Chapter c4

Prentice Hall's Federal Taxation 2016: Corporations, 29e (Pope)Chapter C4: Corporate Nonliquidating Distributions

LO1: Nonliquidating Distributions in General

1) Corporate distributions that exceed earnings and profits are always capital gains.Answer: FALSEPage Ref.: C:3-2Objective: 1

2) On April 1, Delta Corporation distributes $120,000 in cash to each of its two equal shareholders, Sarah and Matt. At the time of the distribution, Delta's E&P is $160,000. Sarah's basis in her stock is $50,000 and Matt's basis in his stock is $20,000. How are the distributions characterized to Sarah and Matt? Be specific.Answer: Sarah and Matt must each recognize $80,000 (0.50 × $160,000) of dividend income. This portion of the distribution reduces Delta's E&P to zero. The additional $40,000 that each shareholder receives is treated as a return of capital or capital gain as summarized in the table below.

Ellen Bob TotalDistribution $120,000 $120,000 $240,000Dividend income ( 80,000) ( 80,000) (160,000)Remaining distribution $ 40,000 $ 40,000 $ 80,000Return of capital ( 40,000) ( 20,000) ( 60,000)Capital Gain $ 0 $ 20,000 $ 20,000

Page Ref.: C:3-2Objective: 1

3) How does a shareholder classify a distribution for tax purposes?Answer: Distributions are treated as follows: (1) dividends to the extent of corporate E&P, (2) return of capital to the extent of the shareholder's stock basis, and (3) gain from the sale of stock.Page Ref.: C:3-2Objective: 1

LO2: Earnings and Profit (E&P)

1) Corporations may always use retained earnings as a substitute for earnings and profits.Answer: FALSEPage Ref.: C:4-5Objective: 2

2) When computing E & P, Section 179 property must be expensed ratably over a five-year period, starting with the month in which it is expensed for Sec. 179 purposes.Answer: TRUEPage Ref.: C:4-5Objective: 2

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3) Identify which of the following statements is false.A) For E&P dividend distribution purposes, property as defined in Sec. 317(a) includes money.B) The function of E&P is to provide a measure of a corporation's economic ability to pay dividends.C) At formation, a corporation's E&P depends on the amount of capital contributed by the shareholders.D) Adjustments to taxable income when computing E&P do not include tax-exempt interest.Answer: CPage Ref.: C:4-3 and C:4-4Objective: 2

4) Identify which of the following increases Earnings & Profits.A) a capital contributionB) life insurance proceeds payable to the spouseC) tax-exempt interest incomeD) All of the above increase E&P of a corporation.Answer: CPage Ref.: C:4-4Objective: 2

5) Current E&P does not includeA) tax-exempt interest income.B) life insurance proceeds where the corporation is the beneficiary.C) federal income tax refunds from prior years.D) All of the above are included.Answer: DPage Ref.: C:4-4Objective: 2

6) Grant Corporation sells land (a noninventory item) with a basis of $57,000 for $100,000. Nichole will be paid on an installment basis in five equal annual payments, starting in the current year. The E&P for the year of sale will be increased as a result of the sale (excluding federal income taxes) byA) $0.B) $8,600.C) $43,000.D) $100,000.Answer: CExplanation: The entire gain on the installment sale must be used to increase E&P in the year of sale.Page Ref.: C:4-5; Example C:4-5Objective: 2


7) Boxer Corporation buys equipment in January of the current year with a seven-year class life for $15,000. The corporation expensed the $15,000 under Sec. 179. The deduction in the year of purchase for E&P purposes due to the acquisition and expensing of the equipment isA) $1,500.B) $3,000.C) $14,000.D) $15,000.Answer: BExplanation: Property expensed under Sec. 179 is expensed ratably using the straight-line method over five years, commencing with the month in which it is deductible for Sec. 179 purposes when computing E&P regardless of the number of years in its class life.

$15,000/5 yrs. = $3,000Page Ref.: C:4-5; Example C:4-6Objective: 2

8) For purposes of determining current E&P, which of the following items cannot be deducted in the year incurred?A) charitable contribution in excess of the 10% limitationB) capital losses in excess of capital gainsC) life insurance premiums (in excess of the increase in cash surrender value for the policy) paid on the lives of key employeesD) dividends-received deductionAnswer: DPage Ref.: C:4-5Objective: 2

9) Identify which of the following statements is true.A) Section 179 property must be expensed ratably over a five-year period when computing E&P.B) Losses on property sales to related parties are not deductible when computing E&P.C) Distributions made out of accumulated E&P are allocated ratably between multiple distributions made during the tax year.D) All of the above are false.Answer: APage Ref.: C:4-5 and C:4-6Objective: 2


10) Poppy Corporation was formed three years ago. Poppy's E&P history is as follows:

Year Current E&PDistribution

s200520062007

$6,0005,0001,000

$4,0001,000

0

Poppy Corporation's accumulated E&P on January 1 will beA) $0.B) $7,000.C) $5,000.D) $12,000.Answer: BExplanation: ($6,000 - $4,000) + ($5,000 - $1,000) + $1,000 = $7,000Page Ref.: C:4-7Objective: 2

11) Crossroads Corporation distributes $60,000 to its sole shareholder Harley. Crossroads has earnings and profits of $55,000 and Harley's basis in her stock is $20,000. After the distribution, Harley's basis isA) $5,000.B) $15,000.C) $20,000.D) $60,000.Answer: BExplanation: $55,000 of the distribution reduces E&P to $0, and $5,000 is a reduction in the basis of Harley's stock.Page Ref.: C:4-7Objective: 2

12) Tomika Corporation has current and accumulated earnings and profits of $0. Tomika distributes $10,000 to its sole shareholder, Alana. What are Tomika's earnings and profits after the distribution?A) $0B) ($10,000)C) $10,000D) none of the aboveAnswer: AExplanation: Distributions cannot create an E&P deficit.Page Ref.: C:4-7Objective: 2


13) Exit Corporation has accumulated E&P of $24,000 at the beginning of the current tax year. Current E&P is $20,000. During the year, the corporation makes the following distributions to its sole shareholder who has a $22,000 basis for her stock.

Date Amount DistributedApril 1 $20,000June 1 20,000August 1 15,000November 1 5,000

The treatment of the $15,000 August 1 distribution would beA) $15,000 is taxable as a dividend; $5,000 from current E&P and the balance from accumulated E&P.B) $15,000 is taxable as a dividend from accumulated E&P.C) $4,000 is taxable as a dividend from accumulated E&P, and $11,000 is tax-free as a return of capital.D) $5,000 is taxable as a dividend from current E&P, and $10,000 is tax-free as a return of capital.Answer: DExplanation:

Date ofDistribution

AmountDistributed Current E&P

Accumulated E&P

Return of Capital

AprilJune

AugustNovember

$20,000 20,000 15,000 5,000$60,000

$ 6,667 6,667 5,000 1,666$20,000

$13,333 10,667

0 0

$24,000

$ 0 2,666

10,000 3,334

$16,000


14) Oreo Corporation has accumulated E&P of $8,000 at the beginning of the current year. During the year (a nonleap year), the corporation incurs a current E&P deficit of $18,250. The corporation distributes $11,000 on March 20th to Morris, its sole shareholder, who has a $9,000 basis for his stock. If the exact loss cannot be determined as of the date of distribution, the treatment of the distribution will beA) $4,100 dividend and a $6,900 capital gain.B) $11,000 return of capital.C) $4,100 dividend and a $6,900 tax free return of capital.D) $8,000 dividend and a $3,000 return of capital.Answer: CExplanation: 31 + 28 + 19 = 78; 78/365 × $18,250 = $3,900 reduction in accumulated E&P.$8,000 - $3,900 loss accrued to distribution date = $4,100 E&P available for distribution. $6,900 ($11,000 - $4,100) balance of the distribution is a return of capital.Page Ref.: C:4-8; Example C:4-13Objective: 2


