1

Chapter 4
Corporate Nonliquidating Distributions
Part I

A) Taxable Dividends -- A SH must include in gross income the amount of any distribution
from a corporation to the extent it is a dividend [§301].

Sec. 316(a) defines a dividend as a distribution of property made by a corporation out of its
earnings and profits (E&P).

Property includes money, securities, and other property except stock or stock rights of the
distributing corporation [§317(a)].

Distributions in excess of E&P are treated as a return of capital that reduces the SH’s basis in
the stock (not below zero), and distributions in excess of basis are capital gains (assuming the
stock is a capital asset to the SH).

B) E & P - A measure of a corporation’s economic ability to pay dividends to shareholders.

E&P consists of two parts: current E&P and accumulated E&P.

Current E&P is calculated annually and accumulated E&P is the sum of undistributed current
E&P balances for all previous years reduced by the sum of all previous current E&P deficits
and any distributions that have been made out of accumulated E&P.

Distributions come first from current E&P and then from accumulated E&P if current E&P is
insufficient.

1) Current E&P – Computed on an annual basis at the end of each tax year. Starting point is
the corporation’s TI or NOL for the year.

a) Income excluded from TI but included in E&P is added back. Although some income
is excluded from TI, any income received must be included in its E&P if it increases
the corporation’s economic ability to pay dividends. Thus, current E&P includes

(i) tax-exempt interest income,

(ii) nontaxable life insurance proceeds,
(iii) federal tax refunds,
(iv) etc.

b) Deductions that reduce TI but are not allowed in computing E&P must be added
back.

(i) DRD (b/c it doesn’t reduce the ability of the corporation to pay dividends).
 2

(ii) NOL carryovers, charitable contribution carryovers, and capital loss

carryovers that reduce TI for the current year. These losses or excess
deductions reduce E&P in the year they are incurred (see d below).

(iii) Amortization of organizational expense

c) Expenses and losses that are not deductible in computing TI but that reduce E&P.

(i) Federal income taxes are not deductible when computing TI but reduce the
corporation’s economic ability to pay dividends. They reduce E&P in the
year they accrue for accrual basis TPs and they reduce E&P in the year paid
for cash basis TPs.

(ii) Charitable contributions are fully deductible for E&P purposes w/out regard to
the 10% of TI limitation.

(iii) Life insurance premiums on policies that insure key employees are not
deductible when computing TI but are a reduction in current E&P (net of
increase in cash surrender value).

(iv) Capital losses in excess of capital gains are not deductible in computing TI but
are a reduction in current E&P.

(v) Nondeductible expenses related to the production of tax-exempt income are a

reduction in current E&P.

(vi) Losses on sales to related parties are not deductible in calculation of TI (§267)
but are a reduction in current E&P.

(vii) Nondeductible fines, penalties, and political contributions are deductible for
E&P purposes.

d) Accounting Method Adjustments -- Some deductions must be computed differently

for E&P purposes than they are for TI.

(i) Income deferred to a later year for calculation of TI but included in the current
year for E&P is added back to TI in the computation of E&P. This is
basically gains on installment sales that are deferred for the computation of
TI. These gains are not deferred for the calculation of E&P. The entire gain
on the installment sale must be included in current E&P in the year of sale
because it is an increase in the corporation’s economic ability to pay
dividends.
Note: Gain deferred in calculation of TI on a like-kind exchange is also
deferred for E&P purposes.
 3

The general rule is that gains and losses on property transactions are
recognized the same for E&P as for TI. The one exception is gains on
installment sales that are deferred for TI but recognized as a part of current
E&P.

(ii) Depreciation must be recomputed using the ADS of §168(g).

• Property expensed under §179 for TI is expensed ratably over a five-year
period for calculation of E&P (starting in the month in which it is deductible
for §179 purposes).
• Other personal property must be depreciated over the property’s class life
using S-L and half-year convention. Also, no bonus depreciation allowed for
E&P.
• Real property must be depreciated over a 40-year period for E&P using S-L
method and mid-month convention.

