Corporate Taxation Provisions and Principles
Congress’ Reaction to the Holding in Chamberlin v. Commissioner (1953)
Prior to passage of the IRS Tax Code by the 83rd Session of Congress in 1954 the tax status of stock dividends relative to its recipient was debatable, but this did not stop corporate tax planners from devising ‘preferred stock bailouts’ (Bailine, 2004). Under normal circumstances, when an owner of a company invests earnings and profits in another company through the purchase of common stock, the monies received are treated as a dividend for tax purposes. Dividends were taxed at a much higher rate than capital gains, so to avoid paying the additional tax the preferred stock bailout was conceived. Essentially, a preferred stock bailout uses a third party to exchange preferred stock for cash under more favorable capital gains treatment.
The ambiguous tax status of preferred stock bailouts was rendered unambiguous in Chamberlin v. Commissioner (1953) when the 6th Circuit Court of Appeals held that stock dividends are nontaxable. The Commissioner of the IRS had argued that the net result of a preferred stock bailout was an exchange of stock for cash and therefore should be taxed as ordinary income. The 6th Circuit disagreed, citing several Supreme Court decisions that held each individual transaction should stand on its own for tax purposes, not the net result.
In response, Congress included provision Â§306 in the 1954 Tax Code that prevented the tax-free sale of preferred stock more than once (Bailine, 2004). Although the sale of the preferred stock would be tax free, it subsequent sale to a third party would be taxed as ordinary income. Preferred stock after the first sale was therefore considered “Section 306 stock.”
Applying Section Â§307
Under Section Â§305(a), stock distributions to shareholders are not considered income for tax purposes as long as these distributions do not meet the exceptions outlined in Section Â§305(b) (LII, n.d.). Section Â§307(a) holds that the stock basis of the distributed stocks (new stock) should be allocated between the old and new stock based on the fair market value (Justia U.S. Law, n.d.). The same applies for the rights to purchase stock. Both distributions are calculated in the year made, regardless of whether the rights were exercised or not.
If the basis for both the new and old shares is identical, then the basis for all shares is determined by dividing the old stock basis by the total number of shares. However, if the basis for the new and old stocks is unequal, then the allocation is based on the old stock basis and the fair market value of both the new stock and the rights (Justia U.S. Law, n.d.). For example, if 1,000 shares of stock were originally purchased for $10, the fair market value of the current stock offer is $11 for another 1,000 shares, and the rights to purchase has a market value of $2 per share, then the amount allocated to the old stock is (11,000/13,000)*10,000 = $8,461.54 for 1,000 shares. The amount allocated to the old stock for rights is (2,000/13,000)*10,000 = $1,538.46 for all 1,000 shares.
If the stock offer had 1,000 additional shares for $9 ($2 below fair market value), then the basis would be $9 plus the rights basis when exercised ($1.54), or $10.54. Should this stock be sold, then the gain or loss will be based on the $8.46 basis per share. Should the shareholder decide to sell the stock rights, then the gain or loss would be based on the rights allocation of $1.54 per share.
Section Â§307(b) provides exceptions to Â§307(b). If the fair market value of the rights is below 15% of the fair market value of the old stock on the date that the rights are distributed, then the rights basis will be zero as long as the stock offered is tax exempt under Â§305(a) (Justia U.S. Law, n.d.). When this is the case the shareholder need not take any action, although they have the right to allocate the rights basis between the old shares and the rights under Section Â§307(b)(2). In the above example, the fair market value of the old stock and rights is $11 and $2, respectively, which is 18%. If the shareholder intends to exercise the stock rights then they need to elect the basis distribution option.
Meeting the Substantially Disproportionate Criteria
A corporation may want to redeem its shares for any number of reasons (Ricketts, n.d.). For example, a shareholder may want to reduce or eliminate their stake in a company or the company may feel cash holdings would be best spent redeeming shares when the price is low. Of primary concern is how the redemption is treated; whether it is a qualified or non-qualified sale under Section Â§302(b)(2). If the transaction can be treated as a sale or exchange then it will be taxed as capital gains or losses, but if it is treated as a dividend then it will be taxed as ordinary income.
Redemption occurs when the corporation exchanges cash, securities, debt, or other property for the stock (Ricketts, n.d.). Property cannot include stock or rights to purchase stock in the same corporation making the redemption. The buyback can be treated as a qualified redemption if it is not equivalent to a dividend under Section Â§302(b)(1), is substantially disproportionate under Section Â§302(b)(2), terminates the shareholders interest in the corporation under Section Â§302(b)(3), or the redeemed shares will be used to partially liquidate the corporation and were held by a noncorporate shareholder as defined by Section Â§302(b)(4).
For the redemption to be substantially disproportionate and therefore qualify for capital treatment, the stockholder cannot own more than 50% of the voting power in the corporation immediately after the redemption per Section Â§302(b)(2)(B) (Ricketts, n.d.). In addition, ratio of the voting stock held by the shareholder must be reduced to less than 80% of the ratio before the redemption, according to Section Â§302(b)(2)(C). Finally, the percent of common stock held by the shareholder after the redemption must be reduced to less than 80% of what was held before the redemption [Section Â§302(b)(2)(C)]. In other words, there must be a substantial reduction of the shareholder’s voting power and corporate holdings before the redemption can qualify for favored tax treatment as a capital gain or loss.