15) Omega Corporation is formed in 2006. Its current E&P and distributions for each year through 2010 are as follows:

Year Current E&P (deficit) Distributions2007 $(20,000) 02008 30,000 02009 36,000 $18,0002010 16,000 0

Is the distribution made from current or accumulated E&P? At the beginning of 2011, what is accumulated E&P?Answer: The $18,000 distribution is made from 2009's current E&P. At the beginning of 2010, Omega's accumulated E&P is $28,000, (-$20,000 + $30,000 + $36,000 - $18,000). At the beginning of 2011, Omega's accumulated E&P is $44,000, ($28,000 + $16,000).Page Ref.: C:3-2Objective: 2

16) In 2010, Tru Corporation deducted $5,000 of bad debts. It received no tax benefit from the deduction because it had an NOL in 2010 that it was unable to carry back or forward. In 2011, Tru recovered $4,000 of the amount due.a) What amount must Tru include in income in 2011?b) What effect does the $4,000 have on E&P in 2011, if any?Answer: a) Tru excludes the $4,000 from gross income in 2011 because it received no tax benefit from the bad debt deduction in 2010.b) Tru must add the $4,000 to its income for purposes of determining current E&P since it was deducted in a prior year.Page Ref.: C:4-4; Example C:4-3Objective: 2

17) In the current year, Ho Corporation sells land that has a $6,000 basis and a $10,000 FMV to Henry, an unrelated individual. Henry makes a $25,000 down payment this year and will pay Ho $25,000 per year for the next three years, plus interest on the unpaid balance at a rate acceptable to the IRS. Ho's realized gain is $4,000. Since Ho is not in the business of selling land, it will use the installment method of accounting. How does this transaction affect Ho's E&P in the current year and the three subsequent years?Answer: In the current year, Ho recognizes $1,000 of gain [($4,000/$10,000 × $2,500] in computing taxable income. Ho will also recognize $1,000 of gain in computing taxable income in each of the next three years. All $4,000 of Ho's realized gain must be included in current E&P. As Ho collects the installments, E&P will need to be reduced by $1,000 in each of those years since all $4,000 was included in E&P in the current year.Page Ref.: C:4-5; Example C:4-5Objective: 2


18) When computing E&P and taxable income, different depreciation methods are often used. What happens when the taxpayer sells such assets?Answer: The taxpayer must calculate a gain or loss separately for taxable income and E&P purposes.Page Ref.: C:4-6Objective: 2

19) River Corporation's taxable income is $25,000, after deducting a $5,000 NOL carryover from last year and after claiming a $10,000 dividends-received deduction. What is the current E&P?Answer: River must add back the $10,000 DRD and the $5,000 NOL. Therefore, current E&P is $40,000 ($25,000 + $10,000 + $5,000).Page Ref.: C:4-6 through C:4-8Objective: 2

20) Splash Corporation has $50,000 of taxable income before any charitable contribution deduction. Splash contributed $20,000 to a qualified charitable organization. Due to the 10% of taxable income limitation on charitable contribution deductions, Splash's contribution deduction is limited to $5,000. What effect does the charitable contribution have on current and future E&P?Answer: Splash deducts the entire $20,000 in computing current E&P. Therefore, $15,000 must be deducted from taxable income of $45,000 ($50,000 - $5,000) to compute current E&P. In future years, when the $15,000 carryover is deducted in determining taxable income, it must be added to taxable income in arriving at current E&P.Page Ref.: C:4-7Objective: 2

21) Peach Corporation was formed four years ago. Its current E&P (or E&P deficit) and distributions for the most recent four years are as follows:

YearCurrent E&P

(Deficit)Distribution

s2005200620072008

($20,000) 8,000 ( 5,000)25,000

$ 2,000 4,000

0 4,000

What is Peach's accumulated E&P at the beginning of 2006, 2007, 2008, and 2009?Answer: 2006: ($20,000)a

2007: ($16,000)b

2008: ($21,000)c

2009: 0d

a A distribution does not reduce a current E&P deficit.b (-$20,000) + ($8,000 - $4,000) = (-$16,000)c (-$16,000) + ($5,000) = (-$21,000)d (-$21,000) + ($25,000 - $4,000) = $0Page Ref.: C:4-7Objective: 2


22) Payment Corporation has accumulated E&P of $19,000 and current E&P of $28,000. During the year, the corporation makes the following distributions to its sole shareholder:

Date Amount Distributed

April 1June 1August 1November 1

$20,00020,00015,0005,000

The sole shareholder's basis in her stock is $45,000. What are the tax consequences of the June 1 distribution?Answer: The current E&P is allocated ratably to each distribution. Accumulated E&P is allocated to the four distributions in chronological order, starting with the April 1 distribution. The taxability of the distributions is as follows:

DateAmountDistribut

ed

Current E&P

Accumulated E&P

Return of Capital

Capital Gain

April 1June 1

August 1November

1

$20,000 20,000 15,000 5,000$60,000

$ 9,333 9,334 7,000 2,333

$28,000

$10,667 8,333 0 0

$19,000

0 $2,333 8,000 2,667$13,000

00000


23) Green Corporation is a calendar-year taxpayer. All of the stock is owned by Evan. His basis for the stock is $35,000. On March 1 (of a non-leap year), Green Corporation distributes $120,000 to Evan. Determine the tax consequences of the cash distribution to Evan in each of the following independent situations:

Current E&P Accumulated E&Pa) $30,000 $100,000 b) 50,000 ( 50,000)c) (73,000) 40,000 d) (20,000) ( 50,000)Answer: a) $120,000 is a dividend to Evan.b) $50,000 is dividend. $35,000 is a return of capital, which reduces Evan's basis to zero. The remaining $35,000 is taxable as a capital gain.c) Green's accumulated E&P as of March 1 is $28,200 {$40,000 - [$73,000 × (59/365)]}. Therefore, $28,200 is taxable as a dividend. $35,000 is a return of capital and the remaining $56,800 is taxable as a capital gain.d) $35,000 is a return of capital, which reduces Evan's basis to zero, and the remaining $85,000 is a capital gain.Page Ref.: C:4-7 and C:4-8Objective: 2

24) When is E&P measured for purposes of determining whether a distribution is a dividend?Answer: Usually at year-end. However, if a current deficit exists, the E&P available for measuring dividend income is determined at the distribution date.Page Ref.: C:4-8Objective: 2


25) Outline the computation of current E&P, including two examples for each adjustment.Answer: Taxable incomePlus: income excluded from taxable income (e.g., tax-exempt interest, life insurance proceeds)Plus: income deferred to a later year when computing taxable income (e.g., installment sales, income reported on percentage of completion method)Plus or minus: income and deduction items that must be recomputed when computing E&P(e.g., excess depreciation over straight-line, percentage depletion in excess of cost depletion).Plus: deductions not allowed in computing E&P (e.g., NOL deduction, dividends-received deduction)Minus: expenses and losses not deductible in computing taxable income (e.g., federalincome taxes, nondeductible political contributions)Equals: current E&P (or E&P deficit).Page Ref.: C:4-4Objective: 2

26) Tia receives a $15,000 cash distribution from Main Corporation in March of the current year. Main has $6,000 of accumulated E&P at the beginning of the year and $12,000 of current E&P. Main also distributed $15,000 in cash to Betty, who purchased all 300 shares of Main stock from Tia in June of the current year. What tax issues should be considered with respect to the distributions paid to Tia and Betty?Answer: • Since the two cash distributions exceed E&P, what portion of each distribution comes out of E&P?• What portion of each shareholder's distribution is a return of capital?• What portion of the return of capital distribution(s) reduces the basis of the shareholder's stock?• What portion of each shareholder's return of capital distribution is a capital gain?• Is the capital gain recognized long-term or short-term?

