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CHAPTER 5 CORPORATIONS: REDEMPTIONS AND LIQUIDATIONS SOLUTIONS TO PROBLEM MATERIALS

Question/ Problem 1 2 3 4 5 6

Topic Tax treatment of return from investment versus Corporate shareholder preference for dividend versus stock redemption Issue recognition Sale or exchange versus dividend treatment on Definition of related parties in attribution

Status: Present Edition

Q/P in Prior Edition

New return of investment Unchanged 2 Unchanged 3 Modified 4 redemption Unchanged 5 rules; attribution from Unchanged Modified required Unchanged Unchanged Modified Unchanged Unchanged Modified Unchanged New Modified Unchanged Unchanged Unchanged Unchanged 6 7 8 9 10 11 12 13 14 16 17 18 19 20

and to entities When stock attribution rules do not apply to stock redemptions 7 Attribution to and from entities; reattribution 8 9 10 11 12 13 14 15 16 17 18 19 20 Basis of stock in a nonqualified stock redemption Disproportionate redemption requirements not met; possible not essentially equivalent redemption Issue recognition Requirements for a partial liquidation Advantages of a redemption to pay death taxes Issue recognition Gain/loss recognition to corporation on redemption distribution Issue recognition Sale of 306 stock Comparison of preferred stock bailout to dividend distribution Sale of stock to related corporation Corporate liquidation for tax purposes Corporate loss limitations in complete liquidation 5-1

5-2

2002 Annual Edition/Solutions Manual Status: Present Edition Unchanged Modified Unchanged Unchanged Unchanged Unchanged New Modified Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged New Modified Unchanged Unchanged Unchanged Unchanged Modified Unchanged Modified Unchanged Unchanged 38 39 40 41 42 43 44 45 46 47 Q/P in Prior Edition 21 22 23 24 25 26 29 30 31 32 33

Question/ Problem 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47

Topic Tax consequences to shareholder in complete liquidation; use of installment method to report gain Liquidation of subsidiary; general requirements Tax consequences in liquidation of subsidiary when minority interest is involved Liquidation of subsidiary; indebtedness to parent Liquidation of subsidiary; tax consequences to parent and subsidiary Requirements for application of 338 Tax consequences of a 338 election Comparison of dividend distribution with qualifying redemption; individual versus corporate shareholder Comparison of tax treatment of dividend distribution and stock redemption to individual shareholder Comparison of tax treatment of dividend distribution and stock redemption to corporate shareholder Comparison of tax treatment of dividend distribution and stock redemption to individual shareholder with capital loss carryover Comparison of tax treatment of dividend distribution and stock redemption to corporate shareholder with capital loss carryover Application of stock attribution rules Meaningful reduction test in a not essentially equivalent redemption Disproportionate redemption [ 302(b)(2)]; family attribution Complete termination redemption [ 302(b)(3)]; family attribution waiver Sale of stock versus complete termination redemption; effect on retiring shareholder, remaining shareholder, and corporation Partial liquidation [ 302(b)(4)] Redemption of stock to pay death taxes [ 303] Redemption of stock to pay death taxes; estate sale of property received Disproportionate redemption; consequences to shareholder and effect on E & P Effect of redemption on E & P Section 306 stock; sale and redemption Redemption through use of related corporations [ 304] Complete liquidation; distribution of property subject to liability Complete liquidation; sale of loss property Complete liquidation; sale of built-in loss property

34 36 37

Corporations: Redemptions and Liquidations Status: Present Edition Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged

5-3 Q/P in Prior Edition 48 49 50 51

Question/ Problem 48 49 50 51 52 53 54 55 56 Research Problem 1 2 3 4 5 6

Topic Complete liquidation; distribution of disqualified property to related parties Complete liquidation; application of related-party loss limitation Complete liquidation; disqualified and built-in loss property Complete liquidation; tax consequences to shareholder when installment notes distributed Liquidation of subsidiary; distribution of loss property to minority shareholder Liquidation of subsidiary; indebtedness of subsidiary to parent Liquidation of subsidiary; tax consequences to subsidiary and parent Nonapplicability of 332 to an insolvent subsidiary When not to make the 338 election

52 54 55 56

Stock redemption in the context of a buy-sell agreement Complete termination of an interest under 302(b)(3); consulting as a prohibited interest in corporation Charitable contribution of 306 stock Determination of complete liquidation status Internet activity Internet activity

Unchanged Unchanged New Unchanged Unchanged New

1 2

4 5

5-4

2002 Annual Edition/Solutions Manual CHECK FIGURES

28.a. 28.b. 28.c. 28.d. 28.e. 29.a. 29.b. 30.a. 30.b. 31.a. 31.b. 31.c. 32.a. 32.b. 33.a. 33.b. 33.c. 34.a. 34.b. 34.c. 35. 36.a. 36.b. 36.c. 36.d. 37.a. 37.b. 38.a. 38.b.

38.c.

Teal taxable gain of $150,000; Grace dividend income of $250,000. Teal taxable gain of $150,000; Grace $250,000 of dividend, subject to the dividends received deduction. Teal taxable gain of $150,000; Grace capital gain of $170,000. Teal taxable gain of $150,000; Grace capital gain of $170,000. Teal no preference; Grace prefers option b., if corporation; option c., if individual. $18,000. $39,600. $30,600. $10,200. $30,000. $3,000. Choose qualifying stock redemption. $30,000. $0. 560 shares. 470 shares. 600 shares. Dividend income of $60,000. $110,000. $140,000. Capital gain of $35,000. Yes. No. No. Yes. Lori dividend income of $400,000; Swan reduces E & P by $400,000; Roberta capital gain of $375,000. Roberta capital gain of $375,000; Swan reduces E & P by $350,000. Helen capital gain of $1,800,000; Yellow dividend of $2,000,000; White gain of $3,000,000. Helen capital gain of $1,800,000 and basis of $2,000,000; Yellow dividend and basis of $2,000,000; White gain of $3,000,000. Helen and Yellow each have dividend and basis of $2,000,000; White gain of $3,000,000.

38.d. 39. 40. 41.a. 41.b. 42. 43.a. 43.b. 43.c. 44. 45.a. 45.b. 46. 47. 48. 49. 50. 51. 52.

53. 54.a. 54.b. 54.c. 54.d. 54.e. 55. 56.a. 56.b.

Helen and Yellow each have dividend and basis of $250,000; White gain of $400,000. Qualifies under 303 to the extent of $100,000. Red no loss recognized; E & P reduced by $800,000; estate $100,000 gain on sale. Capital gain of $55,000. $90,000. $40,000. No tax consequences other than allocation of stock basis. Ordinary income of $20,000, return of capital of $12,000, capital gain of $3,000. Dividend income of $35,000. Bob taxable dividend of $30,000. $500,000 LTCG. $600,000 LTCG. $100,000. $60,000. $0. Pink should either distribute the land to Paul or sell it and distribute the cash. Pink should either distribute the land to Paul or sell it and distribute the cash. Helen must recognize $90,000 of gain in the year of liquidation. Magenta no gain or loss recognized; Fuchsia no gain or loss recognized and basis of $620,000; Marta $20,000 gain recognized and basis of $50,000. Green recognizes no gain; Orange recognizes $50,000 gain. $0. $0. $90,000. $150,000. Carries over to Wren. Section 332 does not apply; ordinary loss allowed. Yes. No.