(iii) Corp must use percentage of completion method for E&P even if completed
contracts method used for TI.

(iv) Must use cost depletion for E&P even if percentage depletion used for TI.

(v) IDC must be capitalized and amortized over 60 months for E&P purposes.

2) Current E&P vs. Accumulated E&P --

a) Distributions are deemed to be from current E&P first and then from accumulated
E&P only if current E&P is insufficient [Reg. Sec. 1.316-2].

If current E&P is sufficient to cover all distributions made during the year, each
distribution is treated as a taxable dividend, even if there is a deficit in accumulated
E&P. Current E&P is computed on the last day of the tax year with no reductions for
distributions made during the year.

b) When distributions exceed current E&P, current E&P is allocated to those

distributions on a pro rata basis regardless of when during the year they were made.

c) Distributions in excess of current E&P come from accumulated E&P (if any) in
chronological order.

d) Distributions in excess of current and accumulated E&P are a return of capital and
reduce the sh’s basis in his/her stock. However, these distributions cannot create an
E&P deficit. Deficits arise only from losses.

Example: At the beginning of the year, Cole Corporation has $20,000 of accumulated E&P.
Cole’s current year E&P is $30,000. Cole distributes $20,000 to its sole shareholder, Bob, on
April 10. On July 15, Cole distributes an additional $25,000 to Bob. On August 1, Bob sells
 4

all of his Cole stock to Lynn. On September 15, Cole distributes $36,000 to Lynn. What are
the tax consequences of the distribution?

Distribution Current Accumulated Dividend Return of

Date Amount E&P E&P Income Capital

April 10 $ 20,000
July 15 24,000
September 15 36,000

Total $ 80,000

e) If the corporation has a current E&P deficit and an accumulated E&P deficit, none of
the distributions are treated as dividends. All distributions are treated as a return of
capital until the sh’s stock basis is reduced to zero. Any additional amounts are
treated a capital gain.

Example: At the beginning of the current year, Rosa Corporation has an accumulated E&P
deficit of $15,000 and Rosa’s current E&P deficit is $20,000. Rosa distributes $10,000 on July
1. What are the tax consequences of the distribution?

f) If the corporation has a current E&P deficit and a positive accumulated E&P balance,
it must net the two accounts at the time of the distribution to determine the amount of
the distribution that comes from E&P [Reg. Sec. 1.316-2(b)].

The deficit in current E&P that has accrued up through the day before the distribution
reduces the accumulated E&P balance on that date, based on an allocation based on
the number of days. If the balance remaining after the reduction is positive, the
distribution is a dividend to the extent of that positive balance. If the E&P balance is
zero or negative, the distribution is a return of capital.

Example: Rosa Corporation has a $15,000 accumulated E&P balance and a current E&P deficit
of $20,000. Rosa distributes $10,000 on July 1. What are the tax consequences of the
distribution?
 5

C) Distributions of Property -- §317(a) defines property as money, securities, and any other
property except stock or stock rights of the distributing corporation.

1) Consequences to SH

a) The amount of the distribution is the FMV of the property distributed determined on
the date of the distribution [§301(b)].

Liability assumed by the SH reduces in connection w/ the distribution, or to which the

distributed property is subject, reduces the distribution amount, but not below zero.

The distribution is dividend to the SH to the extent of the distributing corporation’s

E&P (as above).

b) The basis of property received is the property’s FMV. The basis is not reduced by
any liabilities assumed by the SH (or to which the property is subject [§301(d)].

c) The holding period for the distributed property starts the day after the distribution.

2) Consequences to the distributing Corporation

a) When a corporation has distributed appreciated property, the corporation must

recognize gain as though the property had been sold for its FMV.

However, losses are not recognized on distributions of property that has declined in
value [§311(a)].

If the distributed property is subject to a liability or the SH assumes a liability in

connection with the distribution, the property’s FMV for purposes of determining the
gain on the distribution is deemed to be no less than the amount of the liability
[§311(b)(2)].

b) Distributions of noncash property reduce E&P by the greater of the FMV or the E&P
adjusted basis1 of the property distributed, less any liability on the property [§312].

