(2)(ii) of this section, A and C are treated as one individual.
Accordingly, there is complete shareholder identity and proportionality of ownership in T
and S. Therefore, under ¶ (l)(2)(i) of this section, the requirements of §§ 368(a)(1)(D) and
354(b)(1)(B) are treated as satisfied notwithstanding the fact that no S stock is issued.
Pursuant to ¶ (l)(2)(i) of this section, S will be deemed to issue a nominal share of S stock
to T in addition to the $100x of cash actually exchanged for the T assets, and T will be
deemed to distribute all such consideration to A. A will be deemed to transfer the nominal
share of S stock to C. The transaction qualifies as a reorganization described in §
368(a)(1)(D).

Do the CALI exercise:
Corporate Taxation: Reorganizations: D Reorganizations: Definition.

Do the CALI exercise:
Corporate Taxation: Reorganizations: D Reorganizations: Tax Consequences of
Acquisitive D Reorganizations.

G. Multi-Step Transactions, Forced B Reorganizations, Double Dummy Transactions,
Etc.
Tax law and non-tax objectives do not always mesh perfectly in the context of
reorganizations. Suppose that taxpayers desire a certain result, but the transaction they
contemplate will not yield that result, and another transaction form would yield that result.
Taxpayers may combine successive tax-deferred transactions to achieve their objectives.
We consider here a relatively early court pronouncement on multi-step transactions,
followed by two examples of multi-step transactions.

469

Consider first whether the IRS will permit taxpayers to invoke the step transaction
doctrine.

King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969)
PER CURIAM:
... Judgment is entered for plaintiff ...
OPINION OF COMMISSIONER BERNHARDT, Commissioner:
This is an action to recover Federal income taxes paid by petitioner for the fiscal year
ended June 30, 1960. The issues involve the proper characterization for tax purposes of
the transaction in question, and the tax treatment of the resulting gain. The facts ... sustain
the conclusion that the petitioner is entitled to recover.
Petitioner, King Enterprises, Inc., is a Tennessee corporation presently engaged in the
business, inter alia, of holding and managing various investments. Prior to October 30,
1961, petitioner’s business, then styled Fleetwood Coffee Company, was the sale of
roasted coffee. It was one of 11 shareholders in Tenco, Inc., a corporation organized in
1951 to supply its shareholders with a reliable source of instant coffee for them to market
under their own brand names. Tenco was financially successful over the years, and by
1959 had become the second largest producer of soluble coffee in the United States.
Despite its financial success there was stockholder discontent.
Minute Maid Corporation had become by 1958 one of the nation’s principal producers of
frozen concentrated citrus juices. Because of financial reverses in 1957 Minute Maid
decided to acquire other businesses in order to stabilize its income. ... A ... proposal was
approved by the respective boards on August 25, 1959, and on September 3, 1959,
petitioner and other Tenco shareholders signed an agreement with Minute Maid entitled
“Purchase and Sale Agreement”.
Pursuant to the Agreement providing for the sale of their Tenco stock to Minute Maid, the
Tenco shareholders received a total consideration consisting of $3,000,000 in cash,
$2,550,000 in promissory notes, [footnote omitted] and 311,996 shares of Minute Maid
stock valued at $5,771,926. Petitioner’s share of the total consideration consisted of
$281,564.25 in cash, $239,329.40 in promissory notes, and 29,282 shares of Minute Maid
stock valued at $541,717. The Minute Maid stock received by Tenco stockholders
represented 15.62 percent of the total outstanding Minute Maid shares, and constituted in
excess of 50 percent of the total consideration received.

470

On December 10, 1959, the Minute Maid directors approved the November 24th
recommendation of its general counsel to merge the company’s four subsidiaries,
including Tenco, into the parent company, and authorized that the merger be submitted to
its stockholders for approval at a meeting scheduled for February 1960. Minute Maid’s
annual report to stockholders announced the merger plan about December 3, 1959. On
January 5, 1960, Minute Maid requested a ruling from the Commissioner of Internal
Revenue whether in the event of the proposed Tenco merger the basis of Tenco assets in
Minute Maid’s hands would be determined … by reference to the adjusted basis of the
Tenco stock in the hands of Minute Maid.” [This was approved by the Commissioner by
ruling of February 25, 1960.] On April 30 and May 2, 1960, in accordance with the
applicable state laws, Tenco and certain other subsidiaries were merged into Minute Maid.
On its income tax return for the fiscal year ended June 30, 1960, petitioner reported the
cash and notes received as dividend income, subject to the 85 percent intercorporate
dividends received deduction. The value of the Minute Maid stock received by petitioner
was not reported, it being petitioner’s position that such stock was received in connection
with a nontaxable corporate reorganization. The District Director of Internal Revenue
assessed a deficiency on the ground that the gain portion of the total consideration received
(cash, notes, and Minute Maid stock) constituted taxable capital gain from the sale of a
capital asset. Petitioner paid the deficiency, then sued here.
Petitioner contends that the transfer by the Tenco stockholders of their Tenco stock to
Minute Maid in exchange for Minute Maid stock, cash and notes, followed by the merger
of Tenco into Minute Maid, were steps in a unified transaction qualifying as a
reorganization under § 368(a)(1)(A) of the 1954 Code. Consequently, petitioner continues,
the Minute Maid stock was received by it pursuant to the plan of reorganization and is
nontaxable as such, while the cash and notes received constitute a dividend distribution to
which the 85 percent intercorporate dividends received deduction is applicable. The
Government asserts that the transfer of Tenco stock to Minute Maid was an independent
sales transaction; therefore, the entire gain realized by petitioner on the payment to it of
cash, notes and Minute Maid stock is taxable as gain from the sale of a capital asset.

I.
The Reorganization Issue
The threshold issue is whether the transfer of Tenco stock to Minute Maid is to be treated
for tax purposes as an independent transaction of sale, or as a transitory step in a
transaction qualifying as a corporate reorganization. Significant tax consequences turn on
which characterization is determined to be proper.
The general rule is that when property is sold or otherwise disposed of, any gain realized
must also be recognized, absent an appropriate nonrecognition provision in the Internal
471

Revenue Code. [footnote omitted]. One such nonrecognition provision, § 354(a)(1),
[footnote omitted] provides in pertinent part:
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.190
By its terms, this exception to the general rule of taxation depends for its operation on the
existence of a corporate reorganization. The term “reorganization”, moreover, is a word
of art in tax law and is specifically defined in § 368(a)(1) as comprising six types of
transactions, exclusively.
....
The premise of the corporate reorganization provisions is that certain transactions
constitute corporate readjustments and are not the proper occasion for the incidence of
taxation. Congressional policy is to free from tax consequences those corporate
reorganizations involving a continuity of business enterprise under modified corporate
form and a continuity of interest on the part of the owners before and after, where there is
no basic change in relationships and not a sufficient “cashing in” of proprietary interests
to justify contemporaneous taxation.
It is not disputed that there was a Type A reorganization in April 1960 when Tenco and
Minute Maid were merged in accordance with state law. Nor does the Government dispute
that Minute Maid continued the business of Tenco following the merger, or that the former
Tenco shareholders had a continuity of interest in the enterprise by virtue of their
ownership of stock in Minute Maid received in the exchange. The disagreement centers
on whether the initial exchange of stock was a step in a unified transaction pursuant to a
“plan of reorganization.”
The underlying theory of the petitioner’s claim is that the tax consequences of business
transactions are properly determined by their substance and not by the form in which they

190

In partial relaxation of this restrictive rule, § 356(a)(1) provides:

[If]
(A) § 354 * * * would apply to an exchange but for the fact that
(B)the property received in the exchange consists not only of property permitted by § 354 * * * to be received
without the recognition of gain but also of other property or money,
then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such
money and the fair market value of such other property

472

are cast. Thus petitioner views the substance of the transaction under review to be an
acquisition by Minute Maid of Tenco’s assets in exchange for transferring Minute Maid
stock, cash and notes to Tenco’s stockholders. [citations omitted]. The value of the Minute
Maid stock received, which exceeded 50 percent of the total consideration, constituted a
sufficient continuity of interest to support a Type A reorganization. [footnote omitted].
Petitioner concludes, therefore, that the net result of the entire transaction is a
reorganization, not to be altered by splitting the entire transaction into its component
transitory steps. [citations omitted]. Petitioner’s conclusion is justified in fact and in law.
The problem of deciding whether to accord the separate steps of a complex transaction
independent significance, or to treat them as related steps in a unified transaction, is a
recurring problem in the field of tax law.191 The principle that even extended business
transactions have determinate limits for tax purposes is based on a strong preference for
“closed transactions” upon which to impose tax consequences. This preference is
tempered, however, with respect for the integrity of an entire transaction. Accordingly, the
essence of the step transaction doctrine is 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”. BITTKER AND EUSTICE, FEDERAL INCOME TAXATION OF
CORPORATIONS AND SHAREHOLDERS, p. 18 (1966); [citation omitted]. The mere recitation
of the doctrine, however, does not clarify the necessary relationship between the steps
requisite to characterization as an integrated transaction.
Analysis of the reported cases and the diverse business transactions they encompass
reveals that there is no universal test applicable to step transaction situations. See
Anheuser-Busch, Inc., v. Helvering, 40 B.T.A. 1100 (1939), aff’d, 115 F.2d 662 (8th Cir.
1940), cert. denied, 312 U.S. 699 (1941); American Bantam Car Co. v. Commissioner of
Internal Revenue, 11 T.C. 397 (1948), aff’d, 177 F.2d 513 (3d Cir. 1949), cert. denied,
339 U.S. 920 (1950); South Bay Corp. v. Commissioner of Internal Revenue, 345 F.2d 698
(2d Cir. 1965); Commissioner of Internal Revenue v. Gordon, 391 U.S. 83 (1968). It has
been persuasively suggested that “the aphorisms about `closely related steps’ and
`integrated transactions’ may have different meanings in different contexts, and that there
may be not one rule, but several, depending on the substantive provision of the Code to
which they are being applied”. MINTZ AND PLUMB, STEP TRANSACTIONS 247, 252-253
(1954).
In their attempt to define the criteria upon which application of step transaction principles
depend, the courts have enunciated two basic tests. The “interdependence test” requires an
inquiry as to “whether on a reasonable interpretation of objective facts the steps were so

191 In coping with this and related problems, courts have enunciated a variety of doctrines, such as step

transaction, business purpose, and substance over form. Although the various doctrines overlap and it is not
always clear in a particular case which one is most appropriate, their common premise is that the substantive
realities of a transaction determine its tax consequences.

473

interdependent that the legal relations created by one transaction would have been fruitless
without a completion of the series”. Paul and Zimet, Step Transactions, SELECTED STUDIES
IN FEDERAL TAXATION (2d Series, 1938), pp. 200, 254. See also, American Bantam Car
Co. v. Commissioner of Internal Revenue, supra; ACF-Brill Motors Co. v. Commissioner
of Internal Revenue, 14 T.C. 263 (1950), aff’d, 189 F.2d 704 (3d Cir. 1951); American
Wire Fabrics Corp., 16 T.C. 607 (1951). The “end result” test, on the other hand,
establishes a standard whereby:
* * * purportedly separate transactions will be amalgamated into a single
transaction when it appears that they were really component parts of a single
transaction intended from the outset to be taken for the purpose of reaching the
ultimate result.192
Despite the real differences between the tests, each is faithful to the central purpose of the
step transaction doctrine; that is, to assure that tax consequences turn on the substance of
a transaction rather than on its form.
In support of its position that the step transaction doctrine is inapplicable to the facts of
this case the Government correctly points out that there was no binding commitment for
the merger of Tenco to follow the acquisition of its stock. Defendant erroneously
concludes, however, that the absence of such a commitment here renders the step
transaction doctrine inapplicable. The binding commitment requirement relied upon by the
Government, was enunciated by the Supreme Court in Commissioner of Internal Revenue
v. Gordon, supra, at 96, wherein the Court said “if one transaction is to be characterized
as a `first step’ there must be a binding commitment to take the later steps”. ...
....
The opinion in Gordon contains not the slightest indication that the Supreme Court
intended the binding commitment requirement as the touchstone of the step transaction
doctrine in tax law. Nor is there any indication that the Court intended to overrule any
prior decisions applying the step transaction doctrine to other types of transactions where
there were no binding commitments. ...193 Clearly, the step transaction doctrine would be
a dead letter if restricted to situations where the parties were bound to take certain steps.

192 HERWITZ, BUSINESS PLANNING, p. 804 (1966). [citations omitted].
193 See MINTZ v. [sic &] PLUMB, supra, at 285, where in regard to the similarly restrictive interdependence test it is

concluded:
[The interdependence test] applies * * * in cases * * * where the concept of a “plan or reorganization”
is not pertinent. In reorganization cases, except possibly in applying the “control” requirement * *
* the determinative test seems to be whether the step was intended, or even contemplated as an
alternative possibility, under the plan or reorganization, and the test of “interdependence” has not
been applied.