Corporations: Redemptions and Liquidations DISCUSSION QUESTIONS 1.

5-5

A nonliquidating distribution treated as a return from an investment is taxed as ordinary dividend income. Alternatively, a nonliquidating distribution treated as a return of an investment is taxed as a sale or exchange of the investment. Qualifying stock redemptions are nonliquidating distributions that result in sale or exchange treatment. pp. 5-2 and 5-3 Because of the dividends received deduction available to corporate shareholders, a corporate shareholder would pay taxes on only a small portion of the proceeds if the distribution is treated as dividend income. Thus, a dividend distribution normally provides more favorable tax treatment to a corporate shareholder than sale or exchange treatment. p. 5-3 If Brown redeems Leonas shares, the remaining shareholders, Jacob and Ivan, are not required to use their own funds to purchase the stock. If Brown redeems Leonas shares, Jacob and Ivan will be the only remaining shareholders, thereby possessing total control of the corporation. Other, outside parties will not acquire an ownership interest. If Brown makes the purchase, no effort will be required to develop or cultivate an outside market for Leonas interest.

2.

3.

pp. 5-4 and 5-31 4. Kanishas redemption failed to qualify for sale or exchange treatment and was instead taxed as a dividend at her marginal tax rate (i.e., $5,400 = 36% X $15,000). Kwans redemption, however, satisfied the terms of one of the qualifying redemption provisions and was taxed at the more favorable tax rate for long-term capital gains. That is, $1,400 = 20% X [$15,000 (amount realized) - $8,000 (basis in shares)]. Example 2 Attribution from entities applies in the following manner. Stock owned by a partnership is deemed to be owned by a partner to the extent of the partners proportionate interest in the partnership. Stock owned by a corporation is deemed to be owned proportionately by a shareholder owning 50% or more of the corporations stock. Finally, stock owned by an estate or trust is deemed to be owned by a beneficiary or heir to the extent of the beneficiary or heirs proportionate interest in the estate or trust. Attribution to entities applies in the following manner. Stock owned by a partner is deemed to be owned in full by a partnership. Stock owned by a 50% or more shareholder in a corporation is deemed to be owned in full by the corporation. Finally, stock owned by a beneficiary or heir of an estate or trust is deemed to be owned in full by the estate or trust. Exhibit 5-1 6. The family attribution rules do not apply to a complete termination redemption when the former shareholder does not hold a prohibited interest for ten years after the redemption and files the required notification agreement with the IRS. All other attribution rules still apply to complete termination redemptions, however. pp. 5-9 and 5-10

5.

5-6

2002 Annual Edition/Solutions Manual The stock attribution rules are not relevant in determining whether a distribution qualifies as a partial liquidation. Instead, the distribution must not be essentially equivalent to a

Corporations: Redemptions and Liquidations

5-7

dividend, with reference to the effect of the distribution on the corporation, or the distribution must be pursuant to the termination of an active business. pp. 5-10, 5-11, and Example 16 The stock attribution rules do not apply in satisfying the requirements of a redemption to pay death taxes. p. 5-12 7. This problem requires the use of several of the attribution rules. Zina owns 400 shares directly, 140 shares indirectly from Wren (70% X 200 shares), and 20 shares indirectly from Waxwing (10% X 200 shares), for a total of 560 shares in Cardinal. Wren owns 200 shares directly and 420 shares indirectly from Zina (400 shares owned directly plus 20 shares owned indirectly from Waxwing), for a total of 620 shares in Cardinal. Waxwing owns 200 shares directly and 540 shares indirectly from Zina (400 shares owned directly plus 140 shares owned indirectly from Wren), for a total of 740 shares in Cardinal. Exhibit 5-1 The basis attaches to the shareholders remaining stock basis or, if that shareholder has no remaining direct stock ownership, to stock the shareholder owns constructively. p. 5-7 and Example 9 The redemption does not qualify as a disproportionate redemption. After the redemption, Jacques ownership interest of 43% (600 shares/1,400 shares) does not satisfy the 80% test [43% is not less than 40% (80% X 800 shares/1,600 shares)]. The redemption may qualify as a not essentially equivalent redemption. To qualify, the reduction in Jacques ownership, from 50% to 43%, would have to satisfy the meaningful reduction test. If that test is met, sale or exchange treatment would result. Otherwise, the distribution is dividend income to Jacque. pp. 5-7 to 5-9 Whether the transfer of Polly's property to Flycatcher Corporation qualifies as a nontaxable exchange under 351. Polly's basis in her stock. Whether the redemption qualifies for sale or exchange treatment. Whether Polly is related to any shareholder of Flycatcher Corporation. If Polly is related to a shareholder of Flycatcher, will she continue as a director of Flycatcher or as a consultant to the corporation? What is Flycatchers E & P at the time of the distribution? Whether Flycatcher has a recognized gain (or unrecognized loss) as a result of the distribution. What is the effect of the distribution on Flycatchers E & P? Whether Flycatcher incurred any (nondeductible) redemption expenditures as a result of the distribution.

8.

9.

10.

pp. 5-9, 5-10, 5-13, 5-14, and Chapter 3

5-8 11.

2002 Annual Edition/Solutions Manual In determining whether a distribution is not essentially equivalent to a dividend for the partial liquidation rules, the test is applied at the corporate level (rather than the shareholder level, as is the case of a not essentially equivalent redemption). The test requires a genuine contraction of the corporations business and is based on the facts and circumstances of each case. A safe harbor rule provides that a distribution pursuant to the termination of an active trade or business will satisfy the not essentially equivalent to a dividend test. To qualify for the termination of an active business rule, the distribution must consist of the assets (or the proceeds from the sale of the assets) from a trade or business that was actively conducted throughout the five-year period ending on the date of the distribution. In addition, the corporation must continue to actively conduct another five-year-old trade or business immediately after the distribution. Finally, neither of the active businesses must have been acquired in a taxable transaction within that same fiveyear period. pp. 5-10, 5-11, and Concept Summary 5-1 Section 303 provides two principal advantages to redemptions of decedent-shareholders stock. First, the provision allows for sale or exchange treatment without regard to the stock attribution rules. This exception is particularly advantageous when the stock is that of a family-owned corporation and the beneficiaries of the decedents estate are family members. Under 303, the stock of these beneficiaries is not attributed to the estate; thus, sale or exchange treatment is available for redemptions that might not qualify under 302. The second advantage of 303, relative to redemptions qualifying under 302, is that there is generally no gain recognized by the estate in a redemption to pay death taxes. This is because the stocks basis is stepped up to the fair market value at death (or alternative valuation date, if elected). p. 5-12 Valuation of Angies estate. Chapter 17 Whether the executor should elect the alternative valuation date. Chapter 17 Whether Angies lifetime gifts to Ann included stock in Bluebird Corporation and, if so, the facts surrounding that transfer (e.g., dates, motivation). Whether a redemption of the estate's shares in Redbird Corporation will qualify under 303. Whether a redemption of the estates shares in Bluebird will qualify under 303 (redemption to pay death taxes) or 302 (complete termination redemption). If a redemption of Bluebird stock is advantageous, whether noncash property should be distributed in the redemption and, if so, which property. Whether Ann should purchase the estate's shares in Bluebird. Effect of Angies lifetime gifts for her estate as to the unified tax credit. Chapter 17 Marital and other estate deductions. Chapter 17 Due date of estate tax return. Chapter 17 Income tax return for estate. Chapter 19

