FEDERAL CORPORATE TAX PROFESSOR STEVEN BANK

UNIVERSITY OF CALIFORNIA LOS ANGELES SCHOOL OF LAW

CHAPTER 1: DOUBLE TAXATION, DEBT VS. EQUITY

A corporation is treated as a ______________________________ taxable entity.

o This results in ________________________________ taxation: Earnings are taxed at the

corporate level and distributions to shareholders as dividends are also taxed.

Corporations are taxed differently from individuals.

o There is no _________________________________ preference for corporations, although

capital losses are still limited.

o Corporations can choose either a calendar or fiscal year for taxation, while individuals must

use the calendar year.

o Individuals are frequently under the cash method of accounting. Corporations are typically

required to use the ____________________________ method of accounting.

o Debt and equity (stock) are treated differently: Debt results in ________________________

payments, which are deductible, but ____________________________ payments are not

deductible. This means double taxation for equity and single taxation for debt. Businesses

would therefore like to recharacterize their equity as debt, rather than get nondeductible

dividends.

Distinguishing debt and equity

o Laundry list approach: Instrument is evaluated for whether it has more debt or equity

factors.

Factors:

Whether the contract is a legally enforceable instrument;

Whether the obligation is subordinate to or has precedence over other obligations

of the corporation;

o Typically, a stockholder is the residual claimant—whatever is left after paying

off all the creditors goes to the stockholders (debt is repaid first, preferred stock

second, common stock third);

o If a particular instrument entitles someone to be paid as part of the creditors

and before the residual claimant, it is more likely to be debt than equity;

Ratio of debt to equity;

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o If it is a thinly capitalized corporation, where most of the capital comes from

debt, it suggests that some of the debt may be equity.

Whether the debt is __________________________________ into the stock of the

corporation;

The relationship between the stock holdings of the corporation and the debt and

interest holdings of the corporation; If the debt and equity are held proportionally,

it looks more likely that the debt is really equity.

Other factors the IRS considers:

o The name given to the instrument (is it called debt);

o Whether there is an _____________________________ promise to pay (usually

the traditional definition of debt);

o Whether there is a maturity date (equity doesn't usually expire);

o Whether there is a right to enforce payment;

o Whether there is a right to participate in management;

Factors identify the level of risk or whether the instrument is likely to become debt or

stock upon certain occurrence

o Core ________________________ test: Looks to whether an independent third-party lender

would have loaned money on the same terms.

If debt has unreasonable terms (i.e., tend toward the equity side), court may say it is not

really debt

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CHAPTER 2: SECTION 351 EXCHANGES

Section 351 exchange

o Section 351 provides that non-recognition treatment (defer, rather than recognize

currently) to the shareholder and the corporation on a transaction between them under a

limited set of circumstances.

Requirements for non-recognition

o Shareholder must transfer _________________________ (e.g., money, securities, etc.), not

__________________________

Example 1: You form a corporation with a partner and want to contribute

only your labor (services). Receipt of stock is taxable to you as if it were

compensation.

Services can be converted to property (e.g., draft and contribute a business plan in

exchange for stock—that is "property")

o Transfer must be solely in exchange for _________________ (not cash)

o So if a taxpayer transfers property in exchange for cash or debt, it is a taxable transaction.

____________________ property (cash or other property) received in addition to stock,

is permitted but taxable.

Gain is recognized with respect to the boot property.

Losses are not recognized on receipt of boot.

Example 2: You contribute property worth $100 in exchange for $80 of stock

and $20 in cash. The $20 in boot is recognized, but not the $80 of stock.

Assumption of debt is not recognized as long as it is not done for

____________________________________ purposes and the amount of debt does not

exceed basis in the property contributed.

Example 3: You contribute property worth $100 that has $20 mortgage.

Corporation takes property subject to agreement to repay liability. Assumption

of debt would normally be treated as $20 in cash, but it is exempt under § 351.

Example 4: You take out a loan on property and then immediately contribute

it to a corporation. You keep the cash and the corporation takes the property

subject to debt. This is considered a tax avoidance purpose.

o Must receive enough stock to be in ___________________________

Control: 80% of voting stock and 80% of all other classes of stock

Control group: More than one person can group together and aggregate interests as

long as each contributes property and gets stock

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Previously owned stock can count toward 80% test.