474

The doctrine derives vitality, rather, from its application where the form of a transaction
does not require a particular further step be taken; but, once taken, the substance of the
transaction reveals that the ultimate result was intended from the outset. See
AnheuserBusch, Inc., v. Helvering, supra; Chase v. Commissioner of Internal Revenue, 44
B.T.A. 39 (1941), aff’d, Helvering v. Chase, 128 F.2d 740 (2d Cir. 1942); Edith G.
Goldwasser, 47 B.T.A. 445 (1942), aff’d, 142 F.2d 556 (2d Cir. 1944). In the majority of
cases, it is the Government that relies on the step transaction doctrine for tax
characterization. General application of the binding commitment requirement would
effectively insure taxpayers of virtual exemption from the doctrine merely by refraining
from such commitments. Such an untoward result cannot be intended by the Gordon
opinion ...
In the alternative, the Government asserts that the step transaction doctrine has no
application to this case because the merger of Tenco into Minute Maid was not the
intended end result from the outset. Although the appropriate standard is invoked,
defendant’s assertion is inconsistent with the inferences to be drawn from the record.
The operative facts emerging from the record in this case suggest that Minute Maid,
desirous of diversifying its operations in order to stabilize its income, was presented with
the opportunity to acquire the entire stock of Tenco for a bargain “price”. Tenco’s record
of financial success and its asking price for Tenco stock of seven or eight times its earnings
(while other companies were asking 20 times their earnings), without more, constituted an
attractive investment. After the stock acquisition, moreover, Minute Maid was at liberty
to operate Tenco as a wholly owned subsidiary, if it so desired. ...
....
The operative facts in this case clearly justify the inference that the merger of Tenco into
Minute Maid was the intended result of the transaction in question from the outset, the
initial exchange of stock constituting a mere transitory step. Accordingly, it is concluded
that the initial exchange and subsequent merger were steps in a unified transaction
qualifying as a Type A reorganization, and that petitioner received its Minute Maid stock
pursuant to the plan of reorganization shown by the facts and circumstances above to have
existed.194
II
The Dividend Issue

194 A formal plan or reorganization is not necessary if the facts of the case show a plan to have existed. See William

H. Redfield, 34 B.T.A. 967 (1936).

475

….
There can be little doubt, on the facts of the present case, that the receipt of boot by
petitioner was essentially equivalent to a dividend. ... The amount of cash, promissory
notes and Minute Maid stock, respectively, received by each of the Tenco stockholders
was in direct proportion to his ownership of Tenco stock. …
III
The Deduction Issue
… [P]etitioner is entitled under § 243(a)(1) to a dividends received deduction in the
amount of 85 percent of the dividend portion of its recognizable gain.
....

Questions and comments:
1. Here it was taxpayer who successfully invoked the step-transaction doctrine.
2. If the step-transaction doctrine had not been applicable, what “steps” would have been
relevant, and what would have been the income tax consequences of each?
3. Why did taxpayer want the distribution of cash and notes to be treated as a dividend?
4. The Commissioner wanted to characterize the transaction between Tenco and Minute
Maid as a sale. In what way(s) would such a characterization have changed the tax
consequences of the transactions?
5. In Intermountain Lumber, there was a binding commitment that precluded the taxdeferred treatment of § 351.
6. Multi-step transactions are more common. They can be used to achieve results that the
statutory reorganization forms appear not to permit, or more accurately, to provide for.
Parties may seek outcomes permitted under different code sections (e.g., no boot
limitations) or under state law (e.g., appraisal). Multi-step transactions can be channeled
through these provisions. Some examples follow:

The Forced B Reorganization: A B reorganization is a voting stock for voting stock
exchange. Suppose that the acquiring corporation wants to assure itself that it can acquire
476

100% of the shares of a target, but some target shareholders would do not want to exchange
their shares for shares of the acquiring corporation. Consider the following:
Rev. Rul. 67-448, 1967-2 C.B. 144
Where, pursuant to a plan of reorganization, a parent corporation, P, issues some of its
voting shares to its new subsidiary, S, and S immediately merges into unrelated
corporation, Y, with the result that the shareholders of Y receive shares of P and P receives
80 percent or more of the shares of Y, the substance of the transaction is an acquisition by
P, in exchange solely for part of its voting stock, of stock of Y within the meaning of
section 368(a)(1)(B) of the Internal Revenue Code of 1954.
Advice has been requested whether the transaction described below qualifies as a
reorganization within the meaning of section 368(a)(1)(B) of the Internal Revenue Code
of 1954.
Corporation P and Corporation Y, incorporated in the same state, are publicly owned
corporations. Corporation P wanted to acquire the business of Corporation Y but could do
so with an effective result only if the corporate entity of Y were continued intact due to
the necessity of preserving its status as a regulated public utility. P also desired to eliminate
the possibility of minority shareholders in the event less than all of the shareholders of Y
agreed to the transaction. Since an outright acquisition of stock pursuant to a
reorganization as defined in section 368(a)(1)(B) of the Code would not achieve this result,
the plan of reorganization was consummated as follows:
(a) P transferred shares of its voting stock to its newly formed subsidiary, S, in exchange
for shares of S stock.
(b) S (whose only asset consisted of a block of the voting stock of P) merged into Y in a
transaction which qualified as a statutory merger under the applicable state law.
(c) Pursuant to the plan of reorganization and by operation of state law, the S stock owned
by P was converted into Y stock. At the same time the Y stock held by its shareholders
was exchanged for the P stock received by Y on the merger of S into Y. The end result of
these actions was that P acquired from the shareholders of Y in exchange for its own voting
stock more than 95 percent of the stock of Y.
(d) Y shareholders owning less than five percent of the stock of Y dissented to the merger
and had the right to receive the appraised value of their shares paid solely from the assets
of Y. No funds, or other property, have been or will be provided by P for this purpose.
Thus, upon the consummation of the plan of reorganization Y became a wholly owned
subsidiary of P.
477

At the time of the transaction P had no plan or intention to liquidate Y or to merge it into
any other corporation.
The transaction described above does not constitute a reorganization within the meaning
of either section 368(a)(1)(A) or section 368(a)(1)(C) of the Code because no assets of Y
were transferred to nor acquired by another corporation in the transaction but rather all
assets (except for amounts paid to dissenting shareholders) were retained in the same
corporate entity.
Section 368(a)(1)(B) of the Code provides in part that the term ‘reorganization’ means the
acquisition by one corporation, in exchange solely for all or a part of its voting stock, of
stock of another corporation if, immediately after the acquisition, the acquiring corporation
has control of such other corporation (whether or not such acquiring corporation had
control immediately before the acquisition).
It is evident that the shortest route to the end result described above would have been
achieved by a transfer of P voting stock directly to the shareholders of Y in exchange for
their stock. This result is not negated because the transaction was cast in the form of a
series of interrelated steps. The transitory existence of the new subsidiary, S, will be
disregarded. The effect of all the steps taken in the series is that Y became a wholly owned
subsidiary of P, and P transferred solely its voting stock to the former shareholders of Y.
Accordingly, the transaction will be treated as an acquisition by P, in exchange solely for
part of its voting stock, of stock of Y in an amount constituting control (as defined in
section 368(c) of the Code) of Y, which qualifies as a reorganization within the meaning
of section 368(a)(1)(B) of the Code.

Questions and comments:
1. This transaction is called a “forced B reorganization merger.” Minority shareholders
are forced to surrender their stock. The acquiring corporation creates a transitory
subsidiary to generate a merger under state law in which stock of the acquiring corporation
is used. At that point, state merger law defines the rights of dissenting shareholders. They
have appraisal rights, but do not have the right to retain their stock.

Double Dummy (or Butterfly) Mergers: A “double dummy” merger permits taxpayers to
invoke the step transaction doctrine to achieve results that would be difficult if not
impossible to achieve by any other manner. Back-to-back tax-deferred transactions can be
used to avoid the common law requirements of reorganizations, to permit generous

478

distributions of taxable boot that will increase the basis of assets received by the acquiring
corporation, and to minimize dilution of an acquiring corporation’s shareholders’ interests.
•The “continuity of proprietary interest” (COPI) requirement cannot be met when
only one or a few shareholders with relatively small interests in the target
corporation do not wish to be cashed out, but all the other shareholders do wish to
be cashed out with resulting tax on their capital gains. The minority shareholder
may have a low basis in stock with a high fair market value, may “be getting on in
years,” and may wish that the basis of the stock be “stepped up” (§ 1014) for the
benefit of heirs. COPI is not satisfied when a minority shareholder – say less than
40% – receives stock and the remaining shareholders receive cash. See Kass v.
Commissioner, 60 T.C. 218, 227 (1973), aff’d without opinion, 491 F.2d 749 (CA3
1974)
•Moreover, any form of tax-deferred reorganization that
Recall: in INDOPCO, Inc. v.
involves cash will be taxed, at least in part, while the
Commissioner, 503 U.S. 79
acquiring corporation takes the target’s basis in the
(1992), the target (National
assets that it receives.
Starch) corporation’s largest
•If voting stock of the acquiring corporation is
shareholders owned 14.5% of
exchanged, the existing shareholders’ interests in the
the corporation’s shares. These
acquiring corporation will be diluted.
shareholders were “getting
along in years” and would go
The double dummy can alter these outcomes, albeit at
along with Unilever’s acquisition
certain costs. The key to the transaction is to invoke §
plans only if the acquisition were
351 to provide one level of tax deferral rather than the
tax-deferred – and taxfree to
reorganization provisions. It goes something like this:
the extent of a basis step-up
upon their deaths – as to them.
Acquiring Corporation and shareholders of Target
Ultimately, Unilever acquired
Corporation set up a New Parent Corporation (NPC) in
79% of National Starch’s shares
a § 351 transaction. Acquiring Corporation transfers
for cash. The other shares of
National
Starch
were
cash to NPC and receives its stock. Target Corporation
exchanged for preferred stock.
shareholders transfer their stock to NPC and receive its
For devising what it called a
stock and cash. The basis of what the transferors
“reverse
subsidiary
cash
receive is the basis of what they transferred. §§ 358(a)),
merger,” the attorneys collected
362(a). The Target shareholders who receive cash must
a very nice fee. National Starch
recognize the lesser of boot or gain. § 351(b). But: The
was not permitted to deduct the
amount on which they pay income tax increases the
fee.
basis of the Target stock that NPC receives in the
transfer. § 362(a) (carryout ¶).
NPC sets up two wholly-owned subsidiaries (“double dummy”) in separate § 351
transactions. To one subsidiary (S-1), NPC transfers shares of Target Corporation and
receives shares of S-1. To the other subsidiary (S-2), NPC transfers cash and shares of
NPC. There is no income tax due on these § 351 transactions, and the familiar basis
carryover rules are applicable.
479

One of the dummies merges into the target corporation, and the other dummy merges into
the acquiring corporation. Target Corporation and Acquiring Corporation are the
“surviving” corporations. NPC owns the two surviving corporations. Shareholders of
Target Corporation and of Acquiring Corporation receive stock of New Parent Corporation
in exchange for their stock of Target and Acquiring Corporations. They may also receive
cash. Sections 368/354 would govern the tax treatment of these mergers.
•If shareholders of Acquiring Corporation receive only stock of NPC, the exchange
qualifies as a B reorganization or an A reorganization under ¶ 368(a)(2)(E).
But:
•Shareholders of Target Corporation and shareholders of Acquiring Corporation
may exchange their stock for stock of NPC plus cash. In the language of § 351, the
shareholders would be transferors of property. They would receive stock of NPC.
So long as transferors own 80% by vote and value of every class of NPC stock
issued, the “transferors” receive tax-deferred treatment. Tax-deferred treatment is
provided by § 351, not §§ 368/354.
•The non-statutory (common law) requirements of an acquisitive reorganization
are not met. There is not a continuity of proprietary interest. Nevertheless, the
limitations of Kass, supra, are avoided.
•Instead of one surviving corporation, there is one parent and two subsidiaries.
Hopefully this new corporate structure is acceptable.

Rev. Rul. 84-71, 1984-1 C.B. 106
TRANSFER TO CORPORATION CONTROLLED BY TRANSFERORS; CONTINUITY
OF INTEREST
….
The Internal Revenue Service has reconsidered Rev. Rul. 80-284, 1980-2 C.B. 117, and
Rev. Rul. 80-285, 1980-2 C.B. 119, in which transfers that satisfied the technical
requirements of § 351(a) of the Internal Revenue Code were nevertheless held to constitute
taxable exchanges because they were part of larger acquisitive transactions that did not
meet the continuity of interest test generally applicable to acquisitive reorganizations.
In Rev. Rul. 80-284, fourteen percent of T corporation’s stock was held by A, president
and chairman of the board, and eighty-six percent by the public. P, an unrelated, publicly
held corporation wished to purchase the stock of T. All the T stockholders except A were
willing to sell the T stock for cash. A wished to avoid recognition of gain.
In order to accommodate these wishes, the following transactions were carried out as part
of an overall plan. First, P and A formed a new corporation, S. P transferred cash and other
480

property to S in exchange solely for all of S’s common stock; A transferred T stock to S
solely in exchange for all of S’s preferred stock. These transfers were intended to be taxfree under § 351 of the Code. Second, S organized a new corporation, D, and transferred
to D the cash it had received from P in exchange for all the D common stock. Third, D was
merged into T under state law. As a result of the merger, each share of T stock, except
those shares held by S, were surrendered for cash equal to the stock’s fair market value
and each share of D stock was converted into T stock.
Rev. Rul. 80-284 concluded that if a purported § 351 exchange is an integral part of a
larger transaction that fits a pattern common to acquisitive reorganizations, and if the
continuity of shareholder interest requirement of section 1.368-1(b) of the Income Tax
Regulations is not satisfied with respect to the larger transaction, then the transaction as a
whole resembles a sale and the exchange cannot qualify under § 351 because that section
is not intended to apply to sales. Rev. Rul. 80-285 reached a similar conclusion with
respect to an asset, rather than stock, acquisition in which a purported § 351 exchange was
also part of a larger acquisitive transaction.
Upon reconsideration, the Service has concluded that the fact that “larger acquisitive
transactions,” such as those described in Rev. Rul. 80-284 and Rev. Rul. 80-285, fail to
meet the requirements for tax-free treatment under the reorganization provisions of the
Code does not preclude the applicability of § 351(a) to transfers that may be described as
part of such larger transactions, but also, either alone or in conjunction with other transfers,
meet the requirements of § 351(a).
EFFECT ON OTHER REVENUE RULINGS
Rev. Rul. 80-284 and Rev. Rul. 80-285 are revoked.

