CHAPTER 5

CORPORATIONS: REDEMPTIONS AND LIQUIDATIONS

SOLUTIONS TO PROBLEM MATERIALS

Problems

30. a. 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). Teal’s 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.

b. 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 interest in Teal Corporation, the 80% dividends received deduction is applicable. Grace Corporation would have a basis of $250,000 in the property.

c. 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.

d. 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.

e. 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 (option b). Teal Corporation itself would have no preference because the tax consequences to it are the same under each option.

pp. 5-3 to 5-5 and 5-12

31. 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.

b. Julio's tax liability would be $38,600, computed as follows: $100,000 (dividend) X 38.6% = $38,600.

Example 2

32. 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.

b. 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

33. 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%).

b. 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 $38,600 ($100,000 X 38.6%).

c. The preferred outcome in this situation is that which provides sale or exchange treatment (part a). With a qualifying stock redemption, Julio’s tax liability is $26,600 less ($38,600 - $12,000) than if the redemption is treated as a dividend.

Example 3

34. 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%).

b. 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.

Chapter 2 and Example 4

35. a. Beatrice owns 655 shares, 300 shares directly and 355 shares indirectly, in Silver. Beatrice constructively owns the stock of her husband (120 shares), daughter (80 shares), grandson (50 shares), and 70% of the 150 shares, or 105 shares, owned by Maroon Corporation.

b. 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 550 shares, 300 shares directly and 250 shares owned by her husband (120 shares), daughter (80 shares), and grandson (50 shares).

c. Beatrice would now own 675 shares in Silver, the 655 shares as computed in part a. above plus 20 shares as a result of her 20% Yellow Partnership interest [100 (shares owned by Yellow Partnership) X 20% (Beatrice’s interest in the partnership)].

Exhibit 5-1

36. a. All of the Hawk Corporation stock owned by Vulcan Corporation is deemed to be owned by Shonda. Therefore, Shonda must report the $60,000 as dividend income. The redemption does not qualify as a not essentially equivalent redemption. After the redemption, Shonda owns 53% of the stock of Hawk [95 (Vulcan shares deemed owned by Shonda) ÷ 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 requirements for a disproportionate redemption or complete termination redemption. pp. 5-5 to 5-9 and Example 7

b. The basis in the 20 shares redeemed attaches to Vulcan’s basis in the Hawk Corporation stock it owns. p. 5-7 and Footnote 7

c. Since the redemption is treated as an ordinary dividend distribution, Hawk’s E & P is reduced to $140,000 ($200,000 - $60,000). Chapter 4

37. Hoffman, Raabe, Smith, and Maloney, CPAs
5191 Natorp Boulevard

Mason, OH 45040

May 10, 2002

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 Lori’s 100 shares. Prior to the redemption, you had a 30% ownership [20% (direct ownership) + 10% (Lori’s 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 + Lori’s 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

TAX FILE MEMORANDUM

DATE: May 8, 2002

FROM: Marilyn C. Jones

SUBJECT: Lana Pierce

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. Lana’s 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 Lori’s 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, 5-9, and Exhibit 5-1

38. a. The redemption cannot qualify as a complete termination redemption. Jacque is deemed to own Monique’s 800 shares or 67% (800/1,200) of the remaining shares outstanding. The family attribution waiver does not apply because Jacque holds a prohibited interest in Thrush Corporation (i.e., directorship) immediately after the redemption.

b. The redemption can qualify as a complete termination redemption. Monique’s position as a director does not constitute a prohibited interest for Jacque. Thus, if the other requirements for the family attribution waiver are satisfied (e.g., Jacque files the required agreement with the IRS), the redemption completely terminates Jacque’s ownership interest in Thrush.

c. The redemption cannot qualify as a complete termination redemption. To qualify for the family attribution waiver, the former shareholder cannot acquire a stock ownership interest in the corporation (other than by bequest or inheritance) during the 10 years following the redemption.

p. 5-9 and Examples 12 and 13

39. 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.

b. 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

40. a. To qualify as a partial liquidation, the distribution must be either not essentially equivalent to a dividend or pursuant to the termination of an active business. Further, the distribution must be pursuant to a plan and made within the plan (or succeeding) year. Assuming the plan and timing requirements are satisfied, the redemption will qualify as a partial liquidation as to Walt but not as to Yellow Corporation. The distribution qualifies as a partial liquidation as to Walt because it represents the termination of an active business that has been in existence for at least five years. White Corporation continues to operate the furniture division, a business that also has been in existence for at least five years. A partial liquidation can be pro rata with respect to the shareholders. The distribution does not qualify as a partial liquidation as to Yellow Corporation because such treatment is limited to noncorporate shareholders.

