1. Amended Revenue Ruling 68-55 X Corp Y Corp Asset I FMV = $22K Basis = $52k LT Capital Asset Asset II FMV = $33K Basis = $53k ST Capital Asset Asset III FMV = $55K Basis = $25k Ordinary Income A and B incorporate Y as 50-50 shareholders. A contributes $100,000 and X contributes the following assets with the indicated Adjusted Bases. Y pays X $10,000 is paid to X on the incorporation to compensate the X is contributing $110K in assets. What are the Tax effects? B $100,000 $10,000

2. Amended Revenue Ruling 68-55 X Corp Y Corp Asset I FMV = $22K % of Total = 20% Basis = $52k Loss = $30K LT Capital Asset Asset II FMV = $33K % of Total = 30% Basis = $53k Loss = $20K ST Capital Asset Asset III FMV = $55K % of Total = 50% Basis = $25k Gain = $30K Ordinary Income

3. Amended Revenue Ruling 68-55 This problem assumes the same facts as Rev. Rul. 68-85, except that X’s basis in Asset II is increased to $53K such that Asset II is now a loss asset. How does the result change?

4. Amended Revenue Ruling 68-55 We now have an “net built-in loss” on the assets contributed by X Corp. First Issue: Have the shareholders elected that the loss limitation shall be taken into account by the corporation on the assets that it is receiving from X or have they agreed that X will take the hit into account in the basis of the stock [I.R.C. § 362(e)(2)(c)]? If they do NOT agree, then the reduction is taken into account in Y corp.’s basis in the assets that it receives as follows:

5. Amended Revenue Ruling 68-55 There is an overall net built-in loss for this Transferor (i.e. X Corp) of $20,000 on the contribution (-$30K- 20K+30K=-$20K), which must be allocated to the loss assets in proportion to their respective “built-in losses.” See I.R.C. § 362(e)(2)(A)(iii) explained on page 61 of the text. Following the contribution of assets to Y corp., 60% of the loss will be allocated to reduce the basis of Asset I and 40% of the loss will be allocated to reduce the basis of Asset I. Thus, before we start to worry about the boot, the basis of Asset I goes down by (0.6 x $20K) or $12K to $40K and the basis of Asset II goes down by (0.4 x $20K) or $8K to $45K. This reduces the built-in loss in the assets to zero.

6. Amended Revenue Ruling 68-55 X Corp Y Corp Asset I FMV = $22K % of Total = 20% Basis = $40k Loss = $18K LT Capital Asset Allocation of the $10,000 Asset II FMV = $33K % of Total = 30% Basis = $45k Loss = $12K ST Capital Asset Asset III FMV = $55K % of Total = 50% Basis = $25k Gain = $30K Ordinary Income Resulting Bases before allocation of the $10,000

7. Amended Revenue Ruling 68-55 Now we have to worry about allocating the $10K of Boot received on the transaction. There are two ways that we discussed doing this: –We can allocate the boot to all assets in relation to their fair market value regardless of whether there are realized “losses” or “gains” associated with the assets [for support for this approach, one would cite Treasury Reg. § 1.357-2(a)], or –We can allocate the boot to only the assets with associated gains [this is the approach that Scott was arguing makes more logical sense].

8. Amended Revenue Ruling 68-55 If we follow the first approach: X Corp Y Corp Asset I FMV = $22K % of Total = 20% Basis = $40k Loss = $18K Recognized = Lesser of: $0 Gain or (20% x $10K) = $0 LT Capital Asset Allocation of the $10,000 Asset II FMV = $33K % of Total = 30% Basis = $45k Loss = $12K Recognized = Lesser of: $0 Gain or (30% x $10K) = $0k ST Capital Asset Asset III FMV = $55K % of Total = 50% Basis = $25k Gain = $30K Recognized = Lesser of: $30 Gain or (50% x $10K) = $5k Ordinary Income

9. Amended Revenue Ruling 68-55 20% of the boot would be allocated to Asset I, but would not be recognized because it has a built-in loss and under Rev. Rul. 65-88 (as written) we know that losses on assets contributed as part of a § 351(b) transaction can not be taken. Similarly, 30% of the boot would be allocated to Asset II, but would not be recognized. Finally, 50% of the boot would be allocated to Asset III and would be recognized. This is the answer that I provided and for purposes of the class is a completely correct answer.