Questions and comments:
1. The facts that the IRS considered in Rev. Rul. 84-71 are a slimmed down version of
our double dummy transfers. There was no exchange that would permit the corporation to
increase its basis by the amount on which another party paid income tax, i.e., §361(a).
2. Notice that the corporate structure is altered, i.e., there is a permanent holding company
now in place.
3. The stock of the acquiring corporation is not diluted – or not diluted as much – through
use of voting stock to acquire shares of the target corporation as it would be if using a form
of reorganization.

481

4. Those target shareholders who wanted to be cashed out were cashed out. Those who
wished to retain shares retained shares.
5. Caveat: When issuing stock, a major objective is thwarted if that stock is non-qualified
preferred stock. Such stock is taxed as boot. § 351(g).
6. Acquiring Corporation will own Target Corporation stock with a fmv basis.

IV. Divisive (“D”) Reorganizations and § 355 Distributions
A corporation that divides itself becomes two
corporations. A corporation can effectuate a The requirements of § 355 are
division through a divisive D reorganization. This reviewed in W. Eugene Seago &
will require that a transferor corporation transfer Edward J. Schnee, Spinoffs and Splitassets to a transferee corporation, and that the Offs: Rules and Presumptions, TAX
transferor will control the transferee corporation. NOTES, Apr. 12, 2021, at 179.
The corporation must distribute stock or securities
of the corporation to which assets are transferred in a transaction that qualifies under
§§354, 355, or 356. Shareholders of the original corporation will own stock of the two (or
more) corporations in some proportions. Such a division may be for purposes that, for
policy reasons, should be tax-deferred. However, such tax-deferred treatment may
encourage transactions for no purpose other than tax-deferral or to change the character
of income, and such transactions should be subject to immediate income taxation. Recall
the case of –
•Gregory v. Helvering, 293 U.S. 465 (1935), supra: Mrs. Gregory held all the
shares of United Mortgage Corporation (UMC). UMC held 1000 shares of Monitor
Corporation. If UMC distributed those shares to Mrs. Gregory, she would be in
receipt of a dividend equal to the fair market value of the Monitor shares, to the
extent of UMC’s earnings and profits. Mrs. Gregory caused UMC to organize the
Averill Corporation – thereby dividing UMC into two corporations. UMC then
transferred the 1000 shares of Monitor to it. Averill issued its stock to Mrs.
Gregory. Mrs. Gregory sold the stock of Averill, and treated her gain as capital
gain. She apportioned her basis in UMC between Averill and UMC. In form, UMC
divided itself into two corporations and distributed only stock to Mrs. Gregory.
Such divisions and stock distributions might be tax-deferred reorganizations. There
was no business purpose to the division. The division was a “device” by which
UMC distributed its e&p, and Mrs. Gregory could pay income tax at long term
capital gain rates on receipt. The Supreme Court held, in essence, that in the
absence of a valid business purpose, tax-deferred treatment would not be accorded
the transaction. Presumably then, Mrs. Gregory was taxed on receipt of a dividend
– the substance of the transaction.

482

And now consider the facts and holding of this old case, Helvering v. Elkhorn Coal Co.,
95 F.2d 732 (4th Cir. 1937), cert. denied, 305 U.S. 605 (1938): Elkhorn Coal and Coke
Company transferred unwanted mining properties to a newly created corporation on
December 18. The new corporation’s shares were distributed to Elkhorn’s shareholders as
a dividend. On December 31, as part of the same plan, Elkhorn transferred its remaining
assets to Mill Creek Coal and Coke Company in exchange for voting stock and assumption
of liabilities in what purported to be a C-type transaction. HELD: transfer of assets to Mill
Creek not tax-free.
•Where a corporation forms a new corporation to which it transfers assets not
wanted by an acquiring company, the subsequent disposition of assets for stock of
an acquiring corporation does not qualify as a C-type reorganization when the
transfer is of less than “substantially all” the transferor’s pre-plan assets.
•Taxpayers wanted this to be treated as an A reorganization followed by a C
reorganization. There had been no distribution as required in a D reorganization.
The court would not separate the transactions.
•There was no purpose in creating the new corporation except to transfer unwanted
assets to it. The transfer was a mere shifting of charters with no apparent purpose
except avoidance of taxes. This is not the equivalent of transferring assets to
shareholders, for in that case, the business enterprise would definitely have
divested itself of the property. “Congress has seen fit to grant nonrecognition of
profit in sale or exchange of assets only under certain conditions, one of which is
that one corporation shall transfer ‘substantially all’ of its properties for stock in
another. If nonrecognition of profit can be secured by the plan adopted in this case,
the exemption is broadened to cover all transfers of assets for stock, whether
‘substantially all’ or not, if only the transferor will go to the slight trouble and
expense of getting a new charter for his corporation and making the transfer of
assets to the new corporation thus created in such way as to leave in the old only
the assets to be transferred at the time the transfer is to be made. We do not think
the statutory exemption may be thus broadened by such an artifice.” Helvering v.
Elkhorn Coal Co., 95 F.2d 732, 735 (4th Cir. 1937), cert. denied, 305 U.S. 605
(1938).
The division of a corporation into two or more corporations occurs through a distribution
of stock to shareholders of a corporation that the distributing corporation controls.
Shareholders might surrender some or all of their shares to the corporation – but the
distribution of stock of a corporation that the corporation owns is a necessary step in a
divisive reorganization.
A division of a corporation into two or more corporations may have one of three objectives:
1. The split of an existing corporation in which existing shareholders receive a
stock distribution and continue to own their shares of the corporation and of the
corporation that it controls. This is “spin-off.”

483

•Shareholders could of course sell their shares in the corporation that was
spun off. Were this to occur, there is a strong similarity between the
transactions’ forms and the payment of dividend stock that enables
shareholders to bail out earnings and profits with a pro rated reduction for
recovery of basis at capital gain rates. Cf. Helvering v. Gregory, supra.
Helvering v. Elkhorn Coal Co., supra.
2. The split of an existing corporation in which existing shareholders exchange
some or all their shares for shares of the corporation that the existing corporation
controls. This is a “split-off.”
•Existing shareholders surrender stock in exchange for other stock. They
might sell that “other stock.” In effect, shareholders have again bailed out
earnings and profits at capital gain rates, but they had to surrender shares
of their original stock that other shareholders might not have surrendered.
When the dust settles, this transaction strongly resembles a redemption.
3. The split of an existing corporation into two (or more) corporations. The
existing corporation distributes its assets to one or more corporations. Existing
shareholders exchange their stock for the stock of one (or more) of the corporations
into which it has split. This is a “split-up.”
•This can resemble in effect a liquidation followed by a reincorporation.
A spin-off, split-off, or split-up may be accomplished in a tax-deferred manner. In such
cases, “the corporation to which the assets are transferred” does not acquire “substantially
all of the assets of the transferor of such assets” and so § 354 will not apply. § 354(b)(1).
Therefore, a divisive D reorganization is subject to the strictures of § 355. We summarize
here the requirements of § 355. Notice the conditions of § 355 that are obviously intended
to prevent disguising what should be a taxable distribution to or exchange with
shareholders as a tax-deferred reorganization. More specifically –
•§ 355: Gain/Loss Recognition: No gain or loss is recognized by a shareholder or
security holder when a corporation distributes to a shareholder with respect to its
stock OR distributes to a security holder in exchange for its securities solely stock
or securities in a corporation that it controls (i.e., 80%-stock ownership by vote
and value, § 368(c)) immediately before the distribution, (§ 355(a)(1)(A)) if –
•Distribution of Stock/Securities: the corporation’s distribution is of all the
stock or securities that it held prior to the distribution (§ 355(a)(1)(D)(i)),
or alternatively of stock constituting control if it establishes that retention
of stock or of stock and securities in the controlled corporation was not part
of a plan having as “one of its principal purposes” avoidance of federal
income tax (§ 355(a)(1)(D)(ii));
•the tax-deferred treatment may apply irrespective of whether the
distribution is pro rata with respect to the shareholders of the
484

distributing corporation, whether shareholders of the distributing
corporation surrender stock in the distributing corporation, and
whether the distribution is in pursuance of a plan of a D-type
reorganization. § 355(a)(2). While shareholders of the transferor
must be in control of the corporation after the transfer, they do not
have to own shares in the transferee corporation in the same
proportion that they owned shares of the transferor corporation.
•Device: the distributing corporation does not use the distribution
principally “as a device” to distribute its or the controlled corporation’s or
both the distributing and controlled corporations’ earnings and profits (§
355(a)(1)(B));
•Business purpose: the transaction must be carried out for “one or
more corporate business purposes.” Reg. § 1.355-2(b)(1). Such a
purpose is evidence that the transaction was not used principally as
a “device” to distribute a corporation’s earnings and profits. Reg. §
1.355-2(b)(4). Reg. § 1.355-2(b) provides that § 355 only applies if
there is an independent business purpose for the transaction. The
transaction must be “motivated, in whole or substantial part, by one
or more corporate business purposes.” Id. The potential for
avoiding federal taxes is relevant in making this determination. Id.
“The principal reason for this business purpose requirement is to
provide nonrecognition treatment only to readjustments of
corporate structures required by business exigencies and that effect
only readjustments of continuing interests in property under
modified corporate forms.” Id. A shareholder purpose is not a
corporate business purpose, although it may not always be possible
to distinguish between a shareholder purpose and a corporate
purpose. Reg. § 1.355-2(b)(2). Moreover: “If a corporate business
purpose can be achieved through a nontaxable transaction that does
not involve the distribution of stock of a controlled corporation and
which is neither impractical nor unduly expensive, then, ... the
separation is not carried out for that corporate business purpose.”
Reg. § 1.355-2(b)(3).
•whether a distribution of stock is a “device” to distribute earnings
and profits turns upon facts and circumstances. Reg. § 1.355-2(d)
(examples of evidence tending to show “device,” tending to show
absence of “device,” and presumptively not a “device”
(“ordinarily”)).
•Continuity of Proprietary Interest: one or more of the shareholders who
owned the original enterprise “own, in the aggregate, an amount of stock
establishing a continuity of interest in each of the modified corporate forms

485

in which the enterprise is conducted after the separation.” Reg. § 1.3552(c)(1).
•Principal Amount of Securities Received, Surrendered: the principal
amount of securities in the controlled corporation received does not exceed
the principal amount of securities surrendered in connection with the
distribution, § 355(a)(3)(A)(i), and distributees do not receive securities in
the controlled corporation without a surrender of securities in connection
with the distribution, § 355(a)(3)(A)(ii);
•Active Conduct of Trade or Business: the distributing corporation and the
controlled corporation(s) are engaged immediately after the distribution in
the active conduct of a trade or business, OR immediately before the
distribution(s), the distributing corporation had no assets other than stock
or securities of the controlled corporations, all of which engage in the active
conduct of a trade or business immediately after the distribution (§
355(a)(1)(C) (referencing § 355(b));
•both the distributing corporation and the controlled corporation
must be engaged in the active conduct or a trade or business
immediately after the distribution (§ 355(b)(1)(A));195
•the trade or business must be one that has been carried on for the
five years ending on the date of distribution and one that the
controlling corporation did not acquire during that period in a
taxable transaction (§ 355(b)(2)(B, C));
•control of the corporation conducting the trade or business was not
acquired by the distributing corporation during the same five-year
period through a taxable transaction (§ 355(b)(2)(D));
•stock of the controlled corporation that a corporation acquires
during the five-year period in a recognition transaction is not treated
as stock of the controlled corporation but rather as boot (§
355(a)(3)(B));
•the stock (including non-qualified preferred stock) and securities
may not be attributed to interest that has accrued on the securities
on or after the beginning of the holder’s holding period
(§355(a)(3)(C). However, nonqualified preferred stock is not “stock
or securities” unless distributed with respect to non-qualified stock
(§ 355(a)(3)(D)); and
•for purposes of determining whether a corporation is engaged in
the active conduct of a trade or business, all members of a “separate
affiliated group” are treated as one corporation. A “separate
affiliated group” as to a corporation is an affiliated group as
determined under § 1504(a) (chain of corporations with common