The issue is to what extent Tia's distribution is a dividend. Main Corporation has $18,000 of current and accumulated E&Ps, so only $18,000 can be a dividend to either Betty or Tia. Current E&P is allocated ratably to Betty and Tia ($6,000 each), and accumulated E&P is allocated on a first-in, first-out basis, so the remaining $6,000 of E&P is allocated to Tia. Therefore, Tia has a $12,000 dividend and a $3,000 return of capital. Betty has a $6,000 dividend and a $9,000 return of capital. Any amount received by Tia or Betty after recovering their stock basis is a capital gain. The return of capital distribution reduces the basis of Tia's stock investment and will cause a corresponding increase (decrease) in the capital gain (capital loss) reported on her sale of the Main stock to Betty.Page Ref.: C:4-3 through C:4-8Objective: 2


27) Kiara owns 100% of the shares of Lion Corporation. Kiara's basis is $70,000 and the FMV of the shares is $200,000. Kiara is willing to sell all of the stock to Tia, but Tia is unwilling to pay more than $150,000 for the stock because the Corporation has excess cash balances. They have agreed that Kiara can withdraw $50,000 in cash from Lion before the stock sale. What tax issues should be considered with respect to Kiara and Tia's agreement?Answer: • What is Lion's E&P balance immediately preceding the distribution?• If $50,000 in cash is withdrawn from the business, will it be treated as a dividend to Kiara?• Can the $50,000 withdrawn from the business be considered to have been received as part of Kiara's stock sale?• Can the tax results for the transaction be improved if Kiara has some of her stock redeemed for the $50,000 cash?• Are the tax consequences of the transaction different if the $50,000 is withdrawn from the business either before or as part of the stock sale?• Can the $50,000 payment be classified as payment of back wages to Kiara? Would such an amount be deductible by the corporation?• What is the amount and character of the gain recognized on Kiara's sale of the stock?

The primary issue is whether the $50,000 Kiara receives from Lion's is a dividend or is part of the amount she receives for her stock. If Lion redeems 25% of her stock for $50,000 in cash as part of the same transaction in which her remaining stock is sold to Tia for $150,000, quite likely she can treat the entire $200,000 as being received in exchange for her stock under the bootstrap redemption rules. In such case, she has a $130,000 ($200,000 - $70,000) capital gain.

However, if she receives $50,000 from Lion before entering into the sale agreement with Tia, she will have a $50,000 dividend and then an $80,000 ($150,000 - $70,000) capital gain on a later sale of her stock to Tia.

It is not likely that Lion can treat the $50,000 payment as additional compensation (e.g., a bonus or payment made because of lower-than-normal salary payments made in prior years) and then deduct the payment in computing its corporate tax liability. A possibility might be to treat the $50,000 payment as being paid to Kiara in exchange for a covenant not to compete for a certain period of time. Such payment generally is ordinary income for the recipient but is deductible by the payer over 15 years in accordance with Sec. 197.Page Ref.: C:4-3 through C:4-8, and C:4-33Objective: 2


LO3: Nonliquidating Property Distributions

1) A shareholder's basis in property distributed as a dividend is its fair market value.Answer: TRUEPage Ref.: C:5-9Objective: 3

2) When appreciated property is distributed in a nonliquidating distribution, the net effect on the distributing corporation's E&P is that it is reduced by the FMV of the property distributed and increased by the gain (net of federal income taxes) recognized due to the property distribution.Answer: TRUEPage Ref.: C:4-10Objective: 3

3) Corporations recognize gains and losses on the distribution of property to shareholders if the property's fair market value differs from its basis.Answer: FALSEPage Ref.: C:4-10Objective: 3

4) Dixie Corporation distributes $31,000 to its sole shareholder, Sally. At the time of the distribution, Dixie's E&P is $25,000 and Sally's basis in her Dixie stock is $10,000. Sally's basis in her Dixie stock after the distribution isA) $4,000.B) $10,000.C) $25,000.D) $31,000.Answer: AExplanation: $31,000 - $25,000 = $6,000 distribution in excess of E&P. $10,000 basis - $6,000 excess distribution = $4,000.Page Ref.: C:4-7Objective: 3

5) Identify which of the following statements is true.A) If both the current and accumulated E&P have deficit balances, a corporate distribution cannot be characterized as a dividend.B) The shareholder's basis in property received in a nonliquidating distribution is the property's FMV reduced by liabilities assumed by the shareholder.C) A corporation recognizes gain when distributing money as a dividend to its shareholders.D) All of the above are false.Answer: APage Ref.: C:4-8 and C:4-9Objective: 3


6) Identify which of the following statements is true.A) The holding period for property received by a shareholder in a nonliquidating distribution begins on the day after the distribution.B) When making a nonliquidating distribution, a corporation recognizes gains and losses.C) When making a nonliquidating distribution, the corporation's E&P is reduced by the property's FMV even though the property's basis is greater than its FMV.D) All of the above are false.Answer: APage Ref.: C:5-9Objective: 3

7) Hogg Corporation distributes $30,000 to its sole shareholder, Ima. At the time of the distribution, Hogg's E&P is $14,000 and Ima's basis in her stock is $10,000. Ima's gain from this transaction is aA) $6,000 capital gain.B) $14,000 capital gain.C) $20,000 capital gain.D) $30,000 capital gain.Answer: AExplanation: $30,000 distribution - $14,000 E&P(dividend) - $10,000 return of capital = $6,000Page Ref.: C:5-9Objective: 3

8) One consequence of a property distribution by a corporation to a shareholder is thatA) the amount of the distribution is increased by any liability assumed by the shareholder.B) the holding period of the distributed property includes the holding period of the distributing corporation.C) the shareholder's basis in the distributed property is the same as the distributing corporation's basis.D) any liabilities assumed by the shareholder do not reduce the shareholder's basis.Answer: DPage Ref.: C:5-9Objective: 3

9) Wills Corporation, which has accumulated a current E&P totaling $65,000, distributes land to its sole shareholder, an individual. The land has an FMV of $75,000 and an adjusted basis of $55,000. The shareholder assumes a $15,000 liability associated with the land. The shareholder will recognizeA) $60,000 of dividend income and have a $60,000 basis in the land.B) $65,000 of dividend income and have a $75,000 basis in the land.C) $60,000 of dividend income and have a $75,000 basis in the land.D) $65,000 of dividend income and have a $65,000 basis in the land.Answer: CExplanation: Dividend equals $75,000 FMV - $15,000 liability assumed = $60,000. Basis equals the $75,000 FMV of the property.Page Ref.: C:4-9; Example C:4-14Objective: 3


10) Wills Corporation, which has accumulated a current E&P totaling $70,000, distributes land to its sole shareholder, an individual. The land has an FMV of $75,000 and an adjusted basis of $60,000. The shareholder assumes a $15,000 liability associated with the land. The transaction will have the following tax consequences.A) The corporation will recognize a $15,000 gain; the shareholder will recognize dividend income of $75,000.B) The corporation will recognize no gain; the shareholder will recognize dividend income of $75,000.C) The corporation will recognize a $15,000 gain; the shareholder will recognize dividend income of $60,000.D) The corporation will recognize no gain; the shareholder will recognize dividend income of $60,000.Answer: CExplanation: The corporation will recognize $15,000 ($75,000 FMV - $60,000 basis) of gain as if it had sold the property immediately preceding the distribution. The shareholder has dividend income equal to the $75,000 FMV minus the $15,000 of liabilities assumed, or $60,000, (but not in excess of the E&P).Page Ref.: C:4-10Objective: 3