12.

13.

Corporations: Redemptions and Liquidations 14.

5-9

Corporate distributions in redemption of stock are governed under 311. That provision provides that gains, but not losses, are recognized on the distribution of noncash property when the propertys fair market value differs from its basis. As such, the distribution of Property A would result in a $3,000 recognized gain [$10,000 (fair market value) - $7,000 (basis)] to Indigo. The $4,000 loss inherent in Property B [$10,000 (fair market value) $14,000 (basis)] would not be recognized on the distribution of that property. Indigo could distribute the cash, as neither gain nor loss is recognized by Indigo on a cash distribution. However, a sale of Property B to recognize the $4,000 loss and a distribution of the sales proceeds to Linda produces more favorable results. (To avoid the related party loss disallowance rules of 267, the sale must not be to Linda.) p. 5-13 Whether Kackie should distribute cash and/or property in the redemption(s). Whether Kackie would have a recognized gain (or unrecognized loss) on a distribution of property in the redemption(s). Whether the distribution(s) would result in a qualifying stock redemption to the shareholder(s). What would be the effect of the redemption distribution(s) on Kackies E & P? Whether Kackie would incur any (nondeductible) redemption related expenditures (e.g., fees related to transfer of title in a property distribution).

15.

pp. 5-13 and 5-14 16. Section 306 may apply to the sale of the preferred stock if the preferred stock is 306 stock. To be 306 stock, the stock must have been received as a nontaxable stock dividend, acquired tax-free in a corporate reorganization, acquired in an exchange for 306 stock, or have a basis determined by reference to the basis of 306 stock. If the preferred stock is 306 stock, some or all of Petes gain on the sale of the stock may be treated as ordinary income. The ordinary income portion of the gain would be limited to the corporations E & P balance at the time the 306 stock was issued. The underlying purpose of 306 is to preclude the use of preferred stock as a means of bailing out corporate profits without the loss of voting power. Since Pete also sold an equal amount of common with the preferred stock, it is difficult to see how the tax avoidance at which 306 is aimed is present. Therefore, it is possible that the disposition described would not be caught by the onerous provisions of 306 [see 306(b)(4)]. In any event, the sale would not create any problems if the preferred stock was not 306 stock. pp. 5-15 and 5-16 17. The sale of 306 stock generates ordinary income, but not dividend income. Since dividends are not being distributed, the issuing corporation cannot reduce its E & P by the amount of the income recognized by the shareholder. Thus, the parties may have been better off paying a dividend in the first place because E & P would be reduced in that case. pp. 5-15, 5-16, and Example 21

5-10 18.

2002 Annual Edition/Solutions Manual Under 304, when a shareholder sells stock she owns in one corporation to a related corporation, the sale is treated as a redemption subject to 302 and 303. Two corporations are related if the shareholder has at least a 50% ownership in both corporations. p. 5-17 and Figure 5-1 For tax purposes, a corporate liquidation exists when a corporation ceases to be a goingconcern. The corporation continues solely to wind up affairs, pay debts, and distribute any remaining assets to its shareholders. Retention of a nominal amount of assets to pay remaining debts and preserve legal status will not defeat liquidation status. Legal dissolution under state law is not required for a liquidation to be complete for tax purposes. p. 5-19 Corporate losses arising from complete liquidations are disallowed in four situations. First, a loss is disallowed on the distribution of property to a related person if such distribution either is not pro rata or it consists of disqualified property. Second, a loss is disallowed on the sale, exchange, or distribution of property that was contributed to the corporation (in a 351 transaction or as a contribution to capital) with a built-in loss shortly before the adoption of a plan of liquidation. This disallowance applies when the corporations acquisition of the property was part of a plan whose principal purpose was to recognize a loss on that property by the liquidating corporation. The last two disallowance rules apply in the case of a liquidation of a subsidiary corporation. In liquidation, a subsidiary corporation does not recognize losses on the distribution of property to its parent shareholder. Similarly, losses on the distribution of property to any minority shareholders of a liquidating subsidiary are also not recognized. pp. 5-21 to 523, 5-26, and 5-27 The general rule under 331 provides for sale or exchange treatment to the shareholder. The shareholder is treated as having sold his or her stock to the corporation being liquidated. Thus, the difference between the fair market value of the assets received from the corporation and the adjusted basis of the stock surrendered is the gain or loss recognized. Typically, the stock is a capital asset in the hands of the shareholder and capital gain or loss results. A shareholder's gain on the receipt of installment notes obtained by a liquidating corporation on the sale of its assets may be deferred to the point of collection under 453(h). The shareholder must allocate stock basis among the various assets received from the corporation. With respect to the notes received, the shareholder may defer gain until the notes are collected. p. 5-25, Example 35, and Footnote 36

19.

20.

21.

22.

a.

The date of the adoption of a plan of complete liquidation is crucial in determining whether 332 applies. The parent corporation must own 80% or more of the subsidiary's voting stock and 80% or more in value of all its other stock (other than nonvoting preferred) at the time the plan of liquidation is adopted (and until all property is distributed), or the liquidation will not qualify under 332. The period of time in which the corporation must liquidate also is crucial in determining whether 332 applies. The subsidiary must distribute all its property in complete redemption of all its stock within the taxable year in which the first distribution is made or within three years from the close of the tax year in which

b.