195 Sections 355(g and h) limit treating investing or real estate investment trusts as a separate trade or business.

486

parent linked by stock ownership of at least 80% by vote and value)
with the corporation as the common parent. § 355(b)(3)(B). Hence,
the active trade or business requirement is met if the corporation or
any lower tier corporation carries on an active trade or business.
The active trade or business requirement is § 355’s main filter to prevent bailouts of
earnings and profits. So long as both the distributor and distributee corporations are
actively engaged in the conduct of a trade or business and no one received stock or
securities with a fair market value greater than what she surrendered, no bailout of earnings
and profits should occur. Indeed, the stock received by a distributee is “section 306 stock”
“if the effect of the transaction was substantially the same as the receipt of a stock
dividend, or the stock was received in exchange for section 306 stock.” § 306(c)(1)(B).
Moreover, § 355’s 5-year active trade or business requirement should prevent
accumulation of relatively liquid assets that might be siphoned off into a separate
corporation and then bailed out through distribution of that corporation’s stock followed
by shareholders’ sale of it. Section 355(d and e), infra, further limit earnings and profits
bailout opportunities.
Tax Consequences to Distributees: In the event a corporation does not transfer
“substantially all” its assets to another corporation in a D reorganization, the
reorganization must be qualified under § 355 if at all. A corporation that does not transfer
substantially all its assets continues in existence. Hence such a reorganization would be
divisive in effect. Section 355(a) establishes that distributees of stock or securities do not
recognize gain or loss if the requirements of § 355(a) are met. Distributees allocate the
basis in what they exchanged proportionately to the fair market value of what they
received, Reg. § 1.358-2(a)(2)(i), and what they retained. § 358(a). They tack the holding
period that they had to the holding period of what they received, § 1223(a).
•Boot: When there is boot, § 356(a) prescribes the tax consequences of its receipt
in an exchange, i.e., the recipient of boot must recognize boot or gain, whichever
is less. § 356(a)(1). See Reg. § 1.356-1(d) Example 1. The distributee may not
recognize loss. See Reg. § 1.356-1(d) Example 2.
•When Distributee Surrenders Stock: The distributee’s basis in stock is the
distributee’s basis in the stock exchanged, minus boot received, plus gain
recognized. § 358(a). The parties themselves may allocate exchanges of stock,
securities, and boot as they wish, “provided that such terms are economically
reasonable.” Reg. § 1.356-1(b). If they do not so specify, the allocation of bases
will be made proportionate to the fair market values of what is received. Reg. §
1.356-2.
•When Distributee Does Not Surrender Stock: Section 356(b) prescribes the tax
consequences of the receipt of boot in a distribution. In such cases, the money plus
the fair market value of other property distributed is treated as a distribution to
which § 301 applies.

487

Tax Consequences to Distributing Corporation: Section 361(a) provides that a corporation
that is a “party to a reorganization” that exchanges property “in pursuance of the plan of
reorganization” solely for stock or securities of another corporation that is a party to the
reorganization recognizes no gain or loss. This occurs in a divisive D reorganization when
a parent exchanges property with a newly-formed subsidiary corporation solely in
exchange for the subsidiary’s stock. No gain/loss is recognized on the subsequent
distribution of stock by the parent to its shareholders in pursuance of the plan of
reorganization. § 355(c)(1). However, the distributing corporation recognizes gain (but not
loss) on the distribution of property other than stock that is not in pursuance of a plan of
reorganization. § 361(c). The distributing corporation also must recognize gain to the
extent that liabilities assumed by the distributee exceed the distributing corporation’s
adjusted basis in the property transferred. § 357(c)(1).
•Section 355(c) prescribes the rules for distributions not made “in pursuance of a
plan of reorganization,” i.e., distribution not made pursuant to a divisive D
reorganization. A corporation that distributes property other than “qualified
property,” i.e., stock or securities in the controlled corporation (§ 355(c)(2)(B)),
must recognize gain as if it had sold the property for its fair market value. §
355(c)(2)(A). The fair market value is not treated as less than the amount of the
liability to which the property is subject. § 355(c)(2)(C). Some stock is not treated
as “stock or securities in the controlled corporation,” § 355(c)(2)(B), and so is
treated as boot, i.e., “excess principal” securities, stock acquired in a taxable
transaction within five years prior to distribution, stock attributable to accrued
interest, and non-qualified preferred stock. § 355(a)(3).
•Before §§ 355(d, e, f), imagine that: Corporation X owns assets and that Corporation Y
wishes to acquire much less than “substantially all” of them. Corporation X agrees to
unload enough assets to leave it holding only assets that Corporation Y wants. If
Corporation X were to sell its remaining assets, it would have to recognize gain/loss on
their disposition. If Corporation X stuffed a newly-formed drop-down subsidiary with its
remaining assets (and perhaps threw in some borrowed cash) and distributed stock of the
subsidiary to its shareholders, § 355 might shield Corporation X from income tax on the
built-in gain on the assets distributed to the subsidiary. An A or a C acquisitive
reorganization would complete the execution of the integrated plan.
The key to making this work was a distribution of stock as a means of divestment rather
than an outright sale of assets. In substance, these transactions add up to an acquisition of
assets to which neither § 368(a)(1)(A) nor § 368(a)(1)(C) would apply followed by a
liquidation to which §§ 331/336 should apply. In form, this is a § 355 distribution followed
by an A or C reorganization.
Such split-offs do not have to be crafted so crassly for tax avoidance purposes. In
Commissioner v. Morris Trust, 367 F.2d 794 (CA4 1966), a corporation that owned a state
bank and an insurance business agreed to be acquired by a national bank. National banking
488

laws prohibited the acquiring bank from operating an insurance business, so it was
necessary for the corporation to divest itself of the insurance business. It accomplished
this through a spin-off. The corporation distributed the stock of its subsidiary to its
shareholders. The court held that taxpayer had successfully executed the tax-deferred spinoff and merger.
There was a strong business purpose for both the spin-off and the merger, and tax
avoidance by American’s stockholders was neither a predominant nor a
subordinate purpose. In short, though both of the transactions be viewed together,
there were none of the evils or misuses which the limiting principles and the
statutory limitations were designed to exclude.
Id. at 799. The court found that there were sufficient protections against abuse in the
requirements of § 355 itself.
There followed a period in which corporations engaged in transactions that Congress
believed to be abusive. Furthermore, corporations could avoid the consequences of the
repeal of the General Utilities doctrine, i.e., they could distribute appreciated property to
shareholders without paying income tax on built-in gains. Sections 355(d, e, f) now
address such transactions.
•Sections 355(d and e) address situations where spin-offs should more appropriately be
treated as sales of a controlled corporation. Their application does not turn on whether
there is a reorganization. These provisions effectively deny distributing corporations the
benefit of the General Utilities doctrine. Shareholders, on the other hand, are not taxed on
receipt of distributions.
•Section 355(d)(1) treats as property not “qualified” under § 355(c)(2)(B) or §
361(c)(2) so-called “disqualified stock,” i.e., stock purchased within 5 years prior
to the distribution if it is the subject of a “disqualified distribution.” A “disqualified
distribution” is a distribution of “disqualified stock” if immediately after the
distribution, “any person holds disqualified stock in the distributing corporation
which constitutes a 50% or greater interest in such corporation” (by vote or value,
§ 355(d)(4), § 355(d)(2)(A)), OR “any person holds disqualified stock in the
controlled corporation (or, if stock of more than 1 controlled corporation is
distributed, in any controlled corporation) which constitutes a 50% or greater
interest in such corporation,” § 355(d)(2)(B). In such a case, any stock or securities
is not “qualified property.” § 355(d)(1). The end result is that the parent
corporation is taxed on a “disqualified distribution” of “disqualified stock” as if it
had sold the stock it distributed for a taxable gain.
•Section 355(e) treats as property not “qualified” under § 355(c)(2)(B) or §
361(c)(2) stock or securities in a controlled corporation if its distribution would
otherwise fall within § 355 or § 356 but “which is part of a plan (or series of related
transactions) pursuant to which 1 or more persons acquire directly or indirectly
489

stock representing a 50% or greater interest in the distributing corporation or any
controlled corporation.” § 355(e)(2)(A). A presumption arises if one or more
persons acquire such a stock interest during the 4-year period commencing two
years prior to the distribution and ending two years after the distribution, §
355(e)(2)(B), unless the distributing corporation and controlled corporations are
all members of a single affiliated group. § 355(e)(2)(C).196 The distributing parent
is subject to tax on the built-in gain in any stock or securities distributed. §
355(e)(1). This provision does not apply to distributions within an affiliated group.
§ 355(f).
Sections 355(d)(9) and 355(e)(5) authorize the Secretary to “prescribe such regulations as
may be necessary to carry out the purposes of this subsection …” Through revenue rulings
and Reg. §1.355-7, the IRS and the Secretary have softened the impact of §§355(d and e).
Now suppose: D Corporation operates two businesses, X and Y. D Corporation’s assets
that it uses in the X business are mostly low-basis relative to their fair market value.
Corporation A is unrelated to D Corporation or any of its shareholders. Corporation A
conducts X business and wishes to acquire D Corporation’s X business. D Corporation is
willing to have Corporation A acquire its X business, but wants to transfer the X business
in such a way that it will not be subjected to immediate income tax. D Corporation will
continue to operate the Y business. Can it accomplish such a transfer in the shadow of §
355(e)?

Rev. Rul. 2003-79, 2003-29 I.R.B. 80
Part I
Section 355. – Distribution of Stock and Securities of a Controlled Corporation
(Also: §§ 368(a)(1)(D), 368(a)(1)(C) and [Reg.] 1.368-2.)
Section 355 reverse Morris trust. The acquisition by an unrelated corporation of all the
assets of a newly formed controlled corporation following distribution of the controlled
corporation’s stock under § 355 will satisfy the “substantially all” requirement of §
368(a)(1)(C) even though the acquired assets represent only half of the assets held by the
distributing corporation before it formed the controlled corporation.
ISSUE
Whether the acquisition by an unrelated corporation of all the assets of a newly formed
controlled corporation following the distribution of the stock of the controlled corporation

196 Section 355(e) is not applicable if § 355(d) is applicable.

490

by a distributing corporation will satisfy the requirement of § 368(a)(1)(C) of the Internal
Revenue Code that substantially all of the properties of the acquired corporation be
acquired where the assets of the controlled corporation represent less than substantially all
of the assets that the distributing corporation held before it formed the controlled
corporation.
FACTS
D, a domestic corporation, directly conducts Business X and Business Y. D’s assets are
equally divided between the two businesses. A, a domestic corporation unrelated to D,
conducts Business X and wishes to acquire D’s Business X, but not D’s Business Y.
To accomplish the acquisition, D and A agree to undertake the following steps in the
following order: (i) D will transfer its Business X assets to C, a newly formed domestic
corporation, in exchange for 100% of the stock of C, (ii) D will distribute the C stock to
D’s shareholders, (iii) A will acquire all the assets of C in exchange solely for voting stock
of A, and (iv) C will liquidate. Apart from the question of whether the acquisition of C’s
assets by A will satisfy the requirement of § 368(a)(1)(C) that the acquiring corporation
acquire substantially all of the properties of the acquired corporation, steps (i) and (ii)
together meet all the requirements of § 368(a)(1)(D), step (ii) meets all the requirements
of § 355(a), and steps (iii) and (iv) together meet all the requirements of § 368(a)(1)(C).
LAW
Section 355 provides that if certain requirements are met, a corporation may distribute
stock and securities in a controlled corporation to its shareholders and security holders
without causing the distributees to recognize gain or loss.
Section 368(a)(1)(C) defines a reorganization to include the acquisition by one
corporation, in exchange solely for all or a part of its voting stock, of substantially all of
the properties of another corporation.
Section 368(a)(1)(D) defines a reorganization to include a transfer by a corporation of all
or a part of its assets to another corporation if immediately after the transfer the transferor,
or one or more of its shareholders (including persons who were shareholders immediately
before the transfer), or any combination thereof, is in control of the corporation to which
the assets are transferred; but only if, in pursuance of the plan, stock or securities of the
corporation to which the assets are transferred are distributed in a transaction that qualifies
under §§ 354, 355, or 356.
In Helvering v. Elkhorn Coal Co., 95 F.2d 732 (4th Cir. 1937), cert. denied, 305 U.S. 605,
reh’g denied, 305 U.S. 670 (1938), Elkhorn Coal, in anticipation of being acquired by Mill
Creek, transferred part of its operating assets to a newly formed subsidiary and distributed
the subsidiary’s stock to Elkhorn Coal’s shareholders. The court concluded that the
distribution of subsidiary stock prevented the subsequent acquisition from qualifying
491

under a predecessor of § 368(a)(1)(C) because, as a result of the distribution, Mill Creek
did not acquire substantially all of Elkhorn Coal’s historical assets.
In Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966), aff’g 42
T.C. 779 (1964), the taxpayer, in anticipation of a merger with a national bank, contributed
its insurance business to a new subsidiary and distributed the subsidiary’s stock to its
shareholders. The divestiture was necessary to comply with national banking laws. The
court held that the distribution satisfied the requirements for nonrecognition under § 355(a)
and, therefore, that the contribution qualified as a reorganization under § 368(a)(1)(D).
In Rev. Rul. 68-603, 1968-2 C.B. 148, the Internal Revenue Service announced that it
would follow the decision in Mary Archer W. Morris Trust to the extent it held that (1) the
active business requirements of § 355(b)(1)(A) were satisfied even though the distributing
corporation, immediately after the spin-off, merged into the unrelated acquiring
corporation, (2) the control immediately after requirement of § 368(a)(1)(D) implies no
limitation upon a reorganization of the transferor corporation (the distributing corporation)
after the distribution of the stock of the controlled corporation, and (3) there was a business
purpose for the spin-off and the merger.
Rev. Rul. 98-27, 1998-1 C.B. 1159, states that the Service will not apply any formulation
of the step transaction doctrine to determine whether the distributed corporation was a
controlled corporation immediately before a distribution under § 355(a) solely because of
any postdistribution acquisition or restructuring of the distributed corporation, whether
prearranged or not. The holding of Rev. Rul. 98-27 is based on § 1012(a) and § 1012(c) of
the Taxpayer Relief Act of 1997 (the “1997 Act”), Pub. L. No. 105-34, 111 Stat. 788, 91617. Section 1012(c) amended the control requirements of §§ 368(a)(1)(D) and 351 to
provide that, generally for transactions seeking qualification after August 5, 1997, under
either provision and § 355, the shareholders of the distributing corporation must own stock
possessing more than 50% of the voting power and more than 50% of the total value of
the controlled corporation’s stock immediately after the distribution. See §§ 368(a)(2)(H)
and 351(c). Section 1012(a) amended § 355 by adding subsection (e), which provides rules
for the recognition of gain on certain distributions of stock or securities of a controlled
corporation in connection with acquisitions of stock representing a 50% or greater interest
in the distributing corporation or any controlled corporation.
The Conference Report accompanying the 1997 Act states, in part, that:
The ... bill does not change the present-law requirement under § 355 that the
distributing corporation must distribute 80% of the voting power and 80% of each
other class of stock of the controlled corporation. It is expected that this
requirement will be applied by the Internal Revenue Service taking account of the
provisions of the proposal regarding plans that permit certain types of planned
restructuring of the distributing corporation following the distribution, and to treat
492