11) A corporation distributes land and the related liability to Meg, its sole shareholder. The land has an FMV of $60,000 and is subject to a liability of $70,000. The corporation has current and accumulated E&P of $80,000. The corporation's adjusted basis for the property is $70,000. What effect does the transaction have on the corporation?A) A recognized loss of $10,000; its E&P is reduced by $70,000.B) A recognized loss of $10,000; its E&P is unchanged.C) No recognized gain or loss; its E&P is reduced by $60,000.D) No recognized gain or loss; its E&P is unchanged by the distribution.Answer: DPage Ref.: C:4-10; Example C:4-15Objective: 3

12) A corporation distributes land and the related liability in a nonliquidating distribution to a shareholder. The land (a capital asset) has an adjusted basis of $70,000, an FMV of $100,000 and is subject to a mortgage of $120,000. The corporation must recognizeA) a $20,000 capital loss.B) a $50,000 capital gain.C) a $70,000 capital gain.D) no gain or loss.Answer: BExplanation: The property's FMV is deemed to be at least equal to the liability assumed or acquired (Sec. 311(b)). Therefore a $50,000 capital gain ($120,000 liability - $70,000 basis) is recognized.Page Ref.: C:4-10Objective: 3


13) Identify which of the following statements is true.A) The FMV of an obligation is used to determine the E&P reduction when a corporation distributes the obligation to its shareholders.B) When appreciated property is distributed to shareholders, E&P must be increased by any gain (net of taxes) recognized due to the property distribution.C) When appreciated property is distributed in a nonliquidating distribution, the net effect on the distributing corporation's E&P is that it is reduced by the net of the FMV of the property distributed minus the gain (net of federal income taxes) recognized due to the property distribution.D) Only B and C above are true.Answer: DPage Ref.: C:4-10Objective: 3

14) Which of the following transactions does not have the potential of creating a constructive dividend?A) compensation paid by a corporation to a shareholder-employeeB) purchase of corporate property by the shareholderC) shareholder's rental of corporate propertyD) All of the above can result in a constructive dividend.Answer: DPage Ref.: C:4-11 through C:4-13Objective: 3

15) Identify which of the following statements is true.A) Loans made to shareholders in proportion to their stock ownership in the corporation is evidence that the loans are disguised dividends.B) Corporate payments for the shareholder's benefit may be a taxable dividend.C) If the shareholder can elect to receive distributing corporation stock or money, the receipt of distributing corporation stock will be a taxable dividend.D) All of the above are true.Answer: DPage Ref.: C:4-12 through C:4-14Objective: 3


16) White Corporation is a calendar-year taxpayer. Wilhelmina owns all of its stock. Her basis for the stock is $25,000. On March 1 of the current year (not a leap year), White Corporation distributes $60,000 to Wilhelmina. Determine the tax consequences of the cash distribution to Wilhelmina in each of the following independent situations:a) Current E&P $15,000, accumulated E&P $50,000.b) Current E&P $25,000, accumulated E&P $(25,000).c) Current E&P ($36,500), accumulated E&P $65,000.d) Current E&P ($10,000), accumulated E&P $(25,000.Answer: a) $60,000 dividend to Wilhelmina; $15,000 out of current E&P and $45,000 out of accumulated E&P.b) $25,000 is a dividend to Wilhelmina; $25,000 is a return of capital that reduces Wilhelmina's basis to zero; the excess $10,000 is taxable as a capital gain.c) White's accumulated E&P as of March 1 (of a nonleap year) is $65,000 - [($36,500/365) × 59] = $59,100. Therefore, $59,100 is taxable as a dividend. $900 is a return of capital that reduces Wilhelmina's stock basis to $24,100.d) $25,000 is a return of capital that reduces Wilhelmina's basis to zero; the excess $35,000 is taxable as a capital gain.Page Ref.: C:4-9 and C:4-10Objective: 3

17) In the current year, Pearl Corporation has $300,000 of current and accumulated E&P. On June 3, Pearl Corporation distributes a parcel of land (a capital asset) worth $120,000 to Betty, a shareholder. The land has a $60,000 adjusted basis to Pearl Corporation and is subject to a $16,000 mortgage, which Betty assumes. Assume a 34% marginal corporate tax rate.a) What is the amount and character of the income recognized by Betty as a result of the distribution?b) What is Betty's basis for the land?c) What is the amount and character of Pearl's gain or loss as a result of the distribution?d) What effect does the distribution have on Pearl's E&P?Answer: a) Betty has a taxable dividend of $104,000 ($120,000 - $16,000).b) Betty's basis for the land is $120,000, its FMV.c) Pearl Corporation recognizes a $60,000 ($120,000 FMV - $60,000 basis) gain on the distribution.d) Pearl Corporation's E&P is increased by the $60,000 gain and decreased by the $104,000 ($120,000 - $16,000) net amount of the distribution plus the $20,400 (0.34 × $60,000) of federal income taxes imposed on the gain, or a net reduction of $64,400.Page Ref.: C:4-8 through C:4-11Objective: 3


18) In the current year, Red Corporation has $100,000 of current and accumulated E&P. On March 2, Red Corporation distributes to Randy, a shareholder, a parcel of land (a capital asset) having a $60,000 FMV. The land has a $30,000 adjusted basis (for both tax and E&P purposes) to Red Corporation and is subject to an $8,000 mortgage, which Randy assumes. Assume a 34% marginal corporate tax rate.a) What is the amount and character of the income Randy recognizes as a result of the distribution?b) What is Randy's basis for the land?c) What is the amount and character of Red Corporation's gain or loss as a result of the distribution?d) What effect does the distribution have on Red Corporation's E&P?Answer: a) Randy receives a taxable dividend of $52,000 ($60,000 - $8,000).b) Randy's basis for the land is $60,000, its FMV.c) Red Corporation recognizes a $30,000 [($52,000 net FMV + $8,000 release from liability) - $30,000] capital gain on the distribution.d) Red Corporation's E&P is increased by the $30,000 E&P gain, which is the excess of the land's FMV over its E&P adjusted basis. (Note that the E&P gain and the tax gain are the same in this problem.) E&P is decreased by the $52,000 ($60,000 FMV - $8,000 mortgage) net amount of the distribution and by the $10,200 (0.34 × $30,000) of federal income taxes imposed on the gain, or a net reduction of $32,200.Page Ref.: C:4-8 through C:4-11Objective: 3

19) Digger Corporation has $50,000 of current and accumulated E&P. On March 1, Digger distributes land with a $30,000 FMV and a $17,500 adjusted basis to Dave, its sole shareholder. The land is subject to a $5,000 liability which Dave assumes.a) What are the amount and character of the distribution?b) What is Dave's basis in the property?c) When does his holding period for the property begin?Answer: a) The distribution amount is $25,000 ($30,000 - $5,000), all of which is a dividend to Dave as it does not exceed Digger's E&P balance.b) Dave's basis in the property is $30,000, its FMV.c) Dave's holding period starts on March 2.Page Ref.: C:4-9; Example C:4-14Objective: 3

20) Gould Corporation distributes land (a capital asset) worth $90,000 to Gerry, a shareholder. The land has a $30,000 basis to Gould. What is the amount and character of the gain or loss recognized by Gould?Answer: Gould recognizes a $60,000 ($90,000 - $30,000) capital gain, as though Gould had sold the property.Page Ref.: C:4-10; Example C:4-15Objective: 3


21) Strong Corporation is owned by a group of 20 shareholders. During the current year, Strong Corporation pays $225,000 in salary and bonuses to Stedman, its president and controlling shareholder. The IRS audits Strong's tax return and determines that reasonable compensation for Stedman would be $125,000. Strong Corporation agrees to the adjustment.a) What effect does the disallowance of part of the deduction for Stedman's salary and bonuses have on Strong Corporation and Stedman?b) What tax savings could have been obtained by Strong Corporation and Stedman if an agreement had been in effect that required Stedman to repay Strong Corporation any amounts determined by the IRS to be unreasonable?Answer: a) The $100,000 in disallowed salary and bonuses will be nondeductible by Strong Corporation and taxable as a dividend to Stedman. How the IRS will treat this is unclear. Since salary reclassified as dividend income will be taxed at a maximum of 15%, the IRS is not likely to allow an offsetting ordinary deduction upon repayment.b) The repayment may be deductible by Stedman. How the IRS will treat this is unclear. Since salary reclassified as dividend income will be taxed at a maximum of 15%, the IRS is not likely to allow an offsetting ordinary deduction upon repayment.Page Ref.: C:4-11 through C:4-13Objective: 3