10. Amended Revenue Ruling 68-55 X Corp Y Corp Asset I FMV = $22K % of Total = 20% Basis = $40k Loss = $18K Recognized = $0 Gain LT Capital Asset Allocation of the $10,000 Asset II FMV = $33K % of Total = 30% Basis = $45k Loss = $12K Recognized = $0 Gain ST Capital Asset Asset III FMV = $55K % of Total = 50% Basis = $25k Gain = $30K Recognized = Lesser of: $30 Gain or (100% x $10K) = $10k Ordinary Income If you followed the “more rational” approach endorsed, you would recognize the entire $10K of boot on Asset III.

11. Amended Revenue Ruling 68-55 In support of this approach, you could argue that Treasury Reg. § 1.357-2(a) is not on point because it only dealt with assets that were gain assets and, therefore, is not applicable to allocation to loss assets –Obviously, the application of the Reg. § 1.357-2(a) when loss assets are contributed leads to some weird and peculiar results [i.e. recognized gain on assets with a realized loss]

12. Amended Revenue Ruling 68-55 If they DO agree, then the reduction may taken into account in X corp.’s basis in its stock as follows: –First, we must ask whether we are following Treasury Reg. § 1.357-2(a)? We do this because, before we can calculate X’s basis in his Y stock, we must know how much gain he is recognizing (which depends on whether Treasury Reg. § 1.357-2(a) applies) The same analysis applies, but let’s assume that we are applying Treasury Reg. § 1.357-2(a) applies!

13. Amended Revenue Ruling 68-55 20% of the boot would be allocated to Asset I, but would not be recognized because it has a built-in loss and the corporation would take a $52K basis in Asset I. 30% of the boot would be allocated to Asset II, but would not be recognized and the corporation would take a $53K basis in Asset II. Finally, 50% of the boot would be allocated to Asset III and would be recognized and the corporation would take a $30K basis in Asset III.

14. Amended Revenue Ruling 68-55 X’s basis in his Y stock must take into account the basis limitation to eliminate the loss on the § 351(b) transfer. –although X had a $130K basis in the assets, his basis in his Y stock must be reduced by $20K under I.R.C. § 362(e)(2)(c) to the FMV of the assets being transferred since they jointly elected that X would take the loss in his stock. –Thus, X’s basis in the stock is limited to the FMV of the assets and then he has to take into account the amount realized by the boot received. X’s basis is equal to the FMV of $110K less $10K (boot received) plus $5K (gain recognized) = $105K. –Since we are applying Treasury Reg. § 1.357-2(a) the gain recognized is only $5K.

15. Amended Revenue Ruling 68-55 For completeness, I complete the problem assuming that Treasury Reg. § 1.357-2(a) does not apply: –X’s basis in his Y stock must still take into account the basis limitation to eliminate the loss on the § 351(b) transfer. although X had a $130K basis in the assets, his basis in his Y stock must be reduced by $20K under I.R.C. § 362(e)(2)(c) to the FMV of the assets since they jointly elected that X would take the loss in his stock. –Thus, X’s basis in the stock is limited to the FMV of the assets and then he has to take into account the amount realized by the boot received. X’s basis is equal to the FMV of $110K less $10K (boot received) plus $10K* (gain recognized) = $110K. *X recognized $10K of gain because under this approach all $10K is allocated to the one gain asset (i.e. Asset III)

16. Amended Revenue Ruling 68-55 X Corp Y Corp Asset I FMV = $22K % of Total = 20% Basis = $40k Loss = $18K Recognized = $0 Gain LT Capital Asset Allocation of the $10,000 Asset II FMV = $33K % of Total = 30% Basis = $45k Loss = $12K Recognized = $0 Gain ST Capital Asset Asset III FMV = $55K % of Total = 50% Basis = $25k Gain = $30K Recognized = Lesser of: $30 Gain or (100% x $10K) = $10k Ordinary Income

17. Amended Revenue Ruling 68-55 In either case [i.e regardless of whether he and they elected to have X take the loss or not or whether or not they apply Treasury Reg. § 1.357-2(a)], its holding period for the stock is calculated based on the relative FMV of the assets contributed –20% Long-term –30% Short-term –50% Ordinary Therefore, each share has a 20% holding period that tacks to the longer-term, 30% holding period that tacks to the shorter-term, and 50% that does not tack at all

18. Determine Corporate E&P Calculate Taxable Income –Gross Profit of Corporation= $20MM –Tax Exempt interest=$1MM –Dividends Received=$5MM –LTCG on sale of Stock=$2.5K –Salaries=$6.5MM –Div. received from Google Stock=$1.5MM –LTCL =$550K –LTCG=$400K –LTCL (carryover from previous years)=$100K –Federal Taxes paid=$3MM –Depreciation Assume five-year property that the Corporation purchased this year for $2MM, although it has a 7-year class life and no § 179 election was made and the corporation id not take any special depreciation allowance