E&P is increased by any E&P gain recognized on appreciated property distributed as

a property dividend. E&P gain is the excess of the property’s FMV over its adjusted
basis for E&P purposes.

E&P is also reduced by the income taxes incurred on the gain recognized
[§S312(a)and (c)].

1
Remember a property’s E&P basis can be different from its tax basis b/c we use different methods of depreciation
for E&P purposes.
 6

Example: Brass Corporation distributes to its shareholder, Joan, property with a $25,000 tax
adjusted basis, a $22,000 E&P adjusted basis, and a $40,000 FMV. The property is subject to a
$12,000 mortgage, which Joan assumes. What are the tax consequences of the distribution?

D) Constructive Dividends -- is an indirect payment made to a SH w/out a formal dividend

declaration. Any economic benefit provided to a SH may be treated as a constructive
dividend.

Constructive dividends can be intentional or unintentional. Intentional efforts to avoid

dividend treatment may arise in an attempt to bail out a corporation’s E&P w/out subjecting
it to taxation at the SH level or to obtain a deduction at the corporate level for distributions to
SHs that s/n/b deductible.

1) Loans to SHs -- Loans to SHs may be considered disguised dividends unless they are
bona fide loans. To prove a loan is bona fide there must be evidence that the SH intends
to repay the loan.

If the corporation lends money to a SH and then at a later time cancels the loan, the
amount cancelled is treated as a distribution under §301.

If inadequate interest is charged on a loan from a corporation to a SH, interest will be

imputed on the loan. The corporation will have interest income and a nondeductible
distribution payment and the SH will have dividend income (to the extent of E&P) and he
or she may have an interest deduction for the deemed interest paid [§7872].

2) Excessive Compensation Paid to SH-Employees -- If a corporation pays excessive

compensation to a employee that is a SH, the excess amounts will be considered a
constructive distribution to the SH.

In such cases the constructive distributions are not deductible, but the amounts are still
taxable as ordinary income to the shareholder to the extent the corporation has adequate
E&P.

3) Excessive Compensation Paid to SHs for the Use of SH Property -- amounts deemed
excessive will be constructive distributions. Same treatment as excessive salary.

4) Corporate Payments for SH’s Benefit -- If a corporation pays a personal obligation of its
SH, the amount of the payment may be treated as a constructive distribution. This can
include unsubstantiated travel and entertainment expenses, club dues, and auto, airplane,
and yacht expenses related to the SH-employee’s personal use of the property.
 7

5) Bargain Purchase of Corporate Property -- Any discount given to a SH on the purchase

of corporate property may be a constructive distribution.

6) SH Personal Use of Corporate Property -- FMV of personal use of corporate property

may be constructive distribution to extent FMV of use exceeds amount paid by SH
Examples include personal use of corporation’s hunting lodge, yacht, or airplane.

Constructive distributions are treated the same as actual distributions. The constructive
distribution is taxable dividend to the extent of the corporation’s E&P.

E) Stock Dividends and Stock Rights -- Generally stock dividends are not taxable distributions.
In order to be tax free distributions, they must be pro rata distributions of stock or stock
rights, paid on common stock.

1) There are five exceptions where stock distributions may be taxed.

a) Any SH can elect to receive either stock of the distributing corporation or other
property (e.g., money).

b) Some SHs receive property and other SHs receive an increase in their proportionate
interests in the distributing corporation’s assets or E&P.

c) Some holders of common stock receive preferred stock and others receive additional
common stock.

d) The distribution is on preferred stock (unless it is merely a change in the conversion

ratio of convertible preferred stock made to take into account a common stock
dividend).

e) Convertible preferred stock is distributed unless it can be established that the

distribution will have no disproportionate effect.