Corporations: Redemptions and Liquidations

5-11

the first distribution occurred pursuant to the adoption of a plan by the corporation. Otherwise, the liquidation will not qualify under 332. c. The subsidiary must be solvent, or 332 will not apply. If the subsidiary is insolvent, the parent corporation will have a deductible loss for its worthless stock in the subsidiary.

p. 5-26 and Footnote 41 23. If a minority interest is involved in a 332 liquidation, the nonrecognition provisions of 337 will only apply to distributions to the parent. A distribution to a minority shareholder is treated in the same manner as one made pursuant to a nonliquidating redemption. Gain (but not loss) is recognized to the distributing corporation on the property distributed to the minority shareholder. The minority shareholder is subject to the general rule of 331. p. 5-27 When 332 applies, the subsidiary does not recognize gain or loss upon the transfer of property to the parent. This is the case even if the transfer satisfies a debt. The parent corporation may recognize a gain or loss on the receipt of property in satisfaction of indebtedness, however. Examples 37 and 38 Condor will recognize no gain or loss and will have a carryover basis of $500,000 in Dove's assets. Doves tax attributes (e.g., E & P) carry over to Condor. Condors basis in the Dove stock disappears. Dove recognizes no gain or loss on the liquidation. pp. 526 and 5-28 For 338 to apply, the parent must purchase within a 12-month period at least 80% of the voting power and at least 80% of the value of the acquired corporation. Purchase is defined by 338(h)(3) to include all acquisitions of stock except the following: (1) a transaction where basis of the stock is the same as in the hands of the transferor, (2) an acquisition of stock by inheritance, (3) a transaction where 351 applies, and (4) an acquisition of stock from a related party where ownership of the stock would have been attributed to the transferee under 318. The acquiring corporation must then make the 338 election by the 15th day of the ninth month following the qualified stock purchase. p. 5-29 Upon a 338 election, the subsidiary is treated as having sold its assets on the date of the qualified stock purchase. The deemed selling price is determined with reference to the parents basis in the subsidiary stock plus liabilities of the subsidiary. The subsidiary recognizes gain (or loss) as a result of the deemed sale. Then, as of the day following the qualified stock purchase date, the subsidiary is treated as a new corporation that purchased those same assets for a similarly computed amount. The deemed purchase of the assets thus results in a stepped-up (or -down) basis in the assets. Since the subsidiary is treated as a new corporation, its tax attributes (e.g., E & P) start anew as of such date. If the subsidiary is liquidated, it recognizes no gain (or loss) as a result of the liquidation (except for gain on distributions to minority shareholders). The parent corporation incurs no gain (or loss) as a result of the 338 election, and it retains its basis in the subsidiary stock. If, however, the subsidiary is liquidated, the subsidiary stock basis disappears and the parent takes the stepped-up (or -down) basis in the assets acquired. The parent recognizes no gain (or loss) on the liquidation.

24.

25.

26.

27.

5-12 pp. 5-29 and 5-30 PROBLEMS 28. a.

2002 Annual Edition/Solutions Manual

Teal Corporation would have a taxable gain of $150,000. The gain would be ordinary or capital depending on the type of property distributed. The E & P of Teal Corporation would be increased by $150,000 (the amount of gain to Teal) and decreased by $250,000 (the FMV of the property distributed). Teals E & P also would be decreased by the amount of tax due on the gain recognized. Grace would have dividend income of $250,000 and a basis in the asset of $250,000. The tax consequences to Teal Corporation would be the same as in a. Grace Corporation would have dividend income of $250,000, but only 20% of the $250,000, or $50,000, would be taxed to Grace. Because Grace Corporation has a 20% or more ownership in Teal Corporation, the 80% dividends received deduction is applicable. Grace Corporation would have a basis of $250,000 in the property. The tax consequences to Teal Corporation would be the same as in a. Grace would have a capital gain of $170,000 [$250,000 (value of the property) - $80,000 (basis in stock)] and a basis of $250,000 in the property received. The tax consequences to Teal Corporation would be the same as in a. Grace Corporation would have a capital gain of $170,000 [$250,000 (value of the property) - $80,000 (basis in stock)] and a basis of $250,000 in the property received. Assuming Grace is an individual, she would choose the qualifying stock redemption, option c. If the distribution is a qualifying stock redemption, she has a capital gain of $170,000. If the distribution is a dividend as in option a., she would have dividend income of $250,000. Her basis in the property received is the same whether the transaction is a dividend or a qualifying stock redemption. If Grace is a corporation, it would prefer that the distribution be a dividend because only 20% of the dividend would be taxed. Thus, it would prefer option b. Teal Corporation itself would have no preference because the tax consequences to it are the same under each option.

b.

c.

d.

e.

pp. 5-3 to 5-5, and 5-13 29. a. Julio's tax liability would be $18,000, computed as follows: $100,000 (amount realized) - $10,000 (basis in the 200 shares redeemed) = $90,000 (long-term capital gain) X 20% = $18,000. Julio's tax liability would be $39,600, computed as follows: (dividend) X 39.6% = $39,600. $100,000

b.

Example 2 30. a. Tax liability for a corporate shareholder would be $30,600, computed as follows: $100,000 (amount realized) - $10,000 (basis in the stock) = $90,000 (long-term capital gain) X 34% = $30,600. Corporations do not receive a preferential tax rate on long-term capital gains.

Corporations: Redemptions and Liquidations b.

5-13

Tax liability for a corporate shareholder on a $100,000 dividend from a corporation in which it has a 15% interest would be $10,200, computed as follows: $100,000 (dividend) - $70,000 (dividends received deduction of 70% of $100,000) = $30,000 X 34% = $10,200.

Example 4 31. a. Julio may deduct the entire $30,000 capital loss carryover to offset the $90,000 long-term capital gain. Thus, Julio would be taxed on only $60,000 of gain. Tax liability on the $60,000 long-term capital gain would be $12,000 ($60,000 X 20%). Julio could only deduct $3,000 of the $30,000 capital loss carryover. Julio's tax liability on the $100,000 dividend received would be $39,600 ($100,000 X 39.6%). The preferred outcome in this situation is that which provides sale or exchange treatment (part a). With a qualifying stock redemption, Julios tax liability is $27,600 less ($39,600 - $12,000) than if the redemption is treated as a dividend.

b.

c.

Example 3 32. a. The corporation could offset the entire $30,000 capital loss carryover against the $90,000 long-term capital gain. Thus, only $60,000 of the gain would be taxed. The tax liability would be $20,400 ($60,000 X 34%). The corporation could not deduct any of the $30,000 capital loss carryover. Corporations may only offset capital losses against capital gains. Thus, the corporation would have dividend income of $100,000 less a dividends received deduction of $70,000. The remaining $30,000 would be taxed at 34%, for a tax liability of $10,200.

b.

Chapter 2 and Example 4 33. a. Beatrice owns 560 shares, 300 shares directly and 260 shares indirectly, in Silver. Beatrice constructively owns the stock of her mother (120 shares) and her son (50 shares) and 60% of the 150 shares, or 90 shares, owned by Maroon Corporation. Beatrice is not deemed to own her brothers stock. The stock attribution rules do not apply to stock held by a corporation if the shareholder owns less than 50% of the stock in that corporation. Thus, Beatrice would only own 470 shares, 300 shares directly and 170 shares owned by her mother (120 shares) and son (50 shares). Beatrice would now own 600 shares in Silver, the 560 shares as computed in a. above plus 40 shares as a result of her 40% partnership interest [100 (shares owned by Yellow Partnership) X 40% (Beatrices interest in the partnership)].

b.

c.