Walt will receive sale or exchange treatment on the redemption resulting in a capital gain of $1,020,000 [$1,500,000 (amount realized) - $480,000 (basis in stock redeemed)].

Yellow Corporation will have dividend income equal to the entire distribution received, or $1,500,000. Because Yellow will have a dividends received deduction of $1,200,000 ($1,500,000 X 80%) with respect to the redemption, only $300,000 of the distribution from White will be taxed. The $600,000 basis in the White Corporation stock redeemed attaches to Yellow’s basis in its remaining shares of White stock.

b. The redemption may qualify as a partial liquidation as to Walt but not as to Yellow Corporation. Since White has not operated the furniture division for at least five years prior to the redemption, the distribution will not qualify as the termination of an active business. Therefore, to qualify as a partial liquidation, the distribution must not be essentially equivalent to a dividend. This requires a genuine contraction of White Corporation’s business, a determination that is based on a facts and circumstances basis. White Corporation would be advised to seek a favorable ruling from the IRS as to tax treatment of the distribution to Walt. As discussed in part a. above, partial liquidation treatment is not available to corporate shareholders such as Yellow Corporation.

If the distribution does represent a genuine contraction of White Corporation’s business, Walt will receive sale or exchange treatment on the redemption resulting in a capital gain of $1,020,000 [$1,500,000 (amount realized) - $480,000 (basis in stock redeemed)]. If the distribution does not qualify as a partial liquidation, Walt will have dividend income equal to the entire distribution received, or $1,500,000. In that case, the $480,000 basis in the White Corporation stock redeemed attaches to Walt’s basis in his remaining shares of White stock.

Yellow Corporation will have dividend income equal to the entire distribution received, or $1,500,000. Because Yellow will have a dividends received deduction of $1,200,000 with respect to the redemption, only $300,000 of the distribution from White will be taxed. The $600,000 basis in the White Corporation stock redeemed attaches to Yellow’s basis in its remaining shares of White stock.

pp. 5-10 and 5-11

41. 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 estate’s 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 (estate’s 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 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 (estate’s basis in shares)]. If sale or exchange treatment is not available, the estate would have a $50,000 dividend. (In such case, the estate’s basis in the redeemed shares would presumably attach to the shares attributed to the estate under § 318.) pp. 5-9, 5-11, 5-12, and Examples 17 and 18

42. Red Corporation will recognize a $300,000 gain [$1,000,000 (fair market value) - $700,000 (basis)] on the distribution of the land to the estate. Red Corporation’s E & P is reduced by $1,000,000 as a result of the distribution. The estate will recognize no gain [$1,000,000 (amount realized) - $1,000,000 (estate’s basis in stock)] on the redemption and it will have a basis in the land equal to its fair market value, or $1,000,000. When it sells the land for $900,000, the estate recognizes a loss of $100,000. pp. 5-11 to 5-13

43. 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

b. 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

44. Hoffman, Raabe, Smith, and Maloney, CPAs

5191 Natorp Boulevard

Mason, OH 45040

December 5, 2002

Crane Corporation 506 Wall Street Winona, MN 55987

Dear President of Crane Corporation:

This letter is in response to your questions concerning Crane Corporation’s tax consequences arising out of a redemption of its stock. Crane Corporation had 1,000 shares of stock outstanding when it redeemed 150 shares for $200,000. The shareholder received sale or exchange treatment on the redemption. Crane had paid-in capital of $500,000 and E & P of $900,000 at the time of the redemption. As a result of the redemption transaction, Crane Corporation incurred $30,000 of accounting and legal fees. Our conclusions are based upon the facts as outlined in your November 27 letter. Any change in facts may cause our conclusions to be inaccurate.

Crane Corporation would reduce its E & P in the amount of $135,000 as a result of the redemption. This represents a 15% decrease in the amount of the E & P corresponding to the 15% stock redemption. When a stock redemption results in sale or exchange treatment for the shareholder, the E & P account of a corporation is reduced in an amount not in excess of the ratable share of the E & P of the distributing corporation attributable to the stock redeemed. The $65,000 balance of the redemption distribution would reduce the paid-in capital of the corporation.