similar restructurings of the controlled corporation in a similar manner. Thus, the
80% control requirement is expected to be administered in a manner that would
prevent the tax-free spin-off of a less-than-80% controlled subsidiary, but would
not generally impose additional restrictions on post-distribution restructurings of
the controlled corporation if such restrictions would not apply to the distributing
corporation.
H.R. REP. NO. 105-220, at 529-30 (1997); 1997-4 C.B. 1457, at 1999-2000.
Section 6010(c)(2) of the Internal Revenue Service Restructuring and Reform Act of 1998
(the 1998 Act), P.L. 105-206, 1998-3 C.B. 145, amended § 1012(c) of the 1997 Act to
provide that, in the case of a § 368(a)(1)(D) or § 351 transaction that is followed by a §
355 transaction, solely for purposes of determining the tax treatment of any transfer of
property by the distributing corporation to the controlled corporation, the fact that the
shareholders of the distributing corporation dispose of part or all of the controlled
corporation’s stock after the § 355 distribution shall not be taken into account in
determining whether the control requirement of either § 368(a)(1)(D) or § 351 has been
satisfied.
The Senate Report accompanying the 1998 Act contains three examples in which
distributing corporation D transfers appreciated business X to newly created subsidiary C
in exchange for at least 85% of the C stock and then distributes its C stock to the D
shareholders. As part of the same plan, C then merges into unrelated acquiring corporation
A. Each example concludes that if the distribution satisfies the requirements of § 355, the
control immediately after requirement will be satisfied solely for purposes of determining
the tax treatment of the transfer of business X by D to C. See S. REP. NO. 105-174, at
173176 (1998); 1998-3 C.B. 537, at 709-712.
ANALYSIS
Section 1012 of the 1997 Act, as amended by § 6010(c) of the 1998 Act, evidences the
intention of Congress that a corporation formed in connection with a distribution that
qualifies for nonrecognition under § 355 will be respected as a separate corporation for
purposes of determining (i) whether the corporation was a controlled corporation
immediately before the distribution and (ii) whether a pre-distribution transfer of property
to the controlled corporation satisfies the requirements of § 368(a)(1)(D) or § 351, even if
a post-distribution restructuring causes the controlled corporation to cease to exist. See
Rev. Rul. 98-44, 1998-2 C.B. 315; Rev. Rul. 98-27, supra; S. REP. NO. 105-174, supra.
Therefore, the controlled corporation should also be considered independently from the
distributing corporation in determining whether an acquisition of the controlled
corporation will qualify as a reorganization under § 368. Accordingly, in determining
under § 368(a)(1)(C) whether an acquiring corporation has acquired substantially all of
the properties of a newly formed controlled corporation, reference should be made solely
to the properties held by the controlled corporation immediately following the distributing
493

corporation’s transfer of properties to the controlled corporation, rather than to the
properties held by the distributing corporation immediately before its formation of the
controlled corporation.
Hence, the acquisition by A of all the properties held by C immediately after the
distribution will satisfy the requirement of § 368(a)(1)(C) that A acquire substantially all
the properties of C. This result obtains even though an acquisition by A of the same
properties from D would have failed this requirement if D had retained Business X,
contributed Business Y to C, and distributed the stock of C. See Helvering v. Elkhorn Coal
Co., supra.
HOLDING
The acquisition by an unrelated corporation of all the assets of a newly formed controlled
corporation following the distribution of the stock of the controlled corporation by a
distributing corporation will satisfy the requirement of § 368(a)(1)(C) that substantially all
of the properties of the acquired corporation be acquired where the assets of the controlled
corporation represent less than substantially all of the assets that the distributing
corporation held before it formed the controlled corporation.

Questions and comments:
1. In what significant way(s) are the facts of Rev. Rul. 2003-79 different from the facts of
Helvering v. Elkhorn Coal Co., 95 F.2d 732 (4th Cir. 1937), cert. denied, 305 U.S. 605
(1938)? Why were the facts of this revenue ruling described as a “reverse” Morris Trust?

Tax Attributes of Distributee Corporation: Unlike the case of other reorganizations,
ownership of tax attributes in the case of a divisive D reorganization does not change,
except for earnings and profits. § 381(a) (carryout ¶; rule of succession to tax attributes
not applicable to D reorganization in which transferee corporation does not acquire
substantially all of the assets of the transferor, cross reference to § 354(b)(1)). In the case
of a newly created controlled corporation, earnings and profits are allocated in proportion
to the fair market value (or alternatively, the net basis of assets assumed) of the business
or businesses retained and transferred. Reg. § 1.312-10(a).

Do the CALI exercise:
Corporate Taxation: Reorganizations: D Reorganizations: Definition.

Do the CALI exercise:
494

Corporate Taxation: Reorganizations: Tax Consequences of Divisive D Reorganizations.

V. The Tax Rules for Reorganizations: §§ 354, 355, 356, Boot, and 381
A. Section 354
Read § 354.
Sections 354(a) and 355 provide that no gain or loss is recognized to the distributee in a
reorganization. Rather, recognition of gain or loss is deferred. Deferral occurs through
transfers of bases.197 When something in addition to stock or securities is exchanged, we
can say that it occurs outside the reorganization – and expect the deferral provisions not to
be applicable. In many, if not most, reorganizations, there cannot as a practical matter be
a perfect exchange of stock (or other indicia of proprietary interests). There will be boot
as well. Section 356 names the tax consequences of receiving boot 198 – and they should
not be surprising. Taxpayer must recognize the boot or gain, whichever is less. §356(a)(1).
Read §§ 354, 355, and 356.
Section 356(a)(1, 2) implicitly characterizes boot as either “capital gain boot” or “dividend
boot.” If the boot is dividend boot, its amount is limited both to taxpayer’s gain on the
exchange and to taxpayer’s ratable share of accumulated e&p. §356(a)(2). There is no basis
offset in measuring dividend boot. A boot dividend in excess of the lesser of these amounts
is treated as gain from the exchange of property. §356(a)(2). How do we determine whether
boot is capital gain boot or dividend boot?

Commissioner v. Clark, 489 U.S. 726 (1989)
Justice STEVENS delivered the opinion of the Court.
... In the case we decide today, ... the taxpayer [footnote omitted] in an arm’s-length
transaction exchanged his interest in the acquired corporation for less than 1% of the stock
of the acquiring corporation and a substantial cash payment. The taxpayer held no interest
in the acquiring corporation prior to the reorganization. Viewing the exchange as a whole,
we conclude that the cash payment is not appropriately characterized as a dividend. We
accordingly agree with the Tax Court and with the Court of Appeals that the taxpayer is
entitled to capital gains treatment of the cash payment.

197 Review the applicable statutory provisions at Chapter 9-I.

Non-qualified preferred stock is not “stock or securities,” § 354(a)(2)(C)(i), except for the recapitalization of
a family-owned corporation, § 354(a)(C)(ii).

198

495

I
In determining tax liability under the Internal Revenue Code of 1954, gain resulting from
the sale or exchange of property is generally treated as capital gain, whereas the receipt of
cash dividends is treated as ordinary income. [footnote omitted]. The Code, however,
imposes no current tax on certain stock-for-stock exchanges. In particular, § 354(a)(1)
provides, subject to various limitations, for nonrecognition of gain resulting from the
exchange of stock or securities solely for other stock or securities, provided that the
exchange is pursuant to a plan of corporate reorganization and that the stock or securities
are those of a party to the reorganization. [footnote omitted]. 26 U.S.C. § 354(a)(1).
Under § 356(a)(1) of the Code, if such a stock-for-stock exchange is accompanied by
additional consideration in the form of a cash payment or other property – something that
tax practitioners refer to as “boot” – “then the gain, if any, to the recipient shall be
recognized, but in an amount not in excess of the sum of such money and the fair market
value of such other property.” 26 U.S.C. § 356(a)(1). That is, if the shareholder receives
boot, he or she must recognize the gain on the exchange up to the value of the boot. Boot
is accordingly generally treated as a gain from the sale or exchange of property and is
recognized in the current tax year.
Section 356(a)(2), which controls the decision in this case, creates an exception to that
general rule. It provided in 1979:
“If an exchange is described in paragraph (1) but has the effect of the distribution
of a dividend, then there shall be treated as a dividend to each distributee such an
amount of the gain recognized under paragraph (1) as is not in excess of his ratable
share of the undistributed earnings and profits of the corporation ... The remainder,
if any, of the gain recognized under paragraph (1) shall be treated as gain from the
exchange of property.” 26 U.S.C. § 356(a)(2) (1976 ed.).
Thus, if the “exchange ... has the effect of the distribution of a dividend,” the boot must be
treated as a dividend and is therefore appropriately taxed as ordinary income to the extent
that gain is realized. In contrast, if the exchange does not have “the effect of the distribution
of a dividend,” the boot must be treated as a payment in exchange for property and, insofar
as gain is realized, accorded capital gains treatment. The question in this case is thus
whether the exchange between the taxpayer and the acquiring corporation had “the effect
of the distribution of a dividend” within the meaning of § 356(a)(2).
The relevant facts are easily summarized. For approximately 15 years prior to April 1979,
the taxpayer was the president of Basin Surveys, Inc. (Basin). In January 1978, he became
sole shareholder in Basin, a company in which he had invested approximately $85,000.
The corporation operated a successful business providing various technical services to the
petroleum industry. In 1978, N.L. Industries, Inc. (NL), a publicly owned corporation
496

engaged in the manufacture and supply of petroleum equipment and services, initiated
negotiations with the taxpayer regarding the possible acquisition of Basin. On April 3,
1979, after months of negotiations, the taxpayer and NL entered into a contract.
The agreement provided for a “triangular merger,” whereby Basin was merged into a
wholly owned subsidiary of NL. In exchange for transferring all of the outstanding shares
in Basin to NL’s subsidiary, the taxpayer elected to receive 300,000 shares of NL common
stock and cash boot of $3,250,000, passing up an alternative offer of 425,000 shares of NL
common stock. The 300,000 shares of NL issued to the taxpayer amounted to
approximately 0.92% of the outstanding common shares of NL. If the taxpayer had instead
accepted the pure stock-for-stock offer, he would have held approximately 1.3% of the
outstanding common shares. The Commissioner and the taxpayer agree that the merger at
issue qualifies as a reorganization under §§ 368(a)(1)(A) and (a)(2)(D). [footnote omitted].
Respondents filed a joint federal income tax return for 1979. As required by § 356(a)(1),
they reported the cash boot as taxable gain. In calculating the tax owed, respondents
characterized the payment as long-term capital gain. The Commissioner on audit disagreed
with this characterization. In his view, the payment had “the effect of the distribution of a
dividend” and was thus taxable as ordinary income up to $2,319,611, the amount of Basin's
accumulated earnings and profits at the time of the merger. The Commissioner assessed a
deficiency of $972,504.74.
Respondents petitioned for review in the Tax Court, which, in a reviewed decision, held
in their favor. 86 T.C. 138 (1986). The court started from the premise that the question
whether the boot payment had “the effect of the distribution of a dividend” turns on the
choice between “two judicially articulated tests.” Id., at 140. Under the test advocated by
the Commissioner and given voice in Shimberg v. United States, 577 F.2d 283 (CA5
1978), cert. denied, 439 U.S. 1115 (1979), the boot payment is treated as though it were
made in a hypothetical redemption by the acquired corporation (Basin) immediately prior
to the reorganization. Under this test, the cash payment received by the taxpayer
indisputably would have been treated as a dividend. [footnote omitted]. The second test,
urged by the taxpayer and finding support in Wright v. United States, 482 F.2d 600 (CA8
1973), proposes an alternative hypothetical redemption. Rather than concentrating on the
taxpayer’s prereorganization interest in the acquired corporation, this test requires that one
imagine a pure stock-for-stock exchange, followed immediately by a postreorganization
redemption of a portion of the taxpayer's shares in the acquiring corporation (NL) in return
for a payment in an amount equal to the boot. Under § 302 of the Code, which defines
when a redemption of stock should be treated as a distribution of dividend, NL’s
redemption of 125,000 shares of its stock from the taxpayer in exchange for the $3,250,000
boot payment would have been treated as capital gain.199

199 [The Tax Court applied § 302(b)(2).]