Exhibit 5-1 34. a. Shonda must report the $60,000 as dividend income. The redemption does not qualify as a not essentially equivalent redemption. Shonda owned 55% of the

5-14

2002 Annual Edition/Solutions Manual stock of Hawk Corporation prior to the redemption (110 200). After the redemption, Shonda owns 50% of the stock of Hawk [90 (Shonda's remaining shares in Hawk) 180 (remaining outstanding shares in Hawk)]. Shonda still has the dominant control of Hawk; thus, there has not been a meaningful reduction in her interest in Hawk. Further, her remaining ownership interest fails the 50% test of a disproportionate redemption. pp. 5-7, 5-8, and Example 7 b. c. The basis in the 20 shares redeemed attaches to Shondas remaining stock. Shondas basis in her remaining 90 shares is therefore $110,000. p. 5-7 Since the redemption is treated as an ordinary dividend distribution, Hawks E & P is reduced to $140,000 ($200,000 - $60,000). Chapter 4

35.

Hoffman, Raabe, Smith, and Maloney, CPAs 5101 Madison Road Cincinnati, OH 45227 May 10, 2001 Lana Pierce 1000 Main Street Oldtown, MN 55166 Dear Lana: This letter is in response to your question concerning the tax consequences of the redemption of 100 shares of stock you own in Stork Corporation. You were paid $45,000 for the shares and you have a tax basis of $10,000 in the stock. Your mother, Lori, owns 100 shares in Stork, and the remaining shares are owned by an unrelated individual. Our conclusion is based upon the facts as outlined in your May 5 letter. Any change in facts may cause our conclusion to be inaccurate. You will have a capital gain of $35,000 on the redemption. Stork Corporation redeemed 100 of the 200 shares you owned in the corporation. For purposes of this transaction, you are deemed to own all of Loris 100 shares. Prior to the redemption, you had a 30% ownership (20% direct ownership + Loris 10% constructively owned) in the corporation as Stork Corporation had 1,000 shares outstanding. After the redemption you have only a 22.22% ownership [200 (your remaining 100 shares in Stork + Loris 100 shares) 900 (remaining outstanding shares in Stork)]. Because, after the redemption, you owned less than 50% of the stock in Stork Corporation and less than 80% of your original ownership [22.22% is less than 24% (80% X 300 shares/1,000 shares)], the redemption qualifies for capital gain treatment. Should you need additional information or need to clarify our conclusion, do not hesitate to call on me. Sincerely, Marilyn C. Jones, CPA Partner

Corporations: Redemptions and Liquidations TAX FILE MEMORANDUM DATE: FROM: SUBJECT: May 8, 2001 Marilyn C. Jones Lana Pierce

5-15

Today I talked to Lana Pierce with respect to her May 5 letter. She received a cash payment of $45,000 from Stork Corporation in exchange for 100 of the 200 shares she owned in the corporation. Lanas mother, Lori, owns 100 shares of Stork, and the remaining shares are owned by an unrelated individual. She wants to know the tax consequences of the redemption. At issue: Will the stock redemption qualify for capital gain treatment or will the $45,000 be treated as a taxable dividend? Conclusion: Lana Pierce has a capital gain of $35,000. Lana is deemed to own Loris 100 shares before and after the redemption. Lana's percentage ownership in Stork Corporation was 30% (300 shares/1,000 shares) before the redemption and 22.22% (200 shares/900 shares) after the redemption. Because the 80% and 50% tests set out in 302(b)(2) are met, the stock redemption qualifies for capital gain treatment. pp. 5-8 and 5-9 and Exhibit 5-1 36. a. b. The redemption qualifies under 302(b)(3). A shareholder can reacquire an interest in the corporation by bequest or inheritance. The redemption will not qualify under 302(b)(3). To qualify for the family attribution waiver, filing the agreement to notify the IRS of any acquisition of stock in the redeeming corporation in the next 10 years is mandatory. After the redemption, Jos is, therefore, deemed to own 100% of Thrushs stock and a dividend distribution results. The redemption will not qualify under 302(b)(3). To qualify for the family distribution waiver, the shareholder may not have any interest in the corporation (other than a creditor) including an interest as a director. After the redemption, Jos is, therefore, deemed to own 100% of Thrushs stock and a dividend distribution results. The redemption qualifies under 302(b)(3). The prohibited interest (i.e., that as director) relates to Jos, not Jos's daughter.

c.

d.

p. 5-9 and Examples 12 and 13 37. a. With respect to the distribution, Lori would have ordinary dividend income of $400,000 and Swan Corporation would reduce its E & P by $400,000. As a result of the stock transaction, Lori would have a basis of $400,000 in the newly acquired 100 shares and become the sole shareholder of Swan. Roberta would have a capital gain of $375,000 [$400,000 (amount realized) - $25,000 (basis in stock)] on the sale. The stock transaction would not affect Swan.

5-16 b.

2002 Annual Edition/Solutions Manual The transaction would constitute a complete termination redemption and result in a capital gain of $375,000 [$400,000 (amount realized) - $25,000 (basis in stock)] to Roberta. Lori would become the sole shareholder as a result of the redemption. Swan would reduce its E & P by $350,000 [$700,000 (E & P at time of redemption) X 50% (interest redeemed)].

pp. 5-9, 5-13, and Chapter 4 38. a. The redemption will qualify as a partial liquidation under 302(b)(4) as to Helen but not as to Yellow Corporation. Section 302(b)(4) permits sale or exchange treatment only to noncorporate shareholders. The distribution should qualify as a partial liquidation as to Helen because it is a genuine contraction of a part of the business of White Corporation. Since the genuine contraction test is satisfied, there is no need to meet the 5-year requirement under the termination of an active business test. Partial liquidation redemptions may be pro rata with respect to the shareholders. Helen has a capital gain of $1,800,000 [$2,000,000 (insurance proceeds) $200,000 (basis in 20 shares of stock in White Corporation)]. Yellow Corporation will have dividend income of $2,000,000 (insurance proceeds), reduced by the dividends received deduction of $1,600,000 (80% X $2,000,000). The basis of the redeemed shares ($200,000) is added to the basis of Yellows remaining 80 shares of White stock. White Corporation will have a taxable gain on the farm machinery of $3,000,000 [$4,000,000 (insurance proceeds) - $1,000,000 (basis in the farm machinery)]. E & P for White Corporation will be increased $3,000,000 (gain on the farm machinery) and will be decreased $2,900,000 [10% X $9,000,000 E & P as of the date of the redemption (representing the partial liquidation to Helen), plus $2,000,000 (representing the dividend distribution to Yellow Corporation)]. b. The redemption will again qualify as a partial liquidation as to Helen but not as to Yellow Corporation. The distribution represents the termination of an active business that has been in existence for at least five years. White Corporation continues to manufacture widgets, a business that also has been in existence for at least five years. Helen will have a capital gain of $1,800,000 [$2,000,000 (fair market value of one-half of the farm machinery) - $200,000 (basis in stock)]. Helen will have a basis of $2,000,000 in the farm machinery. Yellow Corporation will have dividend income of $2,000,000 (fair market value of one-half of the farm machinery), reduced by the dividends received deduction of $1,600,000 (80% X $2,000,000). Yellow Corporation will have a basis of $2,000,000 in the farm machinery. The basis of the redeemed shares ($200,000) is added to the basis of Yellows remaining 80 shares of White stock. White Corporation will have a taxable gain of $3,000,000 [$4,000,000 (fair market value of the machinery) - $1,000,000 (basis in the machinery)]. E & P of White Corporation will be increased $3,000,000 and decreased $2,900,000 [10% X $9,000,000 E & P as of the date of the redemption (representing the partial