19. Determine Corporate E&P Calculate Taxable Earnings Income Gross Profit of Corporation= $20,000,000 Div. received from Google Stock=$1,500,000 Dividends=$5,000,000 LTCG=$400,000 LTCG on sale of Stock=$2,500 Total=$26,902,500 Deductions Salaries=$6,500,000 LTCL (allowable to extent of gains)=$402,500 Dividends received deduction ($6.5 x 70%)=4,550,000 Depreciation ($2,000,000 / 5)=400,000 Total=$11,852,500 Taxable Income = ($26,902,500 - $11,852,500) = $15,050,000

20. Determine Corporate E&P Calculate Earnings & Profits Increases Taxable Income= $15,050,000 +Tax Exempt Interest=$1,000,000 +Dividends received deduction ($6.5 x 70%)=$4,550,000 +Depreciation Adjustment* =$257,142 Total=$20,342,857 Decreases -Excess LTCL ($550,000 -$402,500)=$147,500 -Fed Tax Paid=$3,000,000 Total E&P=$17,205,357 * Assuming this is the first year of service -> ($400,000 + ($2,000,000 / 7)/2 = $257,142)

21. § 301 As of January 1 of the this year, company Y has one shareholder (A) and $450,000 of accumulated E&P. During the year, Company Y has an additional $150,000 of current E&P During this year, the following events take place: –April 1, Company Y distributes $200,000 to A –July 1, Company Y distributes $200,000 to A –August 1, A, whose basis in her Y stock is $50,000, sells half of her stock to B for $600,000. –October 1, Company Y distributes $200,000 to A and $200,000 to B What are the tax consequences of the distributions?

22. § 301 Each of the $800,000 in distributions participate proportionately in the current E&P (i.e. $150,000 / $800,000 = 19%) –Thus, ($200,000 x 19%) or $37,500 of each $200,000 distribution is out of current earnings and profits –That leaves $162,500 that may also be a dividend if there is sufficient accumulated Earnings and Profits

23. § 301 Accumulated Earnings & Profits are used on a first-come, first-served basis unless there is a current loss with accumulated E&P. Here there is not! –$162,500 of the $450,000 of accumulated E&P is used in the first distribution to A on April 1 –$162,500 of the $450,000 of accumulated E&P is used in the first distribution to A on July 1

24. § 301 That leaves $125K of accumulated E&P on October 1 –An additional $62,500 of each distribution is dividend (i.e. a total of $37,500 + $62,500 = $100,000 is dividend for each of these last two distributions is dividend) –The remaining $100K is return of basis in the case of B (he has $600K of basis and his remaining basis is $500K).

25. § 301 For A, she only has $25K of basis left (i.e. ½ of her original $50K since she sold half of her stock) –$25K is return of basis in the case of A and the remaining $75K is capital gain with respect to a “sale” of her stock If she held the her stock for more than one-year, this is long term capital gain. Otherwise, it is short- term gain. Her basis following the distribution on October 1 is Zero

26. 302(b)(1), (2), & (3) Family Corporation Great Grandfather 50 Shares Grand- father 20 Shares Father 20 -> 10 Shares Son 10 Shares

27. 302(b)(1), (2), & (3) Constructively by attribution, Father had 50 shares prior to the redemption Following the redemption he has 40 shares –§ 302(b)(2) Does he have less than fifty percent -> Yes Has the percentage he owns gone down by more than 20% (20% of 50% = 10% or he has to be below 40%). He now owns 40/90 = 44.4% NO! –§ 302(b)(2) does not apply!

28. 302(b)(1), (2), & (3) § 302(b)(3) –Is there a total termination -> NO § 302(b)(3) does not apply!

29. 302(b)(1), (2), & (3) § 302(b)(1) –Is this “essentially equivalent to a dividend”? His constructive ownership applying § 318 was 50% before and is now 44.4% after. Is this a meaningful diminution –Absoutely!

30. 302(b)(1), (2), & (3) Family Corporation Great Grandfather 50 Shares Grand- father 20 Shares Father 20 Shares Son 10 -> 5 Shares

31. 302(b)(1), (2), & (3) Constructively by attribution, Son had 30 shares prior to the redemption Following the redemption he has 25 shares –§ 302(b)(2) Does he have less than fifty percent -> Yes Has the percentage he owns gone down by more than 20% (20% of 30% = 6% or he has to be below 24%). He now owns 25/95 = 26.3% –§ 302(b)(2) does not apply!