As the Tax Court explained, receipt of the cash boot reduced the
taxpayer’s potential holdings in NL from 1.3% to 0.92%. 86 T.C. 138, 153 (1986). The taxpayer's holdings were

497

The Tax Court rejected the prereorganization test favored by the Commissioner because it
considered it improper “to view the cash payment as an isolated event totally separate from
the reorganization.” Indeed, it suggested that this test requires that courts make the
“determination of dividend equivalency fantasizing that the reorganization does not exist.”
... The court then acknowledged that a similar criticism could be made of the taxpayer’s
contention that the cash payment should be viewed as a postreorganization redemption. It
concluded, however, that since it was perfectly clear that the cash payment would not have
taken place without the reorganization, it was better to treat the boot “as the equivalent of
a redemption in the course of implementing the reorganization,” than “as having occurred
prior to and separate from the reorganization.” 86 T.C. at 152 (emphasis in original).200
The Court of Appeals for the Fourth Circuit affirmed. 828 F.2d 221 (1987). Like the Tax
Court, it concluded that although “[s]ection 302 does not explicitly apply in the
reorganization context,” and although § 302 differs from § 356 in important respects, it
nonetheless provides “the appropriate test for determining whether boot is ordinary income
or a capital gain.” Thus, as explicated in § 302(b)(2), if the taxpayer relinquished more
than 20% of his corporate control and retained less than 50% of the voting shares after the
distribution, the boot would be treated as capital gain. However, as the Court of Appeals
recognized, “[b]ecause § 302 was designed to deal with a stock redemption by a single
corporation, rather than a reorganization involving two companies, the section does not
indicate which corporation [the taxpayer] lost interest in.” Thus, like the Tax Court, the
Court of Appeals was left to consider whether the hypothetical redemption should be
treated as a prereorganization distribution coming from the acquired corporation or as a
postreorganization distribution coming from the acquiring corporation. It concluded:
“Based on the language and legislative history of § 356, the change-in-ownership
principle of § 302, and the need to review the reorganization as an integrated
thus approximately 71% of what they would have been absent the payment. Ibid. This fact, combined with the
fact that the taxpayer held less than 50% of the voting stock of NL after the hypothetical redemption, would
have qualified the “distribution” as “substantially disproportionate” under § 302(b)(2).
200 The Tax Court stressed that to adopt the pre-reorganization view “would in effect resurrect the now

discredited ‘automatic dividend rule’ ..., at least with respect to pro rata distributions made to an acquired
corporation’s shareholders pursuant to a plan of reorganization.” On appeal, the Court of Appeals agreed. 828
F.2d 221, 226-227 (4th Cir. 1987).
The “automatic dividend rule” developed as a result of some imprecise language in our decision in Commissioner
v. Estate of Bedford, 325 U.S. 283 (1945). Although Estate of Bedford involved the recapitalization of a single
corporation, the opinion employed broad language, asserting that “a distribution, pursuant to a reorganization,
of earnings and profits ‘has the effect of a distribution of a taxable dividend’ within [§ 356(a)(2)].” Id., at 292.
The Commissioner read this language as establishing as a matter of law that all payments of boot are to be
treated as dividends to the extent of undistributed earnings and profits. See Rev. Rul. 56-220, 1956-1 Cum. Bull.
191. Commentators [citations omitted] and courts [citation omitted] however, soon came to criticize this rule.
The courts have long since retreated from the “automatic dividend rule,” [citation omitted], and the
Commissioner has followed suit, see Rev. Rul. 74-515, 1974-2 Cum. Bull. 118. As our decision in this case makes
plain, we agree that Estate of Bedford should not be read to require that all payments of boot be treated as
dividends.

498

transaction, we conclude that the boot should be characterized as a
postreorganization stock redemption by N.L. that affected [the taxpayer’s] interest
in the new corporation. Because this redemption reduced [the taxpayer’s] N.L.
holdings by more than 20%, the boot should be taxed as a capital gain.” Id., at
224225.
This decision by the Court of Appeals for the Fourth Circuit is in conflict with the decision
of the Fifth Circuit in Shimberg v. United States, 577 F.2d 283 (1978), in two important
respects. In Shimberg, the court concluded that it was inappropriate to apply stock
redemption principles in reorganization cases “on a wholesale basis.” Id., at 287; see also
ibid., n. 13. In addition, the court adopted the prereorganization test, holding that “§
356(a)(2) requires a determination of whether the distribution would have been taxed as a
dividend if made prior to the reorganization or if no reorganization had occurred.” Id., at
288.
To resolve this conflict on a question of importance to the administration of the federal tax
laws, we granted certiorari. 485 U.S. 933 (1988).
II
We agree with the Tax Court and the Court of Appeals for the Fourth Circuit that the
question under § 356(a)(2) whether an “exchange ... has the effect of the distribution of a
dividend” should be answered by examining the effect of the exchange as a whole. We
think the language and history of the statute, as well as a commonsense understanding of
the economic substance of the transaction at issue, support this approach.
The language of § 356(a) strongly supports our understanding that the transaction should
be treated as an integrated whole. Section 356(a)(2) asks whether “an exchange is
described in paragraph (1)” that “has the effect of the distribution of a dividend.”
(Emphasis supplied.) The statute does not provide that boot shall be treated as a dividend
if its payment has the effect of the distribution of a dividend. Rather, the inquiry turns on
whether the “exchange” has that effect. Moreover, paragraph (1), in turn, looks to whether
“the property received in the exchange consists not only of property permitted by section
354 or 355 to be received without the recognition of gain but also of other property or
money.” (Emphasis supplied.) Again, the statute plainly refers to one integrated
transaction and, again, makes clear that we are to look to the character of the exchange as
a whole and not simply its component parts. Finally, it is significant that § 356 expressly
limits the extent to which boot may be taxed to the amount of gain realized in the
reorganization. This limitation suggests that Congress intended that boot not be treated in
isolation from the overall reorganization. See Levin, Adess, & McGaffey, Boot
Distributions in Corporate Reorganizations-Determination of Dividend Equivalency, 30
TAX LAWYER 287, 303 (1977).

499

Our reading of the statute as requiring that the transaction be treated as a unified whole is
reinforced by the well-established “step-transaction” doctrine, a doctrine that the
Government has applied in related contexts, see, e.g., Rev. Rul. 75-447, 1975-2 Cum. Bull.
113, and that we have expressly sanctioned, see Minnesota Tea Co. v. Helvering, 302 U.S.
609, 613 (1938); Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945). Under
this doctrine, interrelated yet formally distinct steps in an integrated transaction may not
be considered independently of the overall transaction. By thus “linking together all
interdependent steps with legal or business significance, rather than taking them in
isolation,” federal tax liability may be based “on a realistic view of the entire transaction.”
1 B. BITTKER, FEDERAL TAXATION OF INCOME, ESTATES AND GIFTS ¶ 4.3.5, p. 4-52 (1981).
Viewing the exchange in this case as an integrated whole, we are unable to accept the
Commissioner’s prereorganization analogy. The analogy severs the payment of boot from
the context of the reorganization. Indeed, only by straining to abstract the payment of boot
from the context of the overall exchange, and thus imagining that Basin made a distribution
to the taxpayer independently of NL’s planned acquisition, can we reach the rather
counterintuitive conclusion urged by the Commissioner – that the taxpayer suffered no
meaningful reduction in his ownership interest as a result of the cash payment. We
conclude that such a limited view of the transaction is plainly inconsistent with the statute’s
direction that we look to the effect of the entire exchange.
The prereorganization analogy is further flawed in that it adopts an overly expansive
reading of § 356(a)(2). As the Court of Appeals recognized, adoption of the
prereorganization approach would “result in ordinary income treatment in most
reorganizations because corporate boot is usually distributed pro rata to the shareholders
of the target corporation.” [S]ee also Golub, “Boot” in Reorganizations – The Dividend
Equivalency Test of Section 356(a)(2), 58 TAXES 904, 911 (1980); Note, 20 BOSTON
COLLEGE L. REV. 601, 612 (1979). Such a reading of the statute would not simply
constitute a return to the widely criticized “automatic dividend rule” (at least as to cases
involving a pro rata payment to the shareholders of the acquired corporation), but also
would be contrary to our standard approach to construing such provisions. The
requirement of § 356(a)(2) that boot be treated as dividend in some circumstances is an
exception from the general rule authorizing capital gains treatment for boot. In construing
provisions such as § 356, in which a general statement of policy is qualified by an
exception, we usually read the exception narrowly in order to preserve the primary
operation of the provision. [citation omitted]. See Phillips, Inc. v. Walling, 324 U.S. 490,
493 (1945) (“To extend an exemption to other than those plainly and unmistakably within
its terms and spirit is to abuse the interpretative process and to frustrate the announced will
of the people”). Given that Congress has enacted a general rule that treats boot as capital
gain, we should not eviscerate that legislative judgment through an expansive reading of
a somewhat ambiguous exception.

500

The postreorganization approach adopted by the Tax Court and the Court of Appeals is, in
our view, preferable to the Commissioner’s approach. Most significantly, this approach
does a far better job of treating the payment of boot as a component of the overall
exchange. Unlike the pre-reorganization view, this approach acknowledges that there
would have been no cash payment absent the exchange and also that, by accepting the cash
payment, the taxpayer experienced a meaningful reduction in his potential ownership
interest.
Once the postreorganization approach is adopted, the result in this case is pellucidly clear.
Section 302(a) of the Code provides that if a redemption fits within any one of the four
categories set out in § 302(b), the redemption “shall be treated as a distribution in part or
full payment in exchange for the stock,” and thus not regarded as a dividend. As the Tax
Court and the Court of Appeals correctly determined, the hypothetical postreorganization
redemption by NL of a portion of the taxpayer’s shares satisfies at least one of the
subsections of § 302(b).201 In particular, the safe harbor provisions of subsection (b)(2)
provide that redemptions in which the taxpayer relinquishes more than 20% of his or her
share of the corporation's voting stock and retains less than 50% of the voting stock after
the redemption shall not be treated as distributions of a dividend. Here, we treat the
transaction as though NL redeemed 125,000 shares of its common stock (i.e., the number
of shares of NL common stock forgone in favor of the boot) in return for a cash payment
to the taxpayer of $3,250,000 (i.e., the amount of the boot). As a result of this redemption,
the taxpayer's interest in NL was reduced from 1.3% of the outstanding common stock to
0.9%. Thus, the taxpayer relinquished approximately 29% of his interest in NL and
retained less than a 1% voting interest in the corporation after the transaction, easily
satisfying the “substantially disproportionate” standards of § 302(b)(2). We accordingly
conclude that the boot payment did not have the effect of a dividend and that the payment
was properly treated as capital gain.
III
The Commissioner objects to this “recasting [of] the merger transaction into a form
different from that entered into by the parties,” and argues that the Court of Appeals’
formal adherence to the principles embodied in § 302 forced the court to stretch to “find a
redemption to which to apply them, since the merger transaction entered into by the parties
did not involve a redemption.” There are a number of sufficient responses to this argument.
We think it first worth emphasizing that the Commissioner overstates the extent to which
the redemption is imagined. As the Court of Appeals for the Fifth Circuit noted in
Shimberg, “[t]he theory behind tax-free corporate reorganizations is that the transaction is

201 Because

the mechanical requirements of subsection (b)(2) are met, we need not decide whether the
hypothetical redemption might also qualify for capital gains treatment under the general “not essentially
equivalent to a dividend” language of subsection (b)(1). Subsections (b)(3) and (b)(4), which deal with
redemptions of all of the shareholder's stock and with partial liquidations, respectively, are not at issue in this
case.