Corporations: Redemptions and Liquidations

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liquidation to Helen), plus $2,000,000 (representing the property dividend distribution to Yellow Corporation)]. c. The distribution will not qualify as a partial liquidation either to Helen or to Yellow Corporation. White Corporation has not engaged in the active conduct of two or more trades or businesses for at least five years. The distribution is, therefore, not pursuant to the termination of an active trade or business. The distribution is a dividend both to Helen and to Yellow Corporation. Helen and Yellow Corporation will each have a dividend of $2,000,000 (one-half of the fair market value of the machinery). Yellow Corporation will have a dividends received deduction of $1,600,000 (80% X $2,000,000). Helen and Yellow Corporation will each have a basis of $2,000,000 in the machinery. The two shareholders each will add the basis of the redeemed shares ($500,000) to that of their remaining shares of White stock. White Corporation will have a gain of $3,000,000 [$4,000,000 (fair market value of farm machinery) - $1,000,000 (basis in the farm machinery)], which will increase its E & P to $9,000,000. E & P of White Corporation will then be decreased $4,000,000, the fair market value of the machinery. d. The distribution will not qualify as a partial liquidation to Helen because White Corporation has not satisfied either the not essentially equivalent to a dividend requirement or the termination of an active business requirement. The stock it holds for investment purposes does not constitute a trade or business. Both Helen and Yellow Corporation will have dividend income of $250,000 representing one-half of the fair market value of the stock distributed to them by White Corporation. Yellow Corporation will have a dividends received deduction of $200,000 (80% X $250,000). Each shareholder will have a basis of $250,000 in the stock received. The two shareholders each will add the basis of the redeemed shares ($100,000) to that of their remaining shares of White stock. White Corporation will have a gain of $400,000 [$500,000 (value of the stock) $100,000 (basis in the stock)]. E & P of White Corporation will be increased $400,000 (gain) and decreased by $500,000 (the value of the stock). Note: White Corporations E & P has not been adjusted for any taxes due on the gain recognized in each of these solutions. pp. 5-10, 5-11, and Examples 14 to 16 39. The redemption qualifies under 303 to the extent of $100,000, the amount of death taxes and funeral and administration expenses. Since Debra owned a 20% or more interest in both Lark and Owl, the values of the two stocks can be combined to satisfy the 35% of adjusted gross estate test [i.e., ($150,000 + $250,000)/$900,000 = 44%]. The estates basis in the Lark shares is stepped-up to fair market value; thus, the estate has no gain or loss on this portion of the transaction [i.e., $100,000 (proceeds qualifying for 303 treatment) - $100,000 (estates basis in shares)]. To receive sale or exchange treatment on the $50,000 distribution for the remaining Lark shares, the transaction must qualify under the 302 redemption rules. If the estate is not deemed to own any additional Lark stock under the 318 attribution rules, this portion of the transaction

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2002 Annual Edition/Solutions Manual would qualify as a complete termination redemption. Assuming sale or exchange treatment is available, the estate would have no gain or loss [i.e., $50,000 (proceeds qualifying for 302 treatment) - $50,000 (estates basis in shares)]. If sale or exchange treatment is not available, the estate would have a $50,000 dividend. (In such case, the estates basis in the redeemed shares would presumably attach to the shares attributed to the estate under 318.) pp. 5-9, 5-12, and Examples 17 and 18

Corporations: Redemptions and Liquidations 40.

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Losses are not recognized in nonliquidating corporate distributions; thus, Red Corporation will not recognize the $200,000 loss inherent in the land distributed to the estate. Red Corporations E & P is reduced by $800,000 (limited to 20% X $4 million) as a result of the distribution. The estate will have a basis in the land equal to its fair market value, or $1,000,000. When it sells the land for $1,100,000, the estate recognizes a gain of $100,000. pp. 5-12 and 5-13 a. Ann would have a capital gain of $55,000 [$80,000 (amount realized) - $25,000 (basis in the 25 shares)]. The redemption qualifies as a disproportionate redemption. Ann had a 50% (50 shares/100 shares) ownership in Teal Corporation prior to the redemption and a 33.33% (25 shares/75 shares) ownership after the redemption. Both the 50% and the 80% [33.33% is less than 40% (80% X 50%)] tests are met. p. 5-8 and Example 10 E & P of Teal Corporation will be $90,000 after the redemption: $100,000 (accumulated E & P) + $20,000 (current E & P) - $30,000 [25% (the percentage stock redemption) X $120,000 (the balance in E & P)]. Example 20 Hoffman, Raabe, Smith, and Maloney, CPAs 5101 Madison Road Cincinnati, OH 45227 November 10, 2001 Loon Corporation 506 Wall Street Winona, MN 55987 Dear President of Loon Corporation: This letter is in response to your question concerning the reduction to Loon Corporation's E & P account as a result of a stock redemption that resulted in a sale or exchange for the shareholder. Loon Corporation had 500 shares of stock outstanding when it redeemed 50 shares for $90,000. Loon had paid-in capital of $300,000 and E & P of $400,000 at the time of the redemption. Our conclusion is based upon the facts as outlined in your November 1 letter. Any change in facts may cause our conclusions to be inaccurate. Loon Corporation would reduce its E & P account in the amount of $40,000 as a result of the redemption. This represents a 10% decrease in the amount of the E & P corresponding to the 10% stock redemption. The E & P account of a corporation is reduced by a stock redemption in an amount not in excess of the ratable share of the E & P of the distributing corporation attributable to the stock redeemed. The $50,000 balance paid for the stock would reduce paid-in capital. Should you need additional information or need to clarify our conclusion, do not hesitate to call on me. Sincerely, Marilyn C. Smith, CPA Partner

41.

b.

42.