2) Stock Dividends -- If a stock dividend is nontaxable:

a) The basis of the stock w.r.t. which the distribution was made must be allocated b/t the
old and new shares [§307(a)].

b) The holding period of the new shares includes the holding period of the old shares
[§1223(5)].

c) If the old and new shares are identical, the basis of each share is determined by
dividing the basis of the old shares by the total number of shares after the distribution.

d) If the old shares and the new shares are not identical, the allocation of the old shares’
basis is based on the relative FMV of the old and new shares on the distribution date.
 8

Example: Mark owns 1,000 shares of Axle Corporation common stock with a $60,000 basis.
Mark receives a nontaxable stock dividend payable in 50 shares of preferred stock. At the time
of the distribution, the common stock has a value of $90 per share and the preferred stock has a
FMV of $200 per share. What is Mark’s basis in the common and preferred shares?

3) Tax Free Stock Rights -- Generally, a distribution of stock rights is tax-free under §305
unless it changes or has the potential to change the shareholders’ proportionate interests
in the distributing corporation. Same exceptions for stock dividends above apply.

a) If the value of the stock rights is less than 15% of the value of the stock w.r.t. which
the rights were issued (i.e., the underlying stock), the basis of the stock rights is zero
unless the SH elects to allocate basis to those rights [§307(b)(1)]2.

Example: Linda owns 100 shares of Yale Corporation C.S. that has a $27,000 basis and a
$50,000 FMV. She receives 100 nontaxable stock rights with a $4,000 FMV. What is Linda’s
basis in the stock and the stock rights after the distribution?

Linda plans to sell the stock rights within the next few months. What can she do to minimize her
gain on the sale of the stock rights?

b) If the value of the stock rights is 15% or more of the value of the underlying stock,
the shareholder MUST allocate the basis of the underlying stock b/t the stock and the
stock rights.

Example: Kay owns 100 shares of Minor common stock with a $14,000 basis and a $30,000
FMV. Kay receives 100 stock rights with a total FMV of $5,000. What is Kay’s basis in the
stock rights and the stock after the distribution?

c) A SH cannot claim a loss for any basis assigned to stock rights when the rights lapse.
If the rights lapse, the allocated basis is added back to the basis of the underlying
stock.

2
If a TP plans to sell the rights, it may be desirable to allocate basis to the rights to minimize the recognized gain.
The election to allocate basis to the rights must be made in a statement attached to the SH’s return for the year in
which the rights are received. The allocation is based on the relative FMVs of the stock and the stock rights. The
holding period of the rights includes the holding period for the underlying stock [§1223(5)].
 9

If the SH exercises the stock rights, any basis allocated to the rights is added to the
amount the SH paid to exercise the rights for the new shares. The holding period for
any stock acquired with the rights begins on the exercise date [§1223(6)].

4) Effect on Corporation -- Nontaxable distributions of stock and stock rights have no

effect on the distributing corporation. The corporation does not recognize gain or loss on
the distribution and no adjustment to E&P is necessary [§§ 311(a) and 312(d)].

5) Taxable Stock Dividends and Stock Rights -- If a distribution of stock or stock rights is
taxable, the distribution amount equals the FMV of the stock or stock rights on the
distribution date.

The distribution is treated the same as any other property distribution.

a) It is dividend to the extent it is made out of E&P.

b) The basis of the stock or stock rights to the SH is its FMV.

c) The holding period of the stock or stock rights begins on the day after the distribution
date.

d) No basis adjustment is made to the underlying stock.

e) The distributing corporation recognizes no gain or loss.

f) The distributing corporation reduces its E&P by the FMV of the stock or stock rights
on the distribution date.
 10

Chapter 4
Corporate Nonliquidating Distributions
Part II -- Corporate Redemptions

A) Stock Redemptions -- Defined as a corporation’s acquisition of its own stock in exchange

for property. The property exchanged may be money, securities, or any other property the
corporation wants to use to acquire its own stock [§317].

The corporation may cancel the acquired stock, retire it, or hold it as treasury stock.