501

merely ‘a continuance of the proprietary interests in the continuing enterprise under
modified corporate form.’ Lewis v. Commissioner of Internal Revenue, 176 F.2d 646, 648
(1ST CIR. 1949); Treas. Reg. § 1.368-1(b). See generally Cohen, Conglomerate Mergers
and Taxation, 55 A.B.A. J. 40 (1969).” As a result, the boot-for-stock transaction can be
viewed as a partial repurchase of stock by the continuing corporate enterprise – i.e., as a
redemption. It is, of course, true that both the prereorganization and postreorganization
analogies are somewhat artificial in that they imagine that the redemption occurred outside
the confines of the actual reorganization. However, if forced to choose between the two
analogies, the postreorganization view is the less artificial. Although both analogies
“recast the merger transaction,” the postreorganization view recognizes that a
reorganization has taken place, while the prereorganization approach recasts the
transaction to the exclusion of the overall exchange.
Moreover, we doubt that abandoning the prereorganization and postreorganization
analogies and the principles of § 302 in favor of a less artificial understanding of the
transaction would lead to a result different from that reached by the Court of Appeals.
Although the statute is admittedly ambiguous and the legislative history sparse, we are
persuaded – even without relying on § 302 – that Congress did not intend to except
reorganizations such as that at issue here from the general rule allowing capital gains
treatment for cash boot. 26 U.S.C. § 356(a)(1). The legislative history of § 356(a)(2),
although perhaps generally “not illuminating,” Estate of Bedford, 325 U.S., at 290,
suggests that Congress was primarily concerned with preventing corporations from
“siphon[ing] off” accumulated earnings and profits at a capital gains rate through the ruse
of a reorganization. See Golub, 58 TAXES, at 905. This purpose is not served by denying
capital gains treatment in a case such as this in which the taxpayer entered into an arm’slength transaction with a corporation in which he had no prior interest, exchanging his
stock in the acquired corporation for less than a 1% interest in the acquiring corporation
and a substantial cash boot.
Section 356(a)(2) finds its genesis in § 203(d)(2) of the Revenue Act of 1924. See 43 Stat.
257. Although modified slightly over the years, the provisions are in relevant substance
identical. The accompanying House Report asserts that § 203(d)(2) was designed to
“preven[t] evasion.” H.R. REP. NO. 179, 68th Cong., 1st Sess., 15 (1924). Without further
explication, both the House and Senate Reports simply rely on an example to explain, in
the words of both Reports, “[t]he necessity for this provision.” Ibid.; S. REP. NO. 398, 68th
Cong., 1st Sess., 16 (1924). Significantly, the example describes a situation in which there
was no change in the stockholders’ relative ownership interests, but merely the creation of
a wholly owned subsidiary as a mechanism for making a cash distribution to the
shareholders:
“Corporation A has capital stock of $100,000, and earnings and profits
accumulated since March 1, 1913, of $50,000. If it distributes the $50,000 as a

502

dividend to its stockholders, the amount distributed will be taxed at the full surtax
rates.
“On the other hand, Corporation A may organize Corporation B, to which it
transfers all its assets, the consideration for the transfer being the issuance by B of
all its stock and $50,000 in cash to the stockholders of Corporation A in exchange
for their stock in Corporation A. Under the existing law, the $50,000 distributed
with the stock of Corporation B would be taxed, not as a dividend, but as a capital
gain ... The effect of such a distribution is obviously the same as if the corporation
had declared out as a dividend its $50,000 earnings and profits. If dividends are to
be subject to the full surtax rates, then such an amount so distributed should also
be subject to the surtax rates and not to the ... rate on capital gain.” Ibid.; H.R. REP.
NO. 179, at 15.
The “effect” of the transaction in this example is to transfer accumulated earnings and
profits to the shareholders without altering their respective ownership interests in the
continuing enterprise.
Of course, this example should not be understood as exhaustive of the proper applications
of § 356(a)(2). It is nonetheless noteworthy that neither the example, nor any other
legislative source, evinces a congressional intent to tax boot accompanying a transaction
that involves a bona fide exchange between unrelated parties in the context of a
reorganization as though the payment was in fact a dividend. To the contrary, the purpose
of avoiding tax evasion suggests that Congress did not intend to impose an ordinary
income tax in such cases. Moreover, the legislative history of § 302 supports this reading
of § 356(a)(2) as well. In explaining the “essentially equivalent to a dividend” language of
§ 302(b)(1) – language that is certainly similar to the “has the effect ... of a dividend”
language of § 356(a)(2) – the Senate Finance Committee made clear that the relevant
inquiry is “whether or not the transaction by its nature may properly be characterized as a
sale of stock....” S. REP. NO. 1622, 83d Cong., 2d Sess., 234 (1954); cf. United States v.
Davis, 397 U.S., at 311.
Examining the instant transaction in light of the purpose of § 356(a)(2), the boot-for-stock
exchange in this case “may properly be characterized as a sale of stock.” Significantly,
unlike traditional single corporation redemptions and unlike reorganizations involving
commonly owned corporations, there is little risk that the reorganization at issue was used
as a ruse to distribute a dividend. Rather, the transaction appears in all respects relevant to
the narrow issue before us to have been comparable to an arm’s-length sale by the taxpayer
to NL. This conclusion, moreover, is supported by the findings of the Tax Court. The court
found that “[t]here is not the slightest evidence that the cash payment was a concealed
distribution from BASIN.” As the Tax Court further noted, Basin lacked the funds to make
such a distribution:

503

“Indeed, it is hard to conceive that such a possibility could even have been
considered, for a distribution of that amount was not only far in excess of the
accumulated earnings and profits ($2,319,611), but also of the total assets of
BASIN ($2,758,069). In fact, only if one takes into account unrealized appreciation
in the value of BASIN's assets, including good will and/or going-concern value,
can one possibly arrive at $3,250,000. Such a distribution could only be considered
as the equivalent of a complete liquidation of BASIN....”
In this context, even without relying on § 302 and the post-reorganization analogy, we
conclude that the boot is better characterized as a part of the proceeds of a sale of stock
than as a proxy for a dividend. As such, the payment qualifies for capital gains treatment.
The judgment of the Court of Appeals is accordingly Affirmed.
WHITE, dissenting. Omitted.

Questions and comments:
1. Under the Commissioner’s test, wouldn’t the gain on acquisitions of closely held
corporations for consideration that included boot (almost) always be treated as a dividend?
2. The Court determined the character of boot by invoking §302(b)(2). The fact that Mr.
Clark was given a choice between an exchange with no boot and an exchange with boot
made it easy for the Court to determine the reduction in interest caused by Clark’s election
to receive boot (assuming that the choices had the same value). The boot option left Clark
with a stock interest that was less than 80% of what it would have been if Clark had opted
to receive stock only. What happens if the distributee is not given a choice? Rather the
parties simply agree on a certain number of shares and a certain amount of boot.
The Court’s summary of Wright v. United States, 482 F.2d 600 (CA8 1973) provides an
answer. “[T]his test requires that one imagine a pure stock-for-stock exchange, followed
immediately by a postreorganization redemption of a portion of the taxpayer’s shares in
the acquiring corporation … in return for a payment in an amount equal to the boot.” This
determination requires that we know the fair market value of a share of the acquiring
corporation’s stock as well as the number of shares that the acquiring corporation has
outstanding. It also requires that we know the accumulated e&p of the acquired
corporation and taxpayer’s ratable share of that accumulated e&p.
Example and Problems: A is the sole shareholder of X Corporation. A’s basis in her stock
is $190,000. X Corporation has accumulated e&p of $100,000. A exchanges all of her
stock in X Corporation for 10,000 shares of Y Corporation plus $30,000 cash. Y

504

Corporation has 200,000 shares of stock outstanding immediately before that exchange;
the fmv of each share is $20. How much of the $30,000 boot is dividend?
•Compute A’s gain: $230,000 − $190,000 = $40,000.
•$30,000 of boot would purchase 1500 shares at $20/share.
•Pre-redemption, A’s proportionate interest in Y Corporation would be –
(10,000 + 1500)/(200,000 + 10,000 + 1500)
i.e., 5.437%
•Post-redemption, A’s proportionate interest in Y Corporation would be
10,000/210,000
i.e., 4.762%
•80% of 5.437% is 4.350%. All of the boot is dividend because it does not exceed
A’s ratable share of Corporation X’s accumulated e&p.
2A. Suppose A’s basis in her stock had been $250,000?
2B. Suppose A’s basis in her stock had been $210,000?
2C. Suppose A had received $90,000 of boot?
2D. As the amount of boot increases, what happens to the probability that it will be
characterized as dividend – assuming that the acquired corporation has sufficient e&p?
3. Notice: the Court interpreted § 356(a) wherein Congress used the word “exchange.” In
§ 356(b), Congress used the word “distribution.” What is the tax treatment of such a
“distribution”?
4. Rather than testing for dividend treatment by applying § 302(b)(2), might the Court have
applied § 302(b)(1)?
5. Basis Rules for Distributees: Section 358(a) states the familiar rule that the one who
receives property in a reorganization takes the same basis she had in the property
exchanged, less the fair market value of any property received, less money received, plus
the amount treated as a dividend, plus gain that the taxpayer recognized on the exchange
(except “any portion of such gain which was treated as a dividend”). § 358(a)(1). “Money
received” includes another party’s assumption of a liability of taxpayer. § 358(d)(1).
Section 358(b)(2) provides that in a § 355 distribution where taxpayer retains stock of the
distributing corporation, taxpayer’s basis that she had in the stock or securities prior to the
distribution is to be allocated among both stock and securities received and the stock of
the distributing corporation according to their relative fair market values. § 358(b)(2); Reg.
§ 1.358-2(a)(2)(i).

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6. Recognition and Basis Rules for Distributing Corporation: Section 1032(a) states the
basic rule that a corporation that exchanges its stock for money or other property
recognizes no gain/loss on the exchange. Section 361(a) states the same rule for a
corporation that is a party to a reorganization. The same is true of a corporation’s
distribution to shareholders when the corporation is a party to a reorganization. §
361(c)(1). The corporation takes the basis that a transferor had in property, increased by
any gain that the transferor recognized. § 362(b).

B. Sections 381, 382, and 383: Tax Attributes
Section 381(c) names twenty-five tax attributes to which an acquiring corporation
succeeds in an A, C, D, F, or G reorganization. § 381(a). (Of course, in a B or E
reorganization, the corporation does not transfer any assets and does not go out of
existence; there is no need for a special carryover provision.) Only in the case of an F
reorganization may an acquiring corporation carry back an NOL. § 381(b).202
Perhaps the most important tax attributes for our immediate purposes are provisions
governing the carryover of net operating losses, earnings and profits (and earnings and
profits deficits), and capital loss carryovers. These tax attributes could be particularly
attractive features of a target corporation. Congress has acted to curb the emergence of a
market in such attributes. We consider the gist of certain key Code sections here:
Section 381(c)(1, 2, and 3):
•Net Operating Losses: The acquiring The workings of § 382 are ably
corporation may claim the NOL of the target described in W. Eugene Seago
only for the first taxable year ending after the & Edward J. Schnee, TAX
date of acquisition or transfer. § 381(c)(1)(A). NOTES, Dec. 23, 2019, at 1933.
The allowable NOL is limited to the same
percentage of the NOL as the percentage of the acquiring corporation’s taxable
income earned after the date of transfer or distribution. § 381(c)(1)(B). Except for
an F reorganization, a loss corporation that acquires a profitable corporation may
not carry back an NOL or a net capital loss for a taxable year ending after the date
of transfer or distribution to a taxable year of the transferor or distributor. §
381(b)(3).
•Section 382 further limits the NOL deduction of an acquiring corporation.
Section 382 limits the use of a “loss corporation’s” NOLs when there is a
change in ownership of the corporation – which there most certainly is in
the case of an acquisition. § 382(g)(1, 2 and 3) (definition of “ownership
change”); § 382(k)(7) (definition of “5% shareholder”). Section 382(c)

202 Except for farming losses and non-life insurance company losses, the TCJA eliminated all NOL carrybacks.

506

provides that the new corporation must continue the business of the old
corporation, or the pre-acquisition NOL is lost. § 382(c)(1). This should
curtail the trafficking in NOLs. If there is such continuity of business, the
taxable income that may be offset by preacquisition NOLs is limited to the
value of the old corporation (fmv of its stock, § 383(e)(1)) multiplied by
the “tax exempt rate,” a rate derived from the “applicable federal rate,” (§
382(f), referencing § 1274(d)). § 382(b)(1). This amount can be increased
under specified circumstances by recognition of the old corporation’s builtin gains. § 381(h)(1)(A)(i). This limitation creates a presumption that had
the old corporation continued, it would have earned taxable income equal
to that product. “Section 382 is founded on the principle that when there is
a change in the ownership of the entity that created the loss, the new owners
should not receive a greater tax benefit from the NOL than the previous
owners could have.” W. Eugene Seago & Edward J. Schnee, TAX NOTES,
Dec. 23, 2019, at 1933, 1934. The old corporation could utilize an NOL
only to the extent it had taxable income.
•Earnings and Profits: The acquiring corporation acquires the earnings and profits
of the transferor or distributor corporation, whether or not there is a deficit, at the
close of the date of distribution or transfer. § 381(c)(2)(A). However, a deficit of
the transferor, distributor, or acquiring corporation may be used only to offset
earnings and profits accumulated after the date of transfer. § 381(c)(1)(B). The
acquiring corporation’s earnings and profits for the taxable year of distribution or
transfer are pro rated from the date of acquisition until the close of the taxable year.
§ 381(c)(1)(B).
•Capital Loss Carryovers: For purposes of § 1212 (providing that corporate capital
losses to carry back three years and forward five years), the acquiring corporation
may recognize the capital loss of the distributor or transferor corporation as a STCL
(§ 381(c)(3)(B)) in the first taxable year ending after the distribution or transfer. §
381(c)(3)(A). The amount of loss that the acquiring corporation may recognize is
its capital gain net income pro rated to the period of the taxable year after the date
of transfer or distribution. § 381(c)(3)(B).
Section 383: Section 383 limits the use of any “excess credit” following an ownership
change to the tax on what remains of taxable income after application of § 382 limitations
on NOLs. § 383(a). The principles of § 382 also limit the use of capital loss carryovers. §
383(b).
Section 384: Section 384 generally disallows the offsetting of preacquisition losses against
recognized built-in gains of another corporation of a controlled group for five years. §§
384(a), 384(c)(8), cross-referencing §382(h)(7).

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Section 269: Section 269 permits the “Secretary” (i.e., IRS) to deny a deduction, credit, or
other allowance if the “principal purpose” of the acquisition of control of another
corporation is “evasion or avoidance of Federal Income Tax” by acquiring such a
deduction, credit, or other allowance. § 269(a). “Control” is ownership of stock possessing
at least 50% of the voting power of the corporation or at least 50% of the value of all of a
corporation’s stock.

Do the CALI exercise:
Corporate Taxation: Reorganizations: Tax Consequences of A Reorganizations.