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2002 Annual Edition/Solutions Manual TAX FILE MEMORANDUM DATE: FROM: SUBJECT: November 5, 2001 Marilyn C. Smith Loon Corporation

Today I talked to the President of Loon Corporation with respect to its November 1 letter. Loon Corporation had 500 shares of stock outstanding. It redeemed 50 shares for $90,000 when it had paid-in capital of $300,000 and E & P of $400,000. The redemption qualified for sale or exchange treatment for the shareholder. At issue: What is the reduction in Loon Corporation's E & P as a result of the redemption? Conclusion: The E & P account of a corporation is reduced by a qualifying stock redemption in an amount not in excess of the ratable share of the E & P of the distributing corporation attributable to the stock redeemed. Because Loon redeemed 10% of its stock, the reduction is 10% of the E & P account, or $40,000. Example 20 43. a. There are no tax consequences upon receipt of the preferred stock. It is a nontaxable stock dividend. However, the stock is classified as 306 stock. The basis of $60,000 in their original common shares is reallocated between the preferred and the common stock based on the fair market value of each. The basis is reallocated as follows: Fair market value of common: Fair market value of preferred: 200 X $400 100 X $200 = $ 80,000 = 20,000 $100,000

Basis of common: 80/100 X $60,000 = $48,000 Basis of preferred: 20/100 X $60,000 = $12,000 b. A sale of the preferred stock to Adam will produce $20,000 of ordinary income, which is the fair market value of the preferred stock on the date of distribution. However, the $20,000 will not be dividend income. Thus, the E & P of Blue Corporation will not be reduced. With respect to the remaining $15,000 of the sales price, $12,000 will reduce the basis of the preferred stock to zero (i.e., a return of capital), and the remaining $3,000 will be capital gain. The redemption is treated as a dividend distribution to the extent of Blue Corporations E & P on the date of the redemption; thus, Ahmad will have a dividend of $35,000. The $12,000 basis of the preferred stock is added back to the basis of Ahmads common stock. Blue Corporations E & P is reduced by $35,000 as a result of the distribution.

c.

Examples 21 and 22

Corporations: Redemptions and Liquidations 44.

5-21

Bob has a taxable dividend of $30,000. Pursuant to 304, the sale is treated as a redemption subject to 302. After the redemption, Bob continues to own all 1,000 shares of Goose stock [800 (shares directly owned) + 200 (shares owned constructively through his sole ownership of Heron)]. As a result, the redemption satisfies none of the qualifying stock redemption provisions. The amount of the dividend income is determined by the E & P of the acquiring corporation (Heron Corporation) and then by the E & P of the acquired corporation (Goose Corporation). The basis of the Goose Corporation stock to Heron Corporation is $5,000, the adjusted basis of stock in the hands of Bob. Bobs $5,000 basis in the sold Goose stock is added to his basis in the Heron Corporation stock. p. 5-17 and Figure 5-1

45.

a.

Oriole Corporation would have a recognized gain of $500,000 [$600,000 (fair market value) - $100,000 (basis)]. Under the general rule of 336(a), the land is treated as if it were sold for its fair market value. Since the land was a capital asset held for more than one year, Oriole has a $500,000 long-term capital gain. Oriole Corporation has a recognized long-term capital gain of $600,000 on the distribution. Under 336(b), when property distributed in a complete liquidation is subject to a liability of the liquidating corporation, the fair market value of that property is treated as not being less than the amount of the liability. Thus, the $100,000 adjusted basis in the land is subtracted from the $700,000 liability for a gain of $600,000.

b.

Example 25 and Chapter 2 46. A loss of $100,000 is recognized. Because the fair market value of the land exceeded its basis at the time of the 351 exchange, the built-in loss limitation does not apply. Further, the related-party loss limitation does not apply to a sale of property. The realized loss of $100,000 [$400,000 (selling price) - $500,000 (carryover basis)] is, therefore, fully recognized. pp. 5-20 to 5-23 and Figure 5-2 A loss of $60,000 is recognized. The land was built-in loss property when it was acquired in the 351 exchange. Further, the sale of the land occurred within 2 years of the exchange; thus, a tax avoidance purpose is presumed to exist. The realized loss of $100,000 [$400,000 (selling price) - $500,000 (carryover basis)] is disallowed to the extent of the $40,000 built-in loss [$460,000 (fair market value) - $500,000 (basis)]. Therefore, the recognized loss is $60,000 ($100,000 - $40,000). The 2-year presumptive rule can be overcome and all of the loss recognized if there is a clear and substantial business relationship between the contributed land and Grays business. The related-party loss limitation does not apply to a sale of property. Example 30 and Figure 5-2 No loss is recognized. The land is disqualified property that is distributed to a related party (both Arnold and Beatrice are considered 100% shareholders under the 267 attribution rules). Thus, the related-party loss limitation applies and none of the realized loss of $100,000 [$400,000 (fair market value) - $500,000 (carryover basis)] is recognized. Example 29 and Figure 5-2

47.

48.

5-22 49. a.

2002 Annual Edition/Solutions Manual If Pink Corporation distributes all the land to Maria, none of the loss on the distribution will be allowed since Maria is a related party and the land is disqualified property. If all the land is distributed to Paul, Pink Corporation will have a recognized loss of $1,200,000. The land was valued at more than its basis on the date of the transfer to Pink; thus, the built-in loss limitation does not apply. Because Paul is an unrelated party, the related-party loss limitation does not apply. Even though the distribution is pro rata, the property is disqualified property; thus, the loss on the distribution to Maria, a related party, would be disallowed. Of the $1,200,000 loss, 20%, or $240,000, would be allowed. For the reasons noted in b. above, the loss limitations do not apply to the distribution to Paul. In this case, 50% of the loss, or $600,000, would be disallowed. The property is disqualified property; thus, the loss on the distribution to Maria, a related party, would be disallowed. For the reasons noted in b. above, the loss limitations do not apply to the distribution to Paul. Because the property does not have a built-in loss on the date of the transfer to the corporation, the built-in loss limitation does not apply. Further, the related-party loss limitation does not apply to a sale of property. Upon the sale, Pink Corporation would recognize a $1,200,000 loss [$600,000 (amount realized) $1,800,000 (carryover basis)].

b.

c.

d.

e.