22) Maple Corporation distributes land to a noncorporate shareholder. Explain how the following items are computed:a) The amount of the distribution.b) The amount of the dividend.c) The basis of the land to the shareholder.d) The start of the holding period for the land.How would your answers change if the distribution was made to a corporate shareholder?Answer: a) The distribution amount is the FMV of all property received. If the shareholder assumes or acquires a liability in connection with the distribution, it reduces the amount of the distribution (but not below zero).b) The distribution amount is a dividend to the extent it is paid out of the current and accumulated E&P of the corporation.c) The basis of any property received is its FMV. Any liability assumed or acquired by the shareholder in connection with the distribution does not reduce the property's basis.d) The holding period for the property begins on the day after the distribution date.

The answers would not change if the was made to a corporate shareholder because Sec. 301(c) applies the same dividend rules to each type of shareholder. However, a corporation shareholder may be eligible for the dividend-received deduction.Page Ref.: C:4-8 and C:4-9Objective: 3


23) What is a constructive dividend? Under what circumstances are constructive dividends most likely to arise?Answer: A constructive dividend (or undeclared distribution) is an indirect payment made to a shareholder without a formal declaration. Such dividends are most likely to arise in the context of a closely held corporation. Examples of constructive dividends include excess compensation paid to a shareholder-employee or excess lease payments made to a shareholder-lessor.Page Ref.: C:4-11 through C:4-13Objective: 3

24) Jerry purchased land from Winter Harbor Corporation, his 100%-owned corporation, for $275,000. The corporation purchased the land three years ago for $300,000. Similar tracts of land located nearby have sold for $400,000 in recent months. What tax issues should be considered with respect to the corporation's sale of the land?Answer: • What reasons might cause the sale to be $125,000 below the apparent prevailing market?• What gain or loss does Winter Harbor recognize on the sale?• What is Winter Harbor Corporation's E&P balance?• Do the related party sale rules apply to the sale?• If the $125,000 shortfall is a dividend, what gain or loss does Winter Harbor recognize on the distribution?• What is the shareholder's gross income?• What is the shareholder's basis for the land?• What is the shareholder's holding period for the land?• What is the distributing corporation's gain or loss on the distribution?• What effect does the distribution have on the distributing corporation's E&P?

One issue is whether Winter Harbor can recognize a $25,000 loss on the sale of the land to Jerry for $275,000 ($275,000 sale - $300,000 adjusted basis). It appears that Sec. 267 will prevent the recognition of the loss since Jerry and Winter Harbor Corporation are related parties under Sec. 267(b). An additional issue is whether Jerry has a constructive dividend. If similar land has sold recently for $400,000, it appears that the sale should have been $400,000 instead of $275,000. The $125,000 difference between the actual sales and the amount paid for similar land therefore should be considered a constructive dividend. Classifying the difference as a constructive dividend causes Winter Harbor to recognize a $100,000 ($400,000 - $300,000) capital gain on the deemed land sale that occurs under Sec. 311(b) when appreciated property is distributed. It also will trigger a $34,000 ($100,000 × 0.34) income tax liability that will reduce E&P. Jerry will take a $400,000 basis in the land. The distribution will reduce E&P by $125,000.Page Ref.: C:4-8 through C:4-13Objective: 3


25) John, the sole shareholder of Photo Specialty Corporation has had an exceptional year. He is considering issuing himself a large bonus in lieu of a dividend. You are concerned about unreasonable compensation. What issues must be considered?Answer: • The employee's qualifications• The nature, extent, and scope of the employee's work• The size of the business• The complexities of the business• A comparison of the salaries paid with the corporation's gross and net incomes• The prevailing general economic conditions• Whether the corporation has paid any dividends• Compensation for comparable positions in comparable concerns• The corporation's salary policy to its employees• The amount of compensation paid to the particular employees in previous years• The amount of compensation voted by the board of directors.Page Ref.: C:4-12 and C:4-13Objective: 3

LO4: Stock Dividends and Stock Rights

1) In a nontaxable distribution of stock rights, when the value of the rights is less than 15% of the value of the stock with respect to which the rights were distributed, the basis of the rights is zero unless the shareholder elects to allocate stock basis to the rights.Answer: TRUEPage Ref.: C:4-14 and C:4-15Objective: 4

2) In a taxable distribution of stock, the recipient shareholder takes a basis equal to the FMV of the stock received.Answer: TRUEPage Ref.: C:4-15Objective: 4

3) An individual shareholder owns 3,000 shares of Baxter Corporation common stock with a basis of $10 per share. She receives a nontaxable 5% stock dividend. The basis per share of the common stock after the stock dividend isA) $9.00.B) $9.50.C) $9.52.D) $10.00.Answer: CExplanation: $30,000/[3,000 shares + (0.05 × 3,000 shares)] = $9.52Page Ref.: C:4-14Objective: 4


4) Tia owns 2,000 shares of Bass Corporation common stock with an $80,000 basis. Bass distributes a nontaxable preferred stock dividend. When the preferred stock is distributed, it has an FMV of $60,000 and the FMV of the 2,000 common stock shares is $180,000. The basis of the preferred stock isA) $0.B) $20,000.C) $60,000.D) $80,000.Answer: BExplanation: [$60,000 (FMV)/$240,000 (total FMV)] × $80,000 (basis) = $20,000. Basis is allocated based on relative FMVs.Page Ref.: C:4-14; Example C:4-20Objective: 4

5) Bat Corporation distributes stock rights with a $20,000 FMV to its common stock shareholders. The $20,000 value of the stock rights at the time of distribution is less than 15% of the value of the underlying stock. Which of the following statements is true?A) A shareholder must allocate basis to the rights based on the relative FMVs of the stock and the rights.B) A shareholder cannot allocate any basis to the rights.C) The basis in the rights is zero unless a shareholder makes a valid election to allocate basis to the rights.D) The holding period for the rights begins on the day the rights are distributed in all cases.Answer: CPage Ref.: C:4-15; Example C:4-21Objective: 4

6) Identify which of the following statements is false.A) The distribution of stock rights will be taxable if the value of the stock rights is more than 15% of the value of the underlying stock.B) The distribution of stock rights is generally tax free under Sec. 305.C) If the value of stock rights is less than 15% of the value of the underlying stock, the basis of the rights is zero unless the shareholder elects to allocate basis to the rights.D) The holding period for stock rights includes the holding period for the underlying stock.Answer: APage Ref.: C:4-15Objective: 4

7) Bruce receives 20 stock rights in a nontaxable distribution. The stock rights have an FMV of $5,000. The common stock with respect to which the rights are issued has a basis of $4,000 and an FMV of $120,000. Bruce allows the stock rights to lapse. He can deduct a loss ofA) $0.B) $1,000.C) $5,000.D) none of the aboveAnswer: APage Ref.: C:4-15; Example C:4-23Objective: 4


8) Checkers Corporation has a single class of common stock outstanding. Bert owns 100 shares, which he purchased five years ago for $200,000. In the current year, when the stock is worth $2,500 per share, Checkers Corporation declares a 10% stock dividend payable in common stock. Bert receives ten additional shares on December 10 of the current year. On January 25 of next year he sells all ten shares for $30,000.a) How much income must Bert recognize when he receives the stock dividend?b) How much gain or loss must Bert recognize when he sells the ten shares he received as a stock dividend?Answer: a) The stock dividend is nontaxable (Sec. 305(a)).b) Bert's basis in each share is $1,818.18 ($200,000/110 shares). Therefore, his gain on the sale is $11,818.20 [$30,000 - (10 × $1,818.18)].Page Ref.: C:4-14Objective: 4