Exception: Mere accommodation transfers are not permitted.

o If preexisting holder only contributes property to get a few shares to meet 80%

o Based on whether amount of stock received is small compared to prior holding

o Must be in control immediately after exchange

Immediate sale of stock after §351 exchange may violate this test

____________________________________________ doctrine: Decision to sell must be

disconnected from § 351 transaction

Example 5: You acquire stock in a § 351 transaction and then sold that stock

a nanosecond after the transaction. If those two transfers are part of the same

transaction (the same plan), courts will integrate them under the step

transaction doctrine. Courts will say that you never held the stock immediately

after the exchange, because as part of a pre-arranged deal you were always

going to sell it. You acquired enough to control but were always going to sell it,

so you never really held it.

Example 6: If however, some intervening event occurred between when you

acquired the stock and when you sold it, that might suggest that the two

transactions should be distinct transactions (i.e., that step transaction should

not apply—there was no plan). You will have satisfied the control immediately

after the exchange requirement under § 351 and then proceeded to engage in

another transaction.

Calculating basis when you have satisfied the requirements under § 351

o Shareholder's basis in stock = old basis + gain recognized –

_______________________________________

Example 7: You contribute property with a basis of $10 and a fair market

value of $100, you will hold the stock with a basis of $10.

o Corporation basis in contributed property = ______________________________________ +

gain recognized

Example 8: You contribute property with a basis of $10 and a fair market

value of $100, corporation holds the property with a basis of $10.

Exception: For loss property, corporation's basis is

_____________________________________________

Example 9: You contribute property that you bought for $100 that is now

worth $10. Corporation's basis is $10.

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Note that if both parties are domestic taxpayers, the shareholder can elect to take

fair market value basis in the stock and corporation can take carryover basis.

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CHAPTER 3: DISTRIBUTIONS OF CASH AND PROPERTY

Tax consequences of distribution for corporation

o Cash: Not deductible by the corporation

o Property: Must recognize gain for ___________________________________ property but

may not recognize loss property

Corporation recognizes gain as though corporation sold property to shareholder for its

__________________________________ value

Distribution of cash or property reduces a corporation's earnings and profits.

Tax consequences of distribution for recipients

o If earnings and profits are available, then distribution is taxable as a dividend to the

recipient, but a capital gains rates, if they are ______________________________dividends

o Qualified dividend income is income from a domestic corporation where the parties have

held it for the requisite amount of time and the income is considered net capital gains (i.e.,

subject to a reduced rate—the net capital gains rate).

Dividends are taxable as net capital gains

Disadvantage of dividends vs. capital gains

There is no basis _______________________________________ for qualified dividends.

The entire amount is taxable.

Example 10: If you sell stock for $100 and have basis of $10, then $90 of gain

is included in income. If you receive $100 in dividends, you will be taxed on the

full $100 even if you have $10 basis.

Dividends/net capital gains cannot be offset by ______________________________

o If corporation does not having earnings and profits, then distributions are return of

investment—treated as a recovery of capital

o Taxpayers may try to disguise dividends to eliminate second layer of tax

o Constructive dividends: Courts will construe that a distribution is really a dividend even

though it did not go through the corporate formalities of a dividend

o If corporation makes distribution that is in effect a dividend and there are earnings and

profits available, it will be taxed as a dividend.

o Compensation (salary): Deductible by corporation

o Corporation might attempt to pay out money to shareholder as "salary" rather than as a

dividend.

o There is a reasonableness requirement. If corporation paid out an amount as salary that

was far in excess of what others in a comparable position were paid, IRS might

recharacterize some of that salary as a dividend.

Advertising: Deductible by corporation and not included in income of recipient

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Example 11: If car dealer corporation gives all shareholders cars as a dividend,

it is double taxed. If corporation instead gives shareholders cars to drive as

advertising, it is deductible by the corporation and not included in income of

shareholder.

Loans: Not included in income of shareholder

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CHAPTER 4: DISTRIBUTIONS OF STOCK

Stock dividend or stock split: corporation may distribute a stock dividend (e.g., each share is

split in half and the price is divided between the two shares)

o Generally not taxable (§ 305)

o Basis is split between the split shares

Example 12: You have stock you bought for $50 and it is now worth $100.

After a stock split, you have two shares worth $50 each. Each share now has a

basis of $25. The aggregate gain is $50 both before and after split.