VI. Single Entity Reorganizations: Recapitalizations and Changes in Identity,
Form, or Place of Organization
Section 368(a)(1) includes two forms of reorganization in which a single corporation
survives essentially unchanged. E reorganizations (recapitalizations) are useful when
passing a corporation on to the next generation. Holders of common stock may exchange
their common shares for preferred shares. They are also useful when restructuring the
capital interests of a corporation confronting difficulties, e.g., exchanges of one class of
stock for another. F reorganizations are useful when a corporation wishes to change certain
aspects of its identity without changing its essential character.

A. “E” Reorganization
An “E” reorganization is a “recapitalization.” § 368(a)(1)(E). The regulations do not define
“recapitalization,”203 but the Supreme Court has offered in dictum that a recapitalization
is a “reshuffling of a capital structure, within the framework of an existing corporation.”
Helvering v. Southwest Consolidated Corp., 315 U.S. 194, 202 (1942). It is a useful
transaction when the older generation wishes to pass control of a corporation to the next
generation while retaining an interest – e.g., right to dividend income – in the corporation,
when selling shareholders wish to convert their shares to shares of a different type – e.g.,
common to preferred – as part of a larger reorganizational plan, when a corporation’s
shareholders and creditors agree to restructure the corporation’s debt by exchanging
various stock and debt instruments for existing stock and debt instruments, and others.
While the regulations (Reg. § 1.368-2(e)) do not offer a definition of “recapitalization,”
they present five transactions or exchanges in which a “recapitalization” takes place. They
203 Reg. § 1.368-2(e) merely offers five examples of transactions that constitute recapitalizations.

508

include a corporation’s exchange of preferred stock for bonds,204 an exchange of common
stock for preferred stock, 205 an exchange of preferred for common stock, 206 and an
exchange of preferred stock with dividends in arrears for other stock of the corporation.207
However, in the last case, if there is an increase in the preferred shareholders’
proportionate interests in the corporation’s assets or earning and profits, the lesser of –
•the amount by which the greater of the fair market value or the liquidation
preference of the stock received is greater than the issue price of the preferred stock
surrendered OR
•the amount of dividends in arrears
“shall be treated under § 305(c) as a deemed distribution to which §§ 305(b)(4) and 301
apply.”208
Under § 1036 as well as under § 368(a)(1)(E), an exchange of common for common and
an exchange of preferred for preferred other than non-qualified preferred are not
recognition events. § 1036(a, b). The use of nonqualified preferred stock in the context of
a recapitalization reorganization of a family-owned corporation does qualify for tax-free
treatment. § 354(a)(2)(C).
Section 354(a)(2) names two conditions of tax-free treatment of a reorganization: receipt
of securities whose principal amount equals or exceeds the principal amount of the
securities surrendered, and receipt of securities only upon a surrender of securities.

Rev. Rul. 86-25, 1986-1 C.B. 202
Is the transaction described below a reorganization as defined in § 368(a)(1)(E) of the
Internal Revenue Code or is it a distribution of property to which § 301 applies by reason
of the application of § 305(b)(3)?
FACTS
X, a closely held domestic corporation, had 3,000 shares of $100 par value voting common
stock (“old common”) outstanding. For valid business reasons, a plan of reorganization
was adopted pursuant to which X authorized the issuance of a new class A no par value
voting common stock, a new class B no par value nonvoting common stock, and a new
class C $100 par value nonvoting, nonparticipating, nonconvertible preferred stock. The

204 Reg. § 1.368-2(e)(1).
205 Reg. § 1.368-2(e)(2 and 4).
206 Reg. § 1.368-2(e)(3).
207 Reg. § 1.368-2(e)(5).
208 Reg. § 1.368-2(e)(5).

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only difference between the class A and class B common stock was the voting rights of
the class A stock, and the only difference between the class A common stock and the old
common stock was the par values. No terms of the old common stock, such as dividend or
liquidation rights, are tied to the par value.
The plan of reorganization provided that each outstanding share of old common stock
could be exchanged either for one share of class A common stock plus 99 shares of class
B common stock, or for one share of class A common stock plus six shares of class C
preferred stock. Pursuant to the plan of reorganization, one group of X shareholders
surrendered 2,500 shares of X old common stock in exchange for 2,500 shares of class A
common stock and 15,000 shares of class C preferred stock. A second group of
shareholders surrendered 500 shares of old common stock in exchange for 500 shares of
class A common stock and 49,500 shares of class B common stock. The value of the stock
received by each shareholder of X was equal to the value of the stock surrendered by such
shareholder in the exchange. The exchange of stock was an isolated transaction and not
part of a plan to increase periodically the proportionate interest of any shareholder in the
assets or earnings and profits of X.
LAW AND ANALYSIS
Section 368(a)(1)(E) of the Code provides that the term “reorganization” includes a
recapitalization. In Helvering v. Southwest Consolidated Corp., 315 U.S. 194, 202 (1942),
the Supreme Court of the United States defined a recapitalization under a predecessor of
§ 368(a)(1)(E) as a “reshuffling of a capital structure within the framework of an existing
corporation.”
Section 354(a) of the Code states that no gain or loss will be recognized if stock in a
corporation that is a party to a reorganization is exchanged solely for stock in such
corporation.
Section 305(a) of the Code contains the general rule that gross income does not include
the amount of any distribution of the stock of a corporation made by such corporation to
its shareholders with respect to its stock.
Section 305(b)(3) of the Code provides that § 305(a) shall not apply to a distribution by a
corporation of its stock, and the distribution shall be treated as a distribution of property
to which § 301 applies if the distribution (or a series of distributions of which such
distribution is one) has the result of the receipt of preferred stock by some common
shareholders and the receipt of common stock by other common shareholders.
Section 305(c) of the Code provides that a change in redemption price, a difference
between redemption price and issue price, a redemption which is treated as a distribution
to which § 301 applies, or any transaction (including a recapitalization) having a similar
effect on the interest of any shareholder may be treated as a distribution with respect to
510

any shareholder whose proportionate interest in the earnings and profits or assets of the
corporation is increased by such change, difference, redemption, or similar transaction.
Section 1.305-7(c)(1) of the ... Regulations provides that a recapitalization (whether or not
an isolated transaction) will be deemed to result in a distribution to which § 305(c) of the
Code applies if it is pursuant to a plan to periodically increase a shareholder’s
proportionate interest in the assets or earnings and profits of the corporation.
Section 1.305-7(c)(4) of the regulations provides that an example of the application of §
1.307(c) is example (12) of § 1.305-3(e).
In Example (12) contained in § 1.305-3(e) of the regulations, five shareholders owned 300
shares each and five shareholders owned 100 shares each of Corporation R’s 2,000 shares
of class A stock outstanding. In preparation for the retirement of the five major
shareholders, R, in a single and isolated transaction, had a recapitalization in which each
share of class A stock was exchanged either for five share of new class B nonconvertible
preferred stock plus 0.4 share of new class C common stock, or for two shares of new class
C common stock. As a result of the exchanges, each of the five major shareholders
received 1,500 shares of class B nonconvertible preferred stock and 120 shares of class C
common stock, and the remaining shareholders each received 200 shares of class C
common stock. The example concludes that none of the exchanges are within the purview
of § 305 of the Code.
In the instant case, had X made an outright distribution of the new preferred stock and new
class B common stock on the old common stock, the distribution would have been taxable
as a distribution of property under § 301 of the Code by reason of the application of §
305(b)(3).
Nevertheless, a transaction that effects a reshuffling of a corporation’s capital structure
will be respected as a recapitalization exchange to which § 305(b)(3) of the Code does not
apply so long as it has a bona fide business purpose and is an isolated transaction and not
part of a plan to increase periodically the proportionate interest of any shareholder in the
assets or earnings and profits of a corporation. See Example (12) in § 1.305-3(e) of the
regulations, discussed above. Compare Bazley v. Commissioner, 331 U.S. 737 (1947) (the
exchange lacked a bona fide business purpose and was therefore not a reorganization) and
§ 1.301-1(1) of the regulations (a distribution occurring at the same time as a
recapitalization is taxable as a dividend if, in substance, it is not part of the
recapitalization).
HOLDING
Under the circumstances set forth above, the exchange of old voting common stock for
either class A voting common stock plus class C nonvoting preferred stock or class A
voting common stock plus class B nonvoting common stock, will qualify as a tax-free
511

recapitalization under §§ 368(a)(1)(E) and 354(a) of the Code, and will not be treated as
distributions of property to which § 301 applies by reason of the application of § 305(b)(3).

Questions and comments:
1. If stock other than common stock is received in a recapitalization, it might be § 306
stock. Reg. § 1.306-3(a) provides that when no gain is recognized on the receipt of stock
other than common stock, the stock may be § 306 stock “if a distribution of money by the
distributing corporation in lieu of such stock would have been a dividend in whole or in
part.” The distribution is tested for dividend treatment under § 302(b). The boot rules of §
356(a)(2) may also provide dividend treatment and therefore the stock may be § 306 stock.
2. Reg. § 1.306-3(d) provides in part: “Common stock received in exchange for section
306 stock in a recapitalization shall not be considered section 306 stock.”

Do the CALI exercise:
Corporate Taxation: Reorganizations: E Reorganizations: Definition.

B. “F” Reorganization
An “F” reorganization is “a mere change in identity, form, or place of incorporation of one
corporation, however effected[.]” § 368(a)(1)(F). A “mere change” can be an actual or
deemed transfer of property from one transferor corporation to one “resulting
corporation.” Reg. § 1.368-2(m)(1). A series of transactions may provide the framework
against which to apply F reorganization rules. Reg. § 1.368-2(m)(1). Step transactions
principles apply. Reg. § 1.368-2(m)(1). The Commissioner used F reorganizations to
address liquidation/reincorporation transactions by claiming that various transactions that
were ostensibly recognition events were in fact F reorganizations, and so not recognition
events.
Treasury recently promulgated regulations which are summarized here. As the definition
of an F reorganization implies, an F reorganization is useful when a corporation wants to
change its name, its form, or its state of incorporation. The regulations now provide that
an F reorganization must satisfy all six of the following conditions, Reg. § 1.368-2(m)(1):

512

•all of the stock of the “resulting corporation” must be distributed in exchange for
the stock of the transferor corporation,209 Reg. § 1.368-2(m)(1)(i);
•the same persons must own the stock of the transferor corporation and of the
“resulting corporation” in identical proportions,210 Reg. § 1.368-2(m)(1)(ii);
•the resulting corporation may not have any tax attributes immediately before the
potential F reorganization,211 Reg. § 1.368-2(m)(1)(iii);
•the transferor corporation must completely liquidate for income tax purposes, but
it is not required to liquidate under other applicable law and may retain a de
minimis amount of assets for the sole purpose of preserving its legal existence,
Reg. § 1.368-2(m)(1)(iv);
•no corporation other than the resulting corporation may hold properties that the
transferor corporation held immediately before the potential F reorganization “if
such other corporation would, as a result, succeed to and take into account the” the
tax attributes named in § 381(c) of the transferor, Reg. § 1.368-2(m)(1)(v); and
•the resulting corporation may not hold property acquired from any corporation
other than the transferor corporation if the resulting corporation would take into
account any of the tax attributes named in § 381(c).
The continuity of business enterprise and the continuity of interest requirements of other
reorganizations do not apply to potential F reorganizations. Reg. § 1.368-2(m)(3).
The regulations state two priority rules.
•“If the potential F reorganization or a step thereof qualifies as a reorganization or
part of a reorganization under another provision of § 368(a)(1), and if a corporation
in control (within the meaning of § 368(c)) of the resulting corporation is a party
to such other reorganization (within the meaning of § 368(b)), the potential F
reorganization will not qualify as a reorganization under § 368(a)(1)(F).” Reg. §
1.368-2(m)(3)(iii)(A).
•Except for the immediately foregoing, “if ... the potential F reorganization would
[otherwise] qualify as a reorganization under both § 368(a)(1)(F) and one or more
209 The resulting corporation may issue a de minimis amount of stock that is not exchanged for the stock of the

transferor corporation in order to facilitate organization of the resulting corporation or to maintain its existence.
Reg. § 1.368-2(m)(1)(i). 6
210 One or more shareholders of the transferor corporation may transfer such stock for stock in the resulting

corporation of equivalent value but with different terms from the stock of the transferor corporation, or receive
a distribution of money from either corporation whether or not in exchange for stock of either corporation.
Reg. § 1.368-2(m)(1)(ii). The receipt of money or other property is treated as a separate transaction unrelated to
the reorganization. Reg. § 1.368-2(m)(3)(iii).
211 The resulting corporation holds a de minimis amount of assets to facilitate its organization or to maintain its

existence and has tax attributes related to holding those assets. Reg. § 1.368-2(m)(1)(iii). The resulting
corporation may also hold the proceeds of borrowings undertaken in connection with the potential F
reorganization. Id.

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of §§ 368(a)(1)(A), 368(a)(1)(C), or 368(a)(1)(D), then for all federal income tax
purposes the potential F reorganization will qualify as a reorganization only under
§ 368(a)(1)(F).” Reg. § 1.368-2(m)(3)(iii)(B).
In an F reorganization, as opposed to other reorganization forms, the corporation acquiring
property may carry back a net operating loss or a capital loss. § 381(b)(3). [Such
carrybacks are quite limited after enactment of the TCJA.] Also, the taxable year or the
distributor or transferor corporation does not end on the date of distribution or transfer. §
381(b)(1).

Do the CALI exercise:
Corporate Taxation: Reorganizations: F Reorganizations: Definition.

514