Favorable Treatment under Section Â§318.
Section Â§318 defines stock ownership rules for families, corporations, trusts, and partnerships (Ricketts, n.d.). For the purposes of a stock redemption, the shares owned by the shareholder and his or her parents, spouse, and children are attributed to the shareholder. This means that under Â§318 the shares owned by siblings, aunts or uncles, or cousins would not be counted as owned by the shareholder during a stock redemption.
As discussed above, favorable tax treatment of a redemption requires satisfaction of the dividend non-equivalency test, be substantially disproportionate, completely liquidate the shareholders interest in the corporation, or involve the shares of a noncorporate shareholder during partial liquidation (Ricketts, n.d.). In addition, if a shareholder sold a controlling stake in a corporation to a trusted sibling they might avoid paying regular income taxes on the property received.
The problem with this strategy is that the transfer will likely be viewed as a change in ownership under Section Â§382(g) and therefore be viewed as regular income by the IRS (Raby, 2004). In Garber Industries Holding Co. Inc. v. Commissioner (2005) the court held that the stock transaction between two brothers created a reduction in controlling ownership from 68% to none for one and an increase from 26 to 84% for the other, within a two-year period. Under Section Â§382 a 50% change in ownership within a three-year period is considered a change in ownership. Accordingly, if the redemption had been carried out to ensure that the change in ownership never exceeded 50 percentage points in any three-year period the transaction would likely have qualified for favorable treatment under Section Â§302.
Acquiring Assets through Liquidation
The assets of a company can be acquired in three basic ways (Forte, 1980). The assets can be distributed by the corporation to its shareholders, who then sell the assets to the acquiring company. The company may choose to sell the assets directly to the acquiring corporation and then distribute the proceeds to the shareholders. Or, the acquiring corporation could purchase controlling stock in the target company and then liquidate, thereby acquiring the assets.
Both parties to the liquidation can have substantial tax concerns due to the cost basis of the acquisition and how the distribution to shareholders is treated (Forte, 1980). A direct sale of assets always provided a normal cost basis; however, when a corporation acquired assets through a stock purchase the cost basis was tied to the original cost of the assets for the target corporation. This practice sometimes resulted in substantial deviations from the fair market value. In Kimbell-Diamond Milling Co. v. Commissioner (1950) the tax court held that cost basis for the acquired assets will be determined by the purchase price of the stock, thereby achieving some parity between the two acquisition strategies.
The decision reached in Kimbell-Diamond Milling Co. became known as the Kimbell-Diamond doctrine and was codified in the tax code as Section Â§334(b)(2) (Forte, 1980). Qualified Â§334(b)(2) acquisitions had to meet certain requirements though, including the purchase of 80% of the target corporations voting and non-voting stock within a 12-month period (Martin, Woodruff, and Sewell, 2004). In addition, the purchase had to be a taxable transaction and the liquidation completed within 2 years.
Liquidation is Mandatory
The U.S. Supreme Court decided in Commissioner v. Court Holding Co. (1945) that the transfer of the target corporation’s assets to the shareholders, and the subsequent sale of the assets to the buyer, was not a legal remedy for avoiding the levying of corporate taxation (Forte, 1980). At issue, according to the Court, were all the steps involved in the transaction from start to finish. This decision has been termed the Court-Holding Co. Or step transaction doctrine. Based on the facts before the Court, the corporation liquidated its assets to the shareholders for the sole purpose of avoiding corporate taxation (Soled, 2001). In other words, the liquidation was not required for the sale to take place.
The step transaction doctrine contains three tests: (1) there has to be a binding commitment between the parties, (2) each step of the transaction is dependent on the completion of the other steps to be successful, and (3) and all steps are required for the transaction to be completed (Soled, 2001). In Court Holding Co., the Court believed that to exclude the liquidation step from the acquisition would “would seriously impair the effective administration of the tax policies of Congress” (as cited in Soled, 2001, p. 590, Note 11).
An example where the step transaction doctrine was applied by federal courts was in Driver v. United States (1976), in which the sole owner of a telephone company transferred shares to her nephew in two steps (Soled, 2001). The first step involved the transfer of 42% interest in the company on the last day of 1968. Three days later Driver transferred another 42% to her nephew. When the former owner took steep deductions on the value of the gifted shares on her tax returns, the IRS audited her. When the complaint was brought before the U.S. District Court for the Western District of Wisconsin, the court applied the third test. It held that is was unreasonable to treat each transaction as the transfer of a minority interest in the telephone company, since the transactions were only three days apart. The overall effect was the transfer of ownership in the company and the tax return deductions were therefore inappropriate.
Continuity of Basis and Section Â§1014
Under the continuity of basis principle the value of transferred property would retain the cost basis the previous owner enjoyed, which is allowed under the rules governing reorganizations when Section Â§361(b)(1)(A) does not apply (Wolfman, 1967). Although the purchase price of property may be the fair market value, the basis is retained. There is thus a continuity of basis.