Section 305 Exceptions

o Distributions in ___________________________________________

Shareholders have choice to elect stock or cash or other property

Rationale: Shareholders have a meaningful change in ownership

Taxable even if all shareholders elect stock

o _________________________________ distribution

Some shareholders get stock and some get cash or other property (without election)

o Distributions of ________________________ stock and ________________________ stock

Some shareholders get common while others get preferred

Rationale: Because preferred stock is different in kind (preferred stockholders have a

prior and greater claim to the corporation's assets and earnings and profits than

common stockholders), there is a change in the ownership interest

o Distribution to preferred stockholders

Any distribution of stock to preferred stockholders is considered disproportionate and

therefore taxable because preferred stockholders have limited interest

o Distributions of ___________________________________ preferred stock

Only when it is likely that some shareholders will sell and some will keep stock and

convert it to common stock

o Deemed distribution

Corporation buys back stock of some shareholders but not others

If a series of distributions are made as part of a plan to give some shareholders cash and

others a greater interest in the corporation, it is deemed a distribution even if there was

no actual distribution

Preferred stock bailout

o Distribution is received and then immediately sold in attempt to avoid dividend rules

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o Under § 306, taxable under ordinary income rates if it is tainted stock

Tainted stock: Preferred stock that is distributed tax-free and then sold soon after

Rationale: Shareholder can sell preferred stock without diluting interest in the

underlying residual

o Exceptions to taxation on preferred stock bailouts (i.e., when we won't apply the § 306

taint)

Termination of a shareholder's interest or sale back in complete liquidation

_________________________________ transaction (e.g., recapitalization)

IRS determines it is not part of a ____________________________________ maneuver

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CHAPTER 5: REDEMPTIONS

Redemption: Corporation buys back shareholder's stock

o Looks similar to the distribution of a dividend, but is treated the same as a

____________________________ to an unrelated third party (i.e., entitled to basis offset,

capital loss offset)

Dividend vs. redemption

o Redemption requires a __________________________________________ reduction in the

shareholder's interest in the corporation

Interest in earnings and profits

Interest in voting

Interest in liquidation

Safe harbors for redemption

o Substantially _______________________________________ reduction

Shareholder's voting power must be reduced below 50%

Shareholder must own less than 80% of the voting power and less than 80% of the

common stock that shareholder held pre-redemption

Family attribution rules: Stock owned by close relatives counts toward the shares

relevant under the substantially disproportionate test

Includes spouse, children, grandchildren, and parents (not siblings)

Example 13: A owns 90 of the corporation's 300 shares, or 30% of the total

shares. Corporation redeems 20 of A's shares. A now owns 70 of 280 shares, or

25%. A has less than 50% of the total shares, but his post-redemption

ownership percentage is not less than 80% of his pre-redemption share. If,

however, the corporation redeemed 50 shares, A would own 40 of the 250

shares, or 16%, and would meet the substantially disproportionate test.

Example 14: A owns 90 of the corporation's 300 shares. The other 210 shares

are owned by A's spouse. On a redemption, there would be no meaningful

change in A's ownership percentage because A's spouse's shares are attributed

to A and count toward the shares relevant under the substantially

disproportionate test.

Exception: If shareholder completely terminates interest in corporation, the family

attribution rule is waived

o Cannot retain any interest in corporation except as _______________________

o Eliminates problems family attribution rule creates for closely held corporations

o Partial _______________________, or corporate contraction doctrine

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Size of the pie has dropped

There is 20% or greater reduction in gross revenues, employees, or net asset values of

the corporation—treated as meaningful reduction and not classified as a dividend

Example 15: Corporation owns a big building with aspects of the business on

all floors. The top floor burns down and the corporation does not rebuild it, but

instead contracts the size of the corporation. The corporation sends out some

of the insurance proceeds to shareholders to reflect the fact that the

corporation is now smaller. Those payments are not classified as dividends.

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CHAPTER 6: LIQUIDATIONS

Complete liquidation: Distribution of ___________________ assets of a corporation in complete

termination of all the stock of the corporation

Complete liquidation of a non-controlled subsidiary

o Tax treatment for shareholder (§ 331)

Treated as a sale of stock

Value of what shareholder receives is taxable to the extent it exceeds shareholder's

basis in her stock

Basis of property received is fair market value

o Tax treatment for corporation (§ 336)

Treated as selling property to shareholder and corporation can recognize gain or loss on

the property

o Limits on recognition of loss for corporations

Losses are disallowed for certain distributions to _________________________ persons

(for shareholder who holds 50% or more of the corporation's stock) if:

Distribution is non-_____________________

Example 16: Corporation has gain property worth 80% of corporation and loss

worth 20%. Corporation has 80% shareholder and 20% shareholder.