1) Why?

a) SH may want to withdraw but wants remaining SHs to have control (they may be
his/her family members). It may be a requirement that withdrawing SHs sell their
stock to the corporation.

b) SH may want to reduce his/her ownership in corp. by selling some stock, but may be
unwilling or unable to sell to outsider.

c) SH may want to withdraw assets prior to sale of business. Potential purchaser may
not want all the assets or may not be able to pay full value for the stock. Withdraw
allows purchaser to acquire remaining stock and business assets at a lower price.

d) Corp may be obligated to purchase stock of major SH from his estate or a beneficiary
after the SH’s death.

e) Mgmt may feel stock is selling at a low price, and that the best use of corporation’s
cash is to acquire some of the stock in the open market.

2) Two possible treatments of redemptions:

a) Treated as a sale or exchange – Capital gain

(i) same as if stock sold to third party

b) Treated as a dividend – ordinary income

B) Redemption qualifies as a sale/exchange if it satisfies any of these conditions.

1) Redemption is not essentially equivalent to a dividend [Sec. 302(b)(1)].

2) Redemption is substantially disproportionate [Sec. 302(b)(2)].

3) Redemption is a complete termination of SH’s interest in corp. [Sec. 302(b)(3)].

 11

4) Redemption is a partial liquidation of distributing corporation involving the redemption

of individual shareholder’s stock [Sec. 302(b)(4)].

5) Redemption is made in order to pay death taxes [Sec. 303].

C) Treatment of Qualifying Distributions by Shareholders

1) If the redemption qualifies for sale or exchange treatment the SH is treated as though he
or she sold the stock to an outside party. Gain or loss is equal to the FMV of the property
received less the SH’s adjusted basis for the stock surrendered.

2) The G/L is capital if the stock is a capital asset.

3) Sec. 267 disallows recognition of losses where a sale is made to a related party. If SH
owns >50%, the corporation is related and loss is disallowed [Sec. 267(a)(1) and (b)(2)].

4) The basis for the property received is its FMV and the holding period begins the day
following the exchange (redemption).

D) Treatment of Non- Qualifying Distributions by Shareholders

1) Any distribution that doesn’t satisfy any of the five requirements necessary for sale or
exchange treatment is treated as a property distribution under Sec. 301. Surrender of
shares is of no consequence.
2) If the corporation has sufficient E&P, distribution is dividend.
3) Excess distribution over corporation E&P is return of capital.
4) The basis of the surrendered shares is added to the basis of any remaining shares owned
by the shareholder.
5) If all of the SH’s stock has been redeemed, the basis of the redeemed shares is added to
the basis of the shares owned by those individuals whose ownership is attributed to the
SH under the constructive stock ownership rules [Reg. § 1.302-2(c)].

E) Treatment of Redeeming / Distributing Corporation

1) Sec. 311(b) corporation must recognize gain when it distributes appreciated property to
SH as nonliquidating distribution regardless of whether the redemption is treated as a
dividend or as an exchange at the SH level.

Gain = amount FMV exceeds basis.

2) Sec. 311(b)(2) provides that if property distributed is subject to liability or SH assumes

liability of distributing corporation, the FMV of the distributed property to the
distributing corporation is deemed to be at least equal to the amount of such liability.
Same rule as before. If liability > basis, FMV for purpose of g/l cannot be less than
liability.

3) LOSSES ARE NOT RECOGNIZED

 12

4) E&P increased by gain recognized (FMV less E&P basis), decreased by taxes on the
gain [§312(b)(1)].

5) If redemption treated as a dividend (i.e., it does not qualify for sale or exchange
treatment), the corporation adjusts E&P like before for a regular dividend. Decrease
E&P by the distribution amount (FMV of Dist. Prop. – any Liab)

6) If the redemption qualifies for sale or exchange treatment, E&P is reduced by the amount
of E&P attributable to the shares redeemed. Balance of dist is charged to distributing
corporation’s capital account [§312(n)(7)].

E&P reduction cannot exceed the amount of the redemption distribution.

Example: Kay Corporation has 100 shares outstanding, 40 of which are owned by Trey. Kay
has an E&P balance of $100,000. During the year, Kay redeemed all of Trey’s shares for
$50,000 in a redemption that qualifies for sale treatment. What is the adjustment to Kay
Corporation’s E&P?