9) Ace Corporation has a single class of stock outstanding. Alan owns 200 shares of the common stock, which he purchased for $50 per share two years ago. On April 10, of the current year, Ace Corporation distributes to its shareholders one right to purchase a share of common stock at $60 per share for each share of common stock held. At the time of the distribution, the common stock is worth $75 per share, and the rights are worth $15 per right. On September 10, Alan sells 100 rights for $2,000 and exercises the remaining 100 rights. He sells 60 of the shares acquired with the rights for $80 each on November 10.

a) What is the amount and character of income Alan recognizes when he receives the rights?b) What is the amount and character of gain or loss Alan recognizes when he sells the rights?c) What is the amount and character of gain or loss Alan recognizes when he exercises the rights?d) What is the amount and character of gain or loss Alan recognizes when he sells the new common stock?e) What basis does Alan have in his remaining shares?Answer: a) Alan recognizes no income when he receives the rights.b) Since the value of the rights ($15) is more than 15% of the value of the underlying stock ($75), the basis of the stock must be allocated to the stock and the right. Alan's basis in his stock is: $10,000 × ($75/$90) = $8,333.33 ($41.67 per share). Alan's basis in his rights is $10,000 × ($15/$90) = $1,666.67 ($8.33 per right). Alan recognizes a long-term capital gain of $1,166.67 ($2,000 - $833.33) when he sells the 100 rights.c) Alan recognizes no gain when he exercises the rights. Their basis is added to the basis of the stock purchased with the rights ($6,000 + $833.33 = $6,833.33).d) Alan recognizes a gain of $700 [(60 × $80) - (60 × $68.33)] on the stock sale. The gain is a short-term capital gain since the holding period begins on the September 10 exercise date.e) Alan's basis in his remaining shares is as follows: Alan's original 200 shares: $8,333.33 ($10,000 - $1,666.67). Alan's 40 remaining shares purchased with the rights: $2,733.33 (40 shares × $68.33).Page Ref.: C:4-15 and C:4-16Objective: 4


10) Why are stock dividends generally nontaxable? Under what circumstances are stock dividends taxable?Answer: Stock dividends generally are nontaxable because they do not add anything to the property the shareholder already owns, nor do they reduce the property of the corporation. As a general rule, the distribution is taxable whenever a stock dividend changes or has the potential to change the shareholder's proportionate interest in the distributing corporation.Page Ref.: C:4-13 and C:4-14Objective: 4

LO5: Stock Redemptions

1) A stock redemption is always treated as if the shareholder sold his stock to the corporation.Answer: FALSEPage Ref.: C:4-17Objective: 5

2) The Sec. 318 family attribution rules can be waived for purposes of the Sec. 302(b)(3) complete termination rules even though the redeeming shareholder is a creditor of the corporation.Answer: TRUEPage Ref.: C:4-22Objective: 5

3) A partial liquidation of a corporation is treated as a dividend in the case of a corporate shareholder.Answer: TRUEPage Ref.: C:4-24 and C:4-25Objective: 5

4) Identify which of the following statements is true.A) The distributing corporation's E&P must be reduced by the FMV of nontaxable stock rights distributed to shareholders.B) A stock redemption can be used to withdraw some assets from a corporation prior to a sale of the business.C) A shareholder can redeem part of his stock and recognize a capital gain if the corporation has only one shareholder.D) All of the above are false.Answer: BPage Ref.: C:4-16Objective: 5

5) Which of the following is not a reason for a stock redemption?A) desire by remaining shareholders to retain controlB) desire by shareholders to reduce the corporate tax liabilityC) Redemption of shares is a good corporate investment.D) No outside market exists for the stock.Answer: BPage Ref.: C:4-16Objective: 5


6) Elijah owns 20% of Park Corporation's single class of stock. Elijah's basis in the stock is $8,000. Park's E&P is $28,000. If Park redeems all of Elijah's stock for $48,000, Elijah must report dividend income ofA) $0.B) $28,000.C) $40,000.D) $48,000.Answer: AExplanation: The redemption will be treated as a complete termination under Sec.302(b)(3).Page Ref.: C:4-17; Example C:4-25Objective: 5

7) Joshua owns 100% of Steeler Corporation's stock. Joshua's basis in the stock is $8,000. Steeler Corporation has E&P of $40,000. If Steeler Corporation redeems 60% of Joshua's stock for $50,000, Joshua must report dividend income ofA) $0.B) $8,000.C) $40,000.D) $50,000.Answer: CExplanation: The entire amount of the distribution is dividend income to the extent of E&P. Here, E&P of $40,000 is the maximum dividend distribution. The remaining $10,000 of the distribution reduces the basis of his stock to zero, and causes a $2,000 capital gain to be recognized.Page Ref.: C:4-17; Example C:4-24Objective: 5

8) Which of the following is not a condition that permits a stock redemption to be treated as a sale?A) It provides funds for payment of income taxes.B) It is not essentially equivalent to a dividend.C) The redemption is substantially disproportionate.D) The redemption completely terminates the shareholder's interest.Answer: APage Ref.: C:4-17 through C:4-20Objective: 5

9) Identify which of the following statements is false.A) A stock redemption is treated as a sale or exchange only if the shareholder's ownership of one particular class of stock is terminated.B) An individual is not considered to own stock owned by a brother under the family attribution rules of Sec. 318.C) An individual is considered to own the stock owned by his parents, children, spouse, and grandchildren under the family attribution rules of Sec. 318.D) A person who has an option to purchase stock is considered to own the stock.Answer: APage Ref.: C:4-18Objective: 5


10) What are the consequences of a stock redemption to the distributing corporation?A) The corporation recognizes a gain or loss as if it had sold the distributed property for its FMV immediately before the redemption.B) If the redemption is treated as a dividend, E&P is reduced in the same manner as for a regular dividend.C) If the redemption is treated as a sale, only accumulated earnings and profits is reduced.D) All of the above are correct.Answer: BPage Ref.: C:4-19Objective: 5

11) Identify which of the following statements is true.A) Generally in a stock redemption, if the shareholder's ownership percentage is substantially reduced, the redemption is treated as a sale.B) The family attribution rules of Sec. 318 are as inclusive as the family attribution rules of Sec. 267.C) A 10% shareholder of a corporation is considered to own 10% of any stock that is owned by the corporation under the Sec. 318 attribution rules.D) All of the above are false.Answer: APage Ref.: C:4-18Objective: 5

12) Which of the following requirements must be met for a redemption to be treated as substantially disproportionate?A) The shareholder must own less than 50% of the outstanding stock (in terms of voting power) after the redemption.B) After the redemption, the shareholder must own less than 80% of his percentage ownership of voting stock prior to the redemption.C) After the redemption, the shareholder must own less than 80% of his percentage ownership of common stock (voting and nonvoting) prior to the redemption.D) All of the above must be met.Answer: DPage Ref.: C:4-20Objective: 5

13) Identify which of the following statements is true.A) Stock ownership attributed to a corporation from one of its shareholders cannot be attributed to another of the corporation's shareholders under the Sec. 318 attribution rules.B) Under the attribution rules relating to stock redemptions, a person who has an option to purchase stock is considered to own the stock.C) A stock redemption that qualifies as substantially disproportionate is a safe harbor for capital gain treatment.D) All of the above are true.Answer: DPage Ref.: C:4-20 and C:4-21Objective: 5