Distribution has to be pro rata, with 80% of loss property and gain property

going to the majority shareholder.

Or, if the property had been acquired in a __________________________________

transaction in the last five years (i.e., property constitutes disqualified property)

This an anti-loss stuffing rule (concern that liquidation is a sham)

Pre-contribution loss property

Complete liquidation of a controlled subsidiary (§ 332)

o Parent does not recognize a gain or loss, and takes assets of the subsidiary with a carryover

basis

o Parent corporation must hold 80% or more of by vote and value of stock

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CHAPTER 7: CORPORATE ACQUISITIONS

Ways to transfer corporation without liquidation

o Asset sale

Corporation sells all assets to buyer, which produces a gain to the corporation, and

distributes cash to shareholders in liquidating distribution, which produces a gain for the

shareholders

Double tax: seller corporation and shareholders must recognize gains

Buyer gets a _______________________________________________ in the assets.

Buyer holds the assets at fair market value and can depreciate from a high basis

Buyer must _________________________ the purchase price among the assets.

o Stock sale

Shareholders as a group sell stock to buyer as a group for cash

One layer of tax for seller: Gain to shareholders, but not corporation

Corporation remains intact and becomes subsidiary of new buyer.

Basis: Buyer holds assets of corporation at same basis as when they were owned by

seller

Nothing happened; No step up in basis to fair market value

Advantageous for seller, but not buyer

How to solve this? Controlled subsidiary can make § 338(h)(10) election

Buyer can acquire stock and get stepped up basis in assets

There is no additional tax at the corporate level, so no double tax

Under § 336(e) you could do the reverse and treat an asset sale as a stock sale

o Acquisition expenses (e.g., legal fees, investment banking fees)

o Must ______________________________________, rather than currently deduct, expenses

o Add expenses to basis and recover at sale or over time

o Tax-free reorganization

Merger or consolidation or acquisition of all property of corporation in exchange for

stock rather than cash

No real cashing out, so taxation deferred to a later point in time

Must comply with set of technical rules

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CHAPTER 8: SUBCHAPTER S CORPORATIONS

An eligible corporation formed under state law may make a subchapter S election.

S corporations are eligible for pass-through tax treatment (i.e., tax consequences flow through

to the shareholders of the S corporation).

o Tax benefits and burdens are allocated to shareholders pro rata to their ownership interest.

o Corporation's income is divided among shareholders and shareholders must report it on

their returns regardless of whether a distribution is made.

o S corporations avoid double tax.

Requirements to qualify for subchapter S election

o Must be eligible entity

_________________________________ corporation or limited liability company that

has checked the box for corporate status for federal tax purposes (no foreign entities)

o Must have only ___________________________ of stock (e.g., can't have preferred stock)

Profits and losses must be allocated to shareholders in proportion to that one class of

stock.

o Must have no more than __________________ shareholders

Spouses and all members of a family (within six generations of a common ancestor) are

treated as one shareholder.

o Shareholders must be _____________________________________

Non-resident aliens are excluded.

Gains and losses generally pass through to shareholders.

Loss limitation rules

o Losses limited to ________________________________________ (outside basis)

Example 17: If you invest $100 in stock of a corporation, corporation can only

allocate $100 of losses to you.

Unused losses can be carried forward indefinitely until the shareholder has sufficient

basis.

A shareholder's basis can increase if the shareholder is allocated gains.

o At-risk rules

A shareholder can only take losses to the amount she has at ______________________

(e.g., the personal funds invested and the adjusted basis of unencumbered property;

not non-recourse debt).

o Passive-activity loss limitation rules

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If a shareholder has not materially participated in the activity, losses are considered

passive-activity losses.

Passive-activity losses cannot be passed through unless there are

_____________________________________________________.

Cash distributions

o Cash distributions are only taxed to the extent they exceed basis

Shareholders reported the gains when the money was earned, even if it was not

distributed. Cash distributions simply reduce the shareholders' basis. Any cash that

exceeds basis is taxed.

o Exceptions

Earnings and profits from before corporation made the subchapter-S election

_________________________________ property distributed to shareholders

S corporation has to recognize gains as if the property was sold to the shareholder

The shareholder reduces basis in the stock by fair market value of property

Exam Tip 1: If you are asked to formulate the best entity for a particular venture, consider an S corporation if the parties are concerned about double taxation.

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