Assume Kay redeemed Trey’s shares for $25,000. What is the adjustment to Kay Corporation’s
E&P?

7) Sec. 162(k)(1) disallows a deduction for redemption expenditures.

F) STOCK ATTRIBUTION RULES (SEC. 318)

1) FAMILY ATTRIBUTION -- A person is treated as owning the stock of his or her

spouse, children, grandchildren and parents. Not considered to own stock of brothers,
sisters or grandparents or other relatives (Sec. 318(a)(1)).

Stock once attributed to an individual is not further attributed from that individual to
another individual. Thus, stock attributed to one family member under the family
attribution rules cannot be reattributed from that family member to a second family
member.
 13

Example: Todd; his wife, Connie; their son, Sonny; and Todd’s father, Ralph, each own 25 of
the 100 outstanding shares of Pillar Corporation stock. How many shares are each deemed to
own under the family attribution rules?

2) Stock owned directly or indirectly, by a partnership is considered to be owned

proportionately by the partners. (Sec. 318(a)(2)(A))

However, stock owned by a partner is treated as owned in full by the partnership. (Sec.
318(a)(3)(A)).

3) Stock owned, directly or indirectly, by an estate or trust is considered to be owned

proportionately by the beneficiaries (Sec. 318(a)(2)(B)); but stock owned by or for a
beneficiary is treated as owned in full by the estate or trust (Sec. 318(a)(3)(B)).

4) Stock owned by a corporation is considered to be owned proportionately by any

shareholder owning (directly or indirectly) 50% or more of the corporation’s stock (Sec.
318(a)(2)(C)).

However, stock owned by a shareholder who owns (directly or indirectly) 50% or more
of a corporation is considered to be owned in full by the corporation (Sec. 318(a)(3)(C)).

5) Option attribution: In the case of options to acquire stock, the TP is considered as

owning such stock for purposes of the attribution rules (Sec. 318(a)(4)).

G) Redemptions Qualifying for Sale or Exchange Treatment

1) Sec. 302(b)(2) -- Substantially Disproportionate Redemptions

If a stock redemption qualifies as substantially disproportionate under Sec. 302(b)(2),

then the redemption qualifies for sale/exchange treatment. Code provides a safe haven
for capital gain treatment.

A redemption is “substantially disproportionate” w.r.t. a SH if his ownership interest in

the corporation is significantly reduced.

Statutory requirements are:

 14

a) The sh must own less than 50 percent of the total combined voting power of all
classes of voting stock immediately after the redemption. (Sec. 302(b)(2)(B)

b) The ratio of the sh’s holdings of voting stock immediately after the redemption to all
voting stock outstanding at that time must be less than 80 percent of the same ratio
before the redemption (Sec. 302(b)(2)(C)).

c) The ratio of his holdings of common stock (whether voting or not) immediately after
the redemption to all common stock outstanding at that time must be less than 80
percent of the same ratio before the redemption (Sec. 302(b)(2)(C)).

These tests are applied mechanically to each sh individually.

Sec. 318 attribution rules apply.

To qualify as substantially disproportionate, a redemption cannot be part of a plan whose

purpose is a series of redemptions that, in total, will not be substantially disproportionate
(Sec. 302(b)(2)(D)).

2) Sec. 302(b)(3) -- Complete Termination of a SH’s Interest

Provides sale treatment for sh whose stock is redeemed by a corp “if the redemption is in
complete redemption of all the stock of the corp. owned by the sh.”

Meets same requirements as above (obviously the sh owns less than 50% and less than
80% of previous) but this is for redemption of solely nonvoting stock in complete
termination of interes, and for dist. that terminates sh’s interest but does not qualify as
substantially disproportionate b/c of the family attribution rules.

If sh’s interest in corp is completely terminated, the family attribution rules of Sec. 318
can be waived (Sec. 302(c)(2)). Therefore, outside family members can still continue
ownership.