14) Identify which of the following statements is true.A) The Sec. 318 family attribution rules can be waived for purposes of the Sec. 302(b)(3) complete termination rules even though the redeeming shareholder is a creditor of the corporation.B) Waiver of the Sec. 318 family attribution rules is permitted for all related party stock transactions.C) For a redemption to be essentially equivalent to a dividend, the shareholder must not have control of the corporation immediately following the redemption.D) All of the above are false.Answer: APage Ref.: C:4-22Objective: 5

15) Family Corporation, a corporation controlled by Buddy's family, redeems all of Buddy's stock. For the redemption to be treated as a sale, which one of the following conditions must be met?A) Buddy cannot be a creditor of the corporation after the redemption.B) Buddy cannot be an officer of the corporation after the redemption.C) Buddy cannot acquire an interest, even by inheritance, for 10 years unless the bequest was made prior to the redemption.D) Buddy must have purchased the redeemed stock from a person whose stock ownership would be attributed to Buddy.Answer: BPage Ref.: C:4-22Objective: 5

16) All of Sphere Corporation's single class of stock is owned by four unrelated individuals in the following manner: Zack 27%, Xu 24.33%, Yvonne 24.33%, and Win 24.33%. Some of Zack's stock holdings are redeemed by Sphere Corporation, resulting in Zack's interest being reduced to 22.27%. Xu, Yvonne, and Win owned equally the remaining 77.73% of the Sphere stock. How should the redemption of Zack's stock be treated by Zack?A) dividend incomeB) sale transactionC) return of capitalD) some other treatmentAnswer: BPage Ref.: C:4-23; Example C:4-35Objective: 5

17) Identify which of the following statements is true.A) To have a bona fide partial liquidation, a firm must continue to conduct a qualified trade or business, which it had conducted for a period of more than three years prior to the redemption.B) To qualify as a partial liquidation, a distribution must result in a bona fide contraction of the corporate business at the corporate level.C) A partial liquidation of a corporation must be pro rata.D) All of the above are false.Answer: BPage Ref.: C:4-24Objective: 5


18) Blast Corporation manufactures purses and make-up kits. The corporation decides to quit manufacturing purses and distributes the assets associated with this division to its shareholders. The distribution of the these assets will be treated as a partial liquidation ifA) the corporation so elects.B) the corporation discontinues the line of business and the transaction is "essentially equivalent to a dividend."C) the distribution is made within 24 months of the adoption of a plan of liquidation and the transaction is "not essentially equivalent to a dividend."D) the distribution is "not essentially equivalent to a dividend" and is made within the year a plan of liquidation is adopted or within the succeeding year.Answer: DPage Ref.: C:4-24Objective: 5

19) Perch Corporation has made paint and paint brushes for the past ten years. Perch Corporation is owned equally by Arnold, an individual, and Acorn Corporation. Perch Corporation has $100,000 of accumulated and current E&P. Both Arnold and Acorn Corporation have a basis in their stock of $10,000. Perch Corporation discontinues the paint brush operation and distributes assets worth $10,000 each to Arnold and Acorn Corporation in redemption of 20% of their stock. Due to the distribution, Arnold and Acorn Corporation must report:

A) Arnold Acorn Corporation$8,000 capital gain $8,000 capital gain

B) Arnold Acorn Corporation$8,000 capital gain $10,000 dividend

C) Arnold Acorn Corporation$10,000 dividend $8,000 capital gain

D) Arnold Acorn Corporation$10,000 dividend $10,000 dividend

Answer: BExplanation: Acorn Corporation is a corporate shareholder and not eligible for the partially liquidating distributions to be treated as a sale since the distribution is pro rata. Arnold is eligible for sale treatment under the Sec. 302(b)(4) partial liquidation rules.Page Ref.: C:4-24 and C:4:25; Example C:4-37Objective: 5


20) The gross estate of a decedent contains $2,000,000 cash and 100% of Davis Corporation stock worth $600,000. Funeral and administrative expenses and state death taxes allowable as estate tax deductions amount to $400,000. The estate owes no other liabilities. The decedent's Davis stock can beA) redeemed to the extent of the death taxes and the estate's funeral and administrative costs with sale or exchange treatment.B) redeemed with dividend treatment.C) redeemed in full with sale or exchange treatment only if the proceeds are used to pay the death taxes and funeral and administrative costs.D) redeemed to the extent of the death taxes and the funeral and administrative costs with sale or exchange treatment only if the proceeds are used to pay the death taxes and funeral and administrative costs.Answer: BExplanation: The FMV of the stock does not meet the 35% of the adjusted gross estate minimum [($2,000,000 + $600,000 - $400,000) × 0.35 = $770,000].Page Ref.: C:4-25; Example C:4-38Objective: 5

21) Identify which of the following statements is true.A) If a stock redemption is made by an estate following the decedent's death, the redemption may receive capital gains treatment only if the money is actually used to pay the death taxes.B) Attribution rules do not apply to qualified Sec. 303 stock redemptions.C) The value of decedent's stock satisfies the Sec. 303 minimum if it is less than 35% of the decedent's gross estate.D) All of the above are false.Answer: BPage Ref.: C:4-25Objective: 5

22) Identify which of the following statements is true.A) Only stock included in the decedent's gross estate can be redeemed under the Sec. 303 provisions.B) If the stock redemption proceeds are used to pay either the estate's funeral and administrative expenses or death taxes, the redemption can qualify for capital gains treatment under Sec. 303.C) Usually, a stock redemption qualifying under Sec. 303 as a redemption to pay death taxes will result in little or no gain to the redeeming shareholder.D) All of the above are true.Answer: DPage Ref.: C:4-25Objective: 5


23) Jack Corporation redeems 200 shares of its stock for $100,000 from Junior, who inherited the stock from his father, Ken. The stock's FMV on Ken's date of death was $90,000. Ken's basis in the stock was $40,000. Jack Corporation had an E&P balance of $300,000. If the redemption qualifies under Sec. 303, Junior willA) recognize a capital gain of $10,000.B) recognize a capital gain of $60,000.C) recognize $100,000 in dividend income.D) recognize dividend income of $50,000 and a capital gain of $10,000.Answer: APage Ref.: C:4-26; Example C:4-41Objective: 5

24) Identify which of the following statements is false.A) The rules for the recognition of a gain or loss by a corporation that distributes property in redemption of its stock are the same as the rules for property distributions that are not in redemption of stock.B) Generally, little or no gain is recognized by the redeeming shareholder in a qualified Sec. 303 redemption.C) When a stock redemption is considered a sale of stock by the shareholder, the E&P of the redeeming corporation is reduced by the FMV of the property used to redeem the stock.D) Under Sec. 311, a corporation does not recognize a loss when it distributes property that has declined in value.Answer: CPage Ref.: C:4-27Objective: 5

25) Circle Corporation has 1,000 shares of common stock outstanding. Circle redeems 450 shares owned by Dennis for $75,000 in complete redemption of Dennis's interest. The redemption qualifies as a sale. When the redemption is made, Circle Corporation has $150,000 of current and accumulated E&P and paid-in capital of $50,000. The distribution reduces paid-in capital byA) $67,500.B) $22,500.C) $7,500.D) $0.Answer: CExplanation: $150,000 × 0.45 = $67,500 E&P reduction, leaving $17,500 to reduce paid-in capital. The distribution first reduces E&P by the percentage reduction in stock ownership; the balance reduces paid-in capital.Page Ref.: C:4-27; Example C:4-42Objective: 5

26) Peter owns all 100 shares of Parker Corporation's stock. His basis in the stock is $30,000. Parker Corporation has $300,000 of E&P. Parker Corporation redeems 25 of Peter's shares for $90,000. What are the consequences to Peter and to Parker Corporation?Answer: Since Peter still owns 100% of Parker Corporation's stock, the redemption is treated as a dividend. Peter has a $90,000 dividend taxed at a maximum of 15%. His basis in his remaining 75 shares remains at $30,000. Parker Corporation's E&P is reduced by $90,000.Page Ref.: C:4-16 through C:4-18Objective: 5