32. 302(b)(1), (2), & (3) § 302(b)(3) –Is there a total termination -> NO § 302(b)(3) does not apply!

33. 302(b)(1), (2), & (3) § 302(b)(1) –Is this “essentially equivalent to a dividend”? His constructive ownership applying § 318 was 30% before and is now 26.3% after. Is this a meaningful diminution –Probably not!

34. 302(b)(1), (2), & (3) Family Corporation Great Grandfather 50 -> 0 Shares Grand- father 20 Shares Father 20 Shares Son 10 Shares What Protections is Great Grandfather permitted to have to protect his interest as a creditor until Family Corp pays for his stock over time? What is prohibited?

35. 302(b)(1), (2), & (3) Prohibited Interests – NO interest other than as a creditor –Examples: Consulting agreement with Corp (at least in the 9 th circuit) Employment agreement Remaining as an Officer of the Corporation Seat on the Board of Directors Subordination of the debt to other debt Debt payments dependant on the earnings of the company Excessively long payment period or demand notes

36. 302(b)(1), (2), & (3) Permitted Interests – Those of a bona fide creditor –Examples: Consent with regard to: –Declaration of dividends –Payment of salaries outside the ordinary course of business –Sale of corporate assets (generally does not include inventory) –Any reorganization, recapitalization, merger, consolidation, or liquidation

37. 302(b)4 Company P purchases Company S’s stock for $300,000 in cash, and Company S becomes a wholly owned subsidiary of Company P. Five years later, there is a fire following at the plant of Company S. Company P decides to implement a plan to shut down the operations of Company S and has Company S distribute to Company P the $500,000 of insurance proceeds from the fire who in turn distributes the same proceeds to its shareholders. What are the tax consequences of the distributions? If you had been advising Company A, would you have suggested that they do anything differently?

38. 302(b)4 In order for the distribution to be a “partial liquidation” under § 302(b)(4), there are three factors that must be met: (i) the distribution must be pursuant to a plan, (ii) it must occur within the same taxable year that the plan is adopted or the following taxable year, and (iii) it must not be “essentially equivalent to a dividend” meaning that it is the result of a genuine contraction of the corporation’s business.

39. 302(b)4 The legislative history of § 302(b)(4) seems to imply that the termination of the business due to a fire and distribution of the proceeds is exactly the type of distribution that represents a “genuine contraction of the corporation’s business.” The example is right out of the legislative history. Furthermore, both the businesses were operated for five years and P’s business continues to be run. Thus, the situation appears to be within the safe harbor of § 302(e)(2).

40. 302(b)4 The problem here is that P is making the distribution and the terminated operations were of S. Under the rulings of Revenue Ruling 79-184, the distribution of the proceeds from the sale of a subsidiary’s assets to the shareholder of the parent is not a contraction of the parent’s business, but rather the subsidiary’s. Thus, the facts as stated will not allow for a partial liquidation.

41. 302(b)4 Were the parent to liquidate the subsidiary prior to the distribution, then the parent would take on the tax attributes of the subsidiary under § 381 and then, since the parent would be considered to have operated the business for the previous five years, the subsequent distribution would absolutely qualify as a partial liquidation under § 302(b)(4).

42. 302(b)4 The tax difference is that, without application of § 302(b)(4), the distribution will be treated as a dividend under § 301 to the extent of Earnings & Profits. Should the corporation liquidate S first, then the distribution will be treated as a partial redemption of stock, even though no stock was redeemed and the transaction will have exchange treatment.

43. 302(b) The Problem on Page 255 –X Corporation has 200 shares of stock outstanding. A & B each acquired 100 at the price of $1,000 per share. X has $100K of accumulated E&P and $50K of current E&P. Assuming that Section 302 applies: –X redeems A’s 100 shares in exchange for land: (a) FMV of $250K and AB of $200K (b) FMV of $250K and AB of $300K

44. 302(b) Option (a)Option (a) –Land has a gain of $50K which increases its current E&P to $100K. This with the accumulated $100K creates an overall E&P of $200K. –Since only half of X's shares are being redeemed, the Earnings & Profits may be reduced by 50% or $100K and then the corporation would start the next year with E&P of $100K –For A, the FMV of the land is $250K thus A has a return of basis of $100K and capital gain on the sale or exchange of $150K.

45. 302(b) Option (b) Option (b) –Land has a loss of $50K which does NOT decrease its E&P. Thus, with the accumulated E&P of $100K there remains E&P of $150K. –Since only half of X's shares are being redeemed, the Earnings & Profits can only be reduced by 50% or $75K and the corporation starts the next year with E&P of $75K. –For A, the consequences are the same.