The bases for property purchases and gifts are tied to the cost and the pre-transfer adjusted basis of the transferor, respectively (Siegel, 2012). By comparison, the basis for the transfer of a decedent’s property is generally fixed by the fair market value on the date of death (Section Â§1014). In situations when the property’s value has appreciated beyond the decedent’s adjusted basis just prior to death, Section Â§1014 allows a step up in basis for the recipient. A step up is also allowed for an increase in value since the property was purchased. The basis continuity principle is thus frustrated under Section Â§1014.
The property covered by Section Â§1014 is broad and includes those acquired by bequest, devise, intestacy, or passing to the decedent’s estate (Siegel, 2012). In addition, property that has been held in trust during the life of the decedent is included. All such properties would be susceptible to the stepped up basis rule under Section Â§1014 if the property has appreciated in value. Section Â§1014(e) provides an exception to the stepped up basis rule for property that was gifted to the decedent within one year prior to the date of death. Such property can be bequeathed to beneficiaries with a continuity of basis, but only if the gift had a fair market value at the time of transfer to the decedent.
Purpose of Continuity of Investment Principle
Section Â§351 provides for the tax-free transfer of property in exchange for stock, but only if the transfer results in control of the corporation (Schwidetzky, 2009). Section Â§358 defines control as possessing 80% of the voting stock and total number of shares for all classes of stock for the corporation. To qualify for a Section Â§351 safe harbor the basis of the property and the stock must be equal. The transferor can be a person, a group of people, corporations, and partnerships and the assumption of control must occur immediately after the transfer is completed.
The courts have treated Section Â§351 property transfers as a nothing more than a change in ownership of a corporation without realized gains (Schwidetzky, 2009). Reorganizations under Section Â§368 also enjoy tax-favored status. It could therefore be argued that the purpose of the continuity of investment principle is to allow investors to exchange one form of investment for another without fear of incurring a prohibitive tax liability.
The exchange of investments can happen much more freely in partnerships (LLCs), because there is no 80% rule governing the outcome of an exchange of property for an interest in the partnership (Schwidetzky, 2009). Such property contributions are governed by Section Â§704(c)(1)(A) and if the property contribution results in a gain or loss, taxation is based on the eventual sale of the property. However, when the property is distributed among the partners they normally see an adjustment in the bases of the property. Sections 707(a)(2)(b), 704(c)(1)(B) and 737 have rules to discourage attempts to use partnerships as cover for taxable exchanges or sales, because the controlling threshold provided by Section Â§351 does not exist.
Bailine, Richard W. (2004). Preferred stock bailouts: Could they stage a comeback? Corporate Taxation, 31(1), 25-27.
Chamberlin v. Commissioner of Internal Revenue, 207 F. 2d 462 (6th Cir. 1953).
Forte, Michael C. (1980-1981). Corporate liquidations — Sections 336 and 337 of the Internal Revenue Code — Parity between a direct sale of assets and a stock purchase — Another look at Tennessee-Carolina and R.M. Smith. Western New England Law Review, 3(2), 199-222.
Justia U.S. Law. [n.d.(a)]. 26 C.F.R. Part 1 — Income Taxes. Title 26 — Internal Revenue. Section Â§1.307-1 General, Â§1.307-2 Exception. Justia.com. Retrieved 10 May 2013 from http://law.justia.com/cfr/title26/26-22.214.171.124.1.html.
LII (Legal Information Institute). (n.d.). 26 USC Â§305 — Distributions of stock and stock rights. Law.Cornell.edu. Retrieved 10 May, 2013 from http://www.law.cornell.edu/uscode/text/26/305.
Martin, Mark R., Woodruff, John, and Sewell, Gardere Wynne. (2004). Selective application of the step transaction doctrine in multi-step acquisitions. Tax Executives Institute. Retrieved 11 May 2013 from www.gardere.com/Content/hubbard/tbl…/1204/TEI%20Speech.pdf.
Raby, William L. (2004). Stock ownership tax attribution and siblings. Tax Analysts Document Service. Retrieved 11 May 2013 from www.lawprofessorblogs.com/taxprof/linkdocs/2005-2087-1.pdf.
Ricketts, Robert. (n.d.). Overview — Corporate Tax Redemptions. Rawls College of Business, Texas Tech University. Retrieved 11 May 2013 from http://rricketts.ba.ttu.edu/5327_overview%20stock%20redemptions%20and%20corporate%20liquidations.doc.
Schwidetzky, Walter D. (2009). Integrating Subchapters K. And S — Just do it. The Tax Lawyer, 62(3), 749-821.
Siegel, Mark R. (2012). I.R.C. Section 1014(E) and gifted property reconveyed in trust. Akron Tax Journal, 27, 33-53.
Soled, Jay A. (2001). Use of judicial doctrines in resolving transfer tax controversies. Boston College Law Review, 42(3), 587-617.
Wolfman, Bernard. (1967).Federal Tax Policy. By Joseph a. Pechman. Yale Law Journal, 76, 1030-1050.
Wren, Harold. (1955). The income taxation of corporate distributions under the Internal Revenue Code of 1954. California Law Review, 43(2), 268-294.
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