To waive family attribution of 318, the following rules must be satisfied:

a) The sh must not retain any interest in the corp after the redemption except as a
creditor. This includes any interest as an officer, director, or employee (Sec.
302(c)(2)(A)(i))

b) The sh must not acquire any such interest (other than stock acquired by bequest or
inheritance) for at least ten years for the date of the redemption (Sec.
302(c)(2)(A)(ii)).

c) The sh must file an agreement with the Treasury that he or she will notify the IRS if
any prohibited interest is acquired (Sec. 302(c)(2)(A)(iii)).
 15

Waiver of family attribution rules does not apply if:

(i) Any part of the stock redeemed was acquired, directly or indirectly, from a
related person w/in 10 years of the recdemption (Sec. 302(c)(2)(B)(i)).

Prevents sh from giving stock to son and then getting son to redeem stock at
capital gain treatment.

(ii) Any related person owns stock that was acquired within the previous ten years
from the redeeming sh unless the stock so acquired also is redeemed in the
same transaction (Sec. 302(c)(2)(B)(ii)).

Prevents sole sh from giving half of his stock to his wife and then having the
corp redeem all of his remainings shares at capital gain treatment.

3) Sec. 302(b)(1) -- Redemptions not essentially equivalent to a dividend.

Generally redemptions where sh continues to maintain voting control are not considered
to result in a meaningful reduction in the sh’s interest and do not qualify for sale
treatment

Resolved on facts and circumstances basis.

Sh’s basis in redeeming corp must be meaningfully reduced (us v. Davis, 397 US 301
(USSC 1970)).

Stock attribution rules apply.

4) Sec. 302(b)(4) -- Partial liquidations

According to Sec. 302(e), a dist qualifies as a partial liquidation if it is:

a) Dist that is not essentially equivalent to dividend that occurs within the taxable year
in which a plan of partial liquidation is adopted, or within the succeeding taxable year

b) A dist that is attributable to the termination of one of a corporation’s businesses

where the business has been actively conducted by the corp for at least five years
prior to the dist, and where the corp continues to conduct a business that it has
actively conducted for the past firve years (Sec. 302(e)(2).

IRS has ruled that using proceeds from sale of investments or excess inventory for a
redemption will not qualify.

Only applies to noncorporate shareholders. Sec. 302(b)(4) Title: Redemption from

noncorporate shareholder in partial liquidation. “Subsection (a) shall apply to a
 16

distribution if such distribution is (A) in redemption of stock held by a shareholder

who is not a corporation,…”

5) Sec. 303 -- Redemptions to pay death taxes

Stock may be closely held and not easily marketable.

Allows estate to obtain cash from redeeming corp to pay estate taxes without having to
sell shares to outsiders.

May not qualify under Sec. 302(b) b/c of stock attribution rules.

Redemption of stock that was included in a decedent’s gross estate for federal estate tax
purposes shall be treated as a sale of stock by the sh if:

a) The value of the redeeming corp’s stock that was included in the gross estate of the
decedent must be more than 35 percent of the adjusted gross estate. (can be more than
two corps if sh owns more than 20%).

b) Sec. 303 applies to a dist by a corp only to the extent that the recipient sh’s interest in
the property acquired from the decedent is reduced by the payment of taxes and other
expenses. Thus a sh who inherits stock as a specific legacy and is not liable for any
estate taxes or admin. exp. may not use Sec. 303 to obtain sale or exchange treatment
for a redemption of his/her stock.

c) Sec. 303 applies only to distributions made within certain time limits.

d) The maximum dist received by the estate and beneficiaries in redemption of their
stock that can qualify for sale treatment is the sum of all federal and state estate and
inheritance taxes, plus any interest due on these taxes, and all funeral and admin
expenses that are allowable as deductions on the federal estate tax return.

Generally, the basis of stock owned in a decedent’s estate is its FMV at date of death or
alternate valuation date.

Therefore, in a redemption to pay death taxes, the redemption price equals the basis of
the stock.

H) Preferred Stock Bailouts Scheme to obtain the benefits of a qualifying stock redemption
without the limitations.

Corp issues nontaxable (nonvoting) preferred stock dividend on common stock.