No deduction is allowed for expenditures incurred by a corporation in connection with the redemption of its stock. As such, none of the $30,000 of accounting and legal fees is deductible.

Should you need additional information or need to clarify our conclusions, do not hesitate to call on me.

Sincerely,

Astia Jackson, CPA Partner

TAX FILE MEMORANDUM

DATE: December 2, 2002

FROM: Astia Jackson

SUBJECT: Crane Corporation

Today I talked to the President of Crane Corporation with respect to its November 27 letter. Crane Corporation had 1,000 shares of stock outstanding. It redeemed 150 shares for $200,000, when it had paid-in capital of $500,000 and E & P of $900,000. The redemption qualified for sale or exchange treatment for the shareholder. Crane incurred $30,000 of accounting and legal fees with respect to the redemption transaction.

At issue: What is the reduction in Crane Corporation's E & P as a result of the redemption? Also, are the redemption expenditures deductible by Crane?

Conclusion: Under § 312(n)(7), 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. Since Crane Corporation redeemed 15% of its stock, the reduction in E & P is 15% of the E & P account, or $135,000. Section 162(k) specifically disallows the deductibility of redemption expenditures. As such, none of the $30,000 of accounting and legal fees is deductible by Crane.

p. 5-13

45. 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 stock and the common stock based on the fair market value of each. The basis is reallocated as follows:

Fair market value of common: 200 X $400 = $ 80,000

Fair market value of preferred: 100 X $200 = 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.

c. The redemption is treated as a dividend distribution to the extent of Blue Corporation’s 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 Ahmad’s common stock. Blue Corporation’s E & P is reduced by $35,000 as a result of the distribution.

Examples 21 and 22

46. 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. Bob’s $5,000 basis in the “sold” Goose stock is added to his basis in the Heron Corporation stock.

pp. 5-16, 5-17, and Figure 5-1

47. a. No loss is recognized by either Hawk Corporation or Michele. In the case of Hawk, the $20,000 loss realized [$180,000 (fair market value) - $200,000 (basis)] on the nonliquidating distribution of the land is disallowed under § 311(a). (Note: Hawk Corporation’s loss also would be disallowed under § 267.) As to Michele, her $40,000 loss realized [$180,000 (fair market value of land) - $220,000 (stock basis)] in the qualifying stock redemption is disallowed under § 267 because Michele and Hawk Corporation are related parties. Under that provision, Michele is deemed to own the stock of her sisters, or 100% of the Hawk stock in total. Her basis in the land is its fair market value, or $180,000.

b. Hawk Corporation recognizes no loss and Michele recognizes a $40,000 loss. In the case of Hawk, the $20,000 loss realized on the liquidating distribution of the land is not recognized under the related-party loss limitation of § 336(d)(1). The distribution of the land to Michele, a related party (under § 267), is not pro rata with respect to the shareholders. As to Michele, her $40,000 loss is recognized. Section 267 does not apply in the case of liquidating distributions. Her basis in the land is its fair market value, or $180,000.

pp. 5-12, 5-13, 5-19, 5-21, 5-24, and Example 24

48. a. Oriole Corporation would have 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.

b. 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.

Example 25 and Chapter 2

49. A loss of $20,000 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 $20,000 [$280,000 (selling price) - $300,000 (carryover basis)] is, therefore, fully recognized. pp. 5-20 to 5-23 and Figure 5-2

50. A loss of $15,000 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 $20,000 [$280,000 (selling price) - $300,000 (carryover basis)] is disallowed to the extent of the $5,000 built-in loss [$295,000 (fair market value) - $300,000 (basis)]. Therefore, the recognized loss is $15,000 ($20,000 - $5,000). The 2-year presumption rule can be overcome and all of the loss recognized if there is a clear and substantial business relationship between the contributed land and Gray’s business. The related-party loss limitation does not apply to a sale of property. Example 30 and Figure 5-2

51. 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 $20,000 [$280,000 (fair market value) - $300,000 (carryover basis)] is recognized. Example 29 and Figure 5-2

52. a. If Pink Corporation distributes all the land to Maria, none of the $1,200,000 loss realized [$600,000 (fair market value) - $1,800,000 (basis)] on the distribution will be recognized since Maria is a related party and the land is disqualified property.

b. 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.

c. 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% (Paul’s interest), or $240,000, would be allowed. For the reasons noted in option b. above, the loss limitations do not apply to the distribution to Paul.

d. In this case, 50% of the $1,200,000 realized 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. The remaining $600,000 loss will be recognized. For the reasons noted in option b. above, the loss limitations do not apply to the distribution to Paul.

e. 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 the entire $1,200,000 loss.