Pink Corporation should either distribute the land to Paul (option b.) or sell it and distribute the cash (option e.). pp. 5-20 to 5-23 and Figure 5-2 50. If the plan of liquidation is not adopted until 2002, there is no presumption that the transfer of the land was in furtherance of a plan to utilize the loss to neutralize a gain upon liquidation. Thus, Pink Corporation will be permitted to recognize the loss, assuming the property is not distributed to a related party, if the corporation can show a business reason for acquiring the land. If it cannot, the built-in loss of $300,000 on the land would be disallowed on a sale or a distribution. a. b. The answer would not change. The land is disqualified property. Since it was distributed to a related party, all the loss is disallowed. Because the property had a built-in loss of $300,000, that much of the loss will be disallowed unless Pink Corporation can show a business purpose in acquiring the land. Because the land was acquired more than two years ago, there is no presumption that the principal purpose was to generate a loss deduction upon liquidation. Thus, Pink Corporation may be permitted to recognize the entire $1,200,000 loss. The loss on the property distributed to Maria will be disallowed entirely because there is a distribution of disqualified property to a related party. If Pink Corporation cannot show a business purpose in acquiring the land, an additional $60,000 of the loss [$300,000 (built-in loss) X 20% (Paul's distribution)] will be disallowed. In this case, $180,000 of the loss would be allowed [$900,000 (post

c.

Corporations: Redemptions and Liquidations

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351 exchange loss) X 20% (Paul's distribution)]. If Pink Corporation can show a business reason (there is no presumption of a prohibited purpose), $240,000 of the loss would be allowed [$1,200,000 (total loss) X 20% (Pauls distribution)]. d. Here again, the loss on the distribution of disqualified property to Maria will be disallowed entirely. Of the remaining $600,000 loss, 50% of the built-in loss of $300,000, or $150,000, will also be disallowed if Pink Corporation cannot show a business purpose for the acquisition. If Pink Corporation can demonstrate a business purpose, $600,000 of the loss, or the portion pertaining to the distribution to Paul, would be allowed. If Pink Corporation cannot show a business purpose for the acquisition, the builtin loss of $300,000 would be disallowed. The remaining $900,000 loss would be allowed. If Pink Corporation can show a business purpose for the acquisition, the entire $1,200,000 loss would be allowed. The related-party loss limitation does not apply to a sale of property.

e.

Again, Pink Corporation should either distribute the land to Paul (option b.) or sell it and distribute the cash (option e.). pp. 5-20 to 5-23 and Figure 5-2 51. The tax results of these transactions to Helen are as follows: Helen may defer gain on the receipt of the notes to the point of collection under the installment method. Helen must allocate her $50,000 basis in the Purple Corporation stock between the cash and the installment notes. Using the relative fair market value approach, 20% [$100,000 (amount of cash)/$500,000 (total distribution)] of $50,000 (basis in the stock), or $10,000, is allocated to the cash, and 80% [$400,000 (FMV of the notes)/ $500,000 (total distribution)] of $50,000 (basis in the stock), or $40,000, is allocated to the notes. Helen must recognize $90,000 [$100,000 (cash received) - $10,000 (basis allocated to the cash)] in the year of the liquidation. Since Helen's gross profit on the notes is $360,000 [$400,000 (FMV of notes) $40,000 (basis allocated to the notes)], the gross profit percentage is 90% [$360,000 (gross profit)/$400,000 (FMV of notes)]. Thus, Helen must report a gain of $72,000 [$80,000 (amount of annual payment) X 90% (gross profit percentage)] on the collection of each note over the next five years. The interest element is accounted for separately.

Example 35 52. Magenta recognizes no gain on the distribution of assets to Fuchsia, its parent corporation. The land distribution to Marta results in a $25,000 nonrecognized loss [$50,000 (fair market value) - $75,000 (basis)] to Magenta.

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2002 Annual Edition/Solutions Manual Fuchsia recognizes no gain or loss in the liquidation, and it has a carryover basis of $620,000 in the assets received. Magentas tax attributes (e.g., E & P) carry over to Fuchsia. Fuchsias basis in the Magenta stock disappears. Marta recognizes a $20,000 gain [$50,000 (amount realized) - $30,000 (basis of stock)] in the liquidation, and she has a basis in the land of $50,000. Concept Summary 5-2

53.

Green Corporation recognizes no gain on the transfer of the land to satisfy its indebtedness to Orange Corporation. Transfers by a subsidiary corporation pursuant to a 332 liquidation are subject to the nonrecognition rules of 337. Orange Corporation, however, must recognize a gain of $50,000 [$500,000 (fair market value of the land) $450,000 (basis in the bonds)]. Examples 37 and 38 a. b. c. d. e. $0. 337 $0. 332 $90,000. Cardinal Corporations basis will carry over to Wren. $150,000. Cardinal Corporations basis will carry over to Wren. Cardinals E & P of $200,000 will carry over to Wren. 381 and Chapter 7

54.

pp. 5-26 and 5-28 55. Hoffman, Raabe, Smith, and Maloney, CPAs 5101 Madison Road Cincinnati, OH 45227 October 11, 2001 Quail Corporation 1010 Cypress Lane Community, MN 55166 Dear President of Quail Corporation: This letter is in response to your question as to the tax consequences to Quail Corporation if it liquidates its wholly owned subsidiary, Sparrow Corporation. Our conclusion is based on the facts as outlined in your October 5 letter. Any change in facts may cause our conclusion to be inaccurate. Because Sparrow Corporation is insolvent (its liabilities exceed the value of its assets), Quail Corporation would have an ordinary loss deduction for its worthless stock in Sparrow Corporation. The loss to Quail would be measured by the fair market value of Sparrow's net assets less Quail's basis in the Sparrow stock. Should you need additional information or need to clarify our conclusion, do not hesitate to call on me.

Corporations: Redemptions and Liquidations Sincerely, Larry C. Williams, CPA Partner TAX FILE MEMORANDUM DATE: FROM: SUBJECT: October 8, 2001 Larry C. Williams Quail Corporation

5-25

Today I talked to the President of Quail Corporation with respect to his October 5 letter. Quail Corporation is considering liquidating its wholly owned subsidiary Sparrow Corporation and wants to know the tax consequences upon a liquidation of Sparrow Corporation. At issue: What are the tax consequences of a liquidation of a wholly owned subsidiary when the subsidiary is insolvent? Conclusion: Because Sparrow Corporation is insolvent, 332 does not apply to a liquidation. Quail Corporation would have an ordinary loss deduction for its worthless stock in Sparrow Corporation under 165(g)(3). p. 5-26 and Chapter 3 56. a. b. Because Canary purchased 80% or more of Falcon's stock within a 12-month period, it could make a 338 election. p. 5-29 Canary Corporation should not elect 338. If 338 is elected, Falcon's assets (regardless of whether Falcon Corporation is liquidated) would receive a steppeddown basis. Falcon Corporation would recognize a loss on the deemed sale of its assets; however, the loss probably could not be utilized since Falcon undoubtedly has had tax losses, rather than taxable income, in the past. Further, since Falcon would be treated as a new corporation as a result of the 338 election, any loss carryovers (e.g., NOL) would disappear. pp. 5-29 and 5-30

The answers to the Research Problems are incorporated into the 2002 Annual Edition of the Instructor's Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION: CORPORATIONS, PARTNERSHIPS, ESTATES, AND TRUSTS.

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2002 Annual Edition/Solutions Manual NOTES