SH assigns portion of basis to the new preferred shares.
SH sells PS to a third party.
Doesn’t reduce SH’s percentage ownership in the corp.
No limitation on stock redemption.
 17

Bailout of corporate profits as capital gain.

1) Sec. 306 stock defined:

a) Stock (other than common stock issued w.r.t. common stock) received as a
nontaxable stock dividend.
b) Stock (other than common stock) received in a tax-free corporate reorganization, if
the effect of the transaction was essentially the same as the receipt of a stock
dividend, or if the stock was received in exchange for Sec. 306 stock.
c) Stock that has a basis determined by reference to the basis of Sec. 306 stock.
d) Stock (other than common stock) acquired in an exchange to which Sec. 351 applies
if the receipt of money w/h/b treated as a dividend.

Preferred stock issued by a corporation having no current or accumulated E&P in the year
the stock is issued cannot be §306 stock.

2) Treatment if §306 stock sold.

a) The amount realized is treated as ordinary income (i.e., it is a deemed dividend,

which currently receives preferential treatment) to the extent of the Sec. 306 taint.

Sec. 306 Taint – the amount that would have been a dividend to the SH if the SH
would have received money equal to the FMV of the stock instead of the stock itself.
Thus, the Sec.306 taint is determined by reference to the corporation’s E&P in the
year the §306 stock was distributed.

b) Any additional amounts received in excess of the Sec. 306 taint are treated as a return
of capital. Amount in excess of the SH’s basis in the Sec. 306 stock is treated as
capital gain.

c) If the return of capital (excess of the amount received over the amount treated as
ordinary income) is less than the SH’s basis in the §306 stock, the SH is not entitled
to a capital loss. Instead the unrecovered basis of the §306 stock is added back to the
Sh’s basis in her or her common stock.

d) Not a dividend from the corporation’s standpoint and has no effect on corp. E&P.

e) Doesn’t apply to sales that terminate the SH’s entire interest.

Example: Jimmy owns all 100 outstanding shares of Stetson Corporation’s stock. His basis in
those shares is $100,000. Stetson distributes 50 shares of nonvoting preferred stock to Jimmy as
a nontaxable stock dividend when its E&P was $150,000. The FMV of the preferred stock is
$50,000 and the FMV of the common stock is $200,000 on the distribution date. Jimmy’s basis
in his common stock is $100,000. What is Jimmy’s basis in the common and preferred stock
after the distribution?
 18

Jimmy subsequently sells the preferred stock to Homer for $50,000. What are the consequences
of the sale for Jimmy?

Assume that Jimmy instead sold the preferred stock to Homer for $100,000. What are the
consequences of the sale for Jimmy?

3) Treatment if the Sec. 306 stock is redeemed by the corporation.

a) The SH’s total amount realized is a dividend distribution under Sec. 301 to the extent
of E&P on the redemption date.

b) To extent the redemption exceeds E&P, it is a return of capital. If the return of

capital exceeds the SH’s basis, the SH has capital gain.

c) If the SH’s basis in the redeemed stock is not recovered, the unrecovered basis is
added to the basis of the SH’s common stock.

d) Sec. 306 doesn’t apply to a complete termination redemption or partial liquidation

redemption.

I) Redemptions Through Use of Related Corps

If sh owns a controlling interest in two or more corps, the redemption rules c/b circumvented.
The Sh could sell stock in one corp to the other and get cap gain treatment.

1) Sec. 304(a): If one or more persons are in control of each of each of 2 corps and in return
for property, one of the corps acquires stock in the other corp from the Person (or
persons) so in control, then such property shall be treated as a dist. in redemption of the
stock of the acquiring corporation.

2) To extent it’s treated under Sec. 301, the stock transferred from SH to corp is treated as a
contribution to capital.

3) SH contributes stock to acquiring corp in exchange for acquiring corp’s stock. in Sec. 351
transaction.
 19

4) Acquiring corp is treated as though the newly issued shares are redeemd from sh.

Transaction analyzed to see if it falls under redemption rules of Sec. 302(b).