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

53. a. The answer would not change. The land is disqualified property that is distributed to a related party; thus, the entire $1,200,000 loss realized is disallowed under the related-party loss limitation.

b. The property had a built-in loss of $300,000 [$1,500,000 (fair market value) - $1,800,000 (basis)] when it was transferred to Pink Corporation. Further, the transfer occurred within 2 years of the date the plan of liquidation was adopted. Unless Pink can rebut the presumption of a tax avoidance purpose for the transfer, the built-in loss of $300,000 is disallowed. The remaining $900,000 loss will be recognized. Because Paul is an unrelated party, the related-party loss limitation does not apply to a distribution to him. If Pink Corporation can establish a business reason for the transfer of the property to the corporation and rebut the 2-year presumption rule, the entire $1,200,000 loss would be recognized.

c. The loss on the property distributed to Maria, or $960,000, will be disallowed entirely because it is a distribution of disqualified property to a related party. Unless Pink Corporation can rebut the presumption of a tax avoidance purpose for the transfer, an additional $60,000 of the loss [$300,000 (built-in loss) X 20% (Paul’s distribution)] will be disallowed. As a result, $180,000 of the loss will be recognized [$900,000 (post-transfer loss) X 20% (Paul’s distribution)]. If Pink Corporation can rebut the 2-year presumption rule, $240,000 of loss would be recognized [$1,200,000 (total loss) X 20% (Paul’s distribution)].

d. The loss on the distribution of disqualified property to Maria, or $600,000, will be disallowed. Of the remaining $600,000 loss, 50% of the built-in loss of $300,000, or $150,000, will be disallowed unless Pink Corporation can demonstrate a business purpose for the transfer. If Pink can rebut the 2-year presumption rule, $600,000 of the loss, or the portion pertaining to the distribution to Paul, would be recognized.

e. If Pink Corporation cannot show a business purpose for the transfer, the built-in loss of $300,000 would be disallowed. The remaining $900,000 loss would be recognized. If Pink can rebut the 2-year presumption rule, the entire $1,200,000 loss would be recognized. The related-party loss limitation does not apply to a sale of property.

Pink Corporation should either distribute the land to Paul (option b.) or sell it and distribute the proceeds (option e.).

pp. 5-20 to 5-23 and Figure 5-2

54. The tax results of these transactions to Helen are as follows:

1. 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

55. 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.

Fuchsia recognizes no gain or loss in the liquidation, and it has a carryover basis of $620,000 in the assets received. Magenta’s tax attributes (e.g., E & P) carry over to Fuchsia. Fuchsia’s 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

56. 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

57. a. Wren Corporation recognizes no gain (or loss) on its liquidation under § 337. The liquidation meets the requirements of § 332. Since the Wren stock was acquired three years ago, a § 338 election is not available to Cardinal.

b. Cardinal Corporation recognizes no gain (or loss) on the liquidation under § 332.

c. Cardinal Corporation takes a carryover basis in the assets, or $900,000. Cardinal’s basis in the Wren stock disappears. As noted in part a. above, a § 338 election is not available to Cardinal.

d. Cardinal Corporation acquires Wren Corporation’s E & P of $500,000 and net operating loss carryover of $120,000 under § 381.

pp. 5-26, 5-28, and Chapter 7

58. Hoffman, Raabe, Smith, and Maloney, CPAs

5191 Natorp Boulevard

Mason, OH 45040

October 11, 2002

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.

Sincerely,

Larry C. Williams, CPA Partner

TAX FILE MEMORANDUM

DATE: October 8, 2002

FROM: Larry C. Williams

SUBJECT: Quail Corporation

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 would not apply to the 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

59. a. Because Canary purchased 80% or more of Falcon's stock within a 12-month period, it could make a § 338 election. p. 5-29

b. Canary Corporation should not elect § 338. If § 338 is elected, Falcon's assets (regardless of whether Falcon Corporation is liquidated) would receive a stepped-down 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 2003 Annual Edition of the Instructor's Guide with Lecture Notes to Accompany West Federal Taxation: Corporations, Partnerships, Estates, and Trusts.
NOTES