27) Maury Corporation has 200 shares of stock outstanding as follows:

Name SharesAmy (an individual) 30


APB Partnership (Amy is a 20% partner) 25ABC Partnership (Amy is a 70% partner) 50Silver Corporation (Amy is a 30% shareholder) 50Gold Corporation (Amy is a 60% shareholder) 45

Total 200

How many shares is Amy deemed to own under the Sec. 318 attribution rules?Answer: Amy owns: 30 shares directly

5 shares through APB Partnership (0.20 × 25 shares)35 shares through ABC Partnership (0.70 × 50 shares)0 shares through Silver Corporation27 shares through Lime Corporation (0.60 × 45 shares)

Thus, total deemed constructive ownership is 97 shares.Page Ref.: C:4-18 through C:4-20Objective: 5

28) Dave, Erica, and Faye are all unrelated. Each has owned 100 shares of News Corporation stock for five years and each has a $180,000 basis in those 100 shares. News Corporation's E&P is $720,000. News redeems all 100 of Dave's shares for $300,000, their FMV.a) What is the amount and character of Dave's recognized gain or loss? What basis do Erica and Faye have in their remaining shares? What effect does the redemption have on News's E&P?b) Assuming instead that Dave is Erica's son, answer the questions in part (a) again.Answer: a) This is a complete termination of interest and therefore Sec. 302(b)(3) applies. Dave recognizes a gain of $120,000 ($300,000 - $180,000 basis). Erica and Faye each retain a basis of $180,000 in their shares. News's E&P is reduced by $240,000 [(100/300 shares) × $720,000].b) If Erica is Dave's mother and a waiver of the family attribution rules is not elected, Dave is considered to own 200/300 or 66 2/3% before the redemption and 100/200 or 50% after the redemption. Therefore, the redemption is treated as a dividend of $300,000 to Dave. Erica's $180,000 basis is increased by Dave's $180,000 basis in the shares surrendered to $360,000. Faye's basis remains the same at $180,000. News's E&P is reduced by $300,000, the amount of the dividend paid to Dave.

Alternatively, Dave could elect under Sec. 302(c) to waive the family attribution rules. If such an election is made, the Sec. 302(b)(3) rules that applied in determining the answer in part (a) will provide capital gain treatment.Page Ref.: C:4-21 through C:4-23Objective: 5


29) What is a stock redemption? What are some of the reasons for making a stock redemption? Why are some redemptions treated as sales and others as dividends?Answer: A stock redemption is the acquisition by a corporation of its own stock. Some reasons for a redemption are listed on pages C:4-16. Some redemptions that substantially change the shareholder's proportionate interest closely resemble a sale of stock to a third party and are treated as a sale or exchange, while others that do not produce such a change are essentially equivalent to a dividend and are taxed as a dividend.Page Ref.: C:4-16Objective: 5

30) Stone Corporation redeems 1,000 share of its stock from Steve for $100,000. Steve's basis in those shares is $80,000. What tax issues should Steve consider with respect to the transaction?Answer: • Is the redemption a sale?• Is the redemption not a sale?

If the redemption is treated as a sale, Steve has a $2,000 capital gain ($10,000 - $8,000). If the redemption is not treated as a sale, Steve has a $10,000 distribution that is a dividend to the extent of Stone Corporation's current and accumulated E&P. In the dividend case, Steve's $8,000 basis in the redeemed stock is added to his basis in his remaining stock.Page Ref.: C:4-17Objective: 5


31) Nichol Corporation has 100 shares of common stock outstanding. Nichol repurchased all of Ned's 30 shares for $35,000 cash during the current year. Ned received the shares as a gift from his mother three years ago. They have a basis to him of $16,000. Nichol Corporation has $100,000 in current and accumulated E&P. Ned's mother owns 40 of the remaining shares; unrelated individuals own the other 30 shares. What tax issues should be considered with respect to the corporation's purchase of Ned's shares?

Answer: • What is Ned's stock ownership before and after the redemption?• Are any shares attributed to Ned from his mother?• Can Ned elect to waive the family stock attribution rules?• What is the amount and character of Ned's gain or income on the stock redemption?• What is Ned's basis in the 30 shares of stock he received as a gift from his mother?• If the transaction is a dividend, what happens to Ned's basis in his stock?• What is Ned's mother's basis for her stock after the redemption (i.e., is any of Ned's remaining basis transferred to his mother)?• Does the corporation recognize any gain on the repurchase of the shares?• What is its basis for the shares repurchased?• What effect does the redemption have on Nichol Corporation's E&P?

The issue is whether the redemption should be treated as a sale or a dividend. Ned is deemed to own the shares owned by his mother. Therefore, he is deemed to have owned 70 shares before the redemption (70/100 = 70% of the Nichol stock) and 40 shares after the redemption (40/70 = 57% of the Nichol stock). Thus, the redemption is not substantially disproportionate under Sec. 302(b)(2).

The second issue is whether Ned can sign a waiver to have the family attribution rules waived under Sec. 302(b)(3). The problem is that he received his shares as a gift from his mother. If Ned can show that tax avoidance was not the principal purpose for the gift of the Nichol stock, he can sign a waiver, and the redemption will be treated as a sale. In such case, he has a $19,000 ($35,000 - $16,000) LTCG. E&P will be reduced by 30% of the current and accumulated E&P, or $30,000 (0.30 × $100,000). If a waiver of the family attribution rules is not possible, Ned will most likely have a $35,000 dividend. It is not likely that the Sec. 302(b)(1) "not essentially equivalent to a dividend" rules will apply since Ned still maintains a majority stock ownership position in Nichol following the redemption. If the transaction is a dividend, his basis for all 30 shares will be reallocated to his mother since she is the individual whose stock ownership prevented the redemption from receiving capital gain treatment. E&P will be reduced by the $35,000 distributed to Ned. The corporation's basis for the redeemed shares is not important since it recognizes no gain or loss when it issues new or treasury stock (Sec. 1032).Page Ref.: C:4-16 through C:4-23Objective: 5


LO6: Preferred Stock Bailouts

1) Identify which of the following statements is true.A) The distribution of preferred stock as a stock dividend will result in income or a taxable gain being recognized by the shareholder on the date of the distribution if the stock is Sec. 306 stock.B) Corporations without E&P can distribute preferred stock as a stock dividend that is Sec. 306 stock.C) Two corporations are considered to be brother-sister corporations for purposes of the Sec. 304 redemption rules if one shareholder owns more than 50% of each corporation.D) All of the above are false.Answer: CPage Ref.: C:4-30Objective: 6

2) Bart, a 50% owner of Atlas Corporation's common stock, receives a distribution of a new class of Atlas preferred stock having a $40,000 FMV. Bart's basis in the Atlas common stock is $30,000. Its FMV is $80,000 on the distribution date. One year later, the corporation redeems the preferred stock for $75,000. At the time the stock was issued, the corporation's current and accumulated E&P was $80,000. At the end of the year of redemption, the current and accumulated E&P is $25,000. No other distributions out of E&P were made in the year of redemption. What are the tax consequences of the transaction?Answer: The basis allocated of the common stock is: $30,000 × [$40,000/($40,000 + $80,000)] = $10,000

The redemption of Bart's preferred stock is treated as a dividend under Sec. 301. Bart's dividend income under Sec. 306 is limited to Atlas Corporation's E&P at the time of the stock redemption, or $25,000. Consequently, Bart has $25,000 of dividend income, $10,000 treated as a return of capital, and $40,000 of capital gain [$75,000 - ($25,000 + $10,000)].Page Ref.: C:4-28 through C:4-30Objective: 6

3) Define Sec. 306 stock.Answer: Sec. 306 stock is stock, other than common stock, issued with respect to common stock that is received in a nontaxable stock dividend. It can also be stock, other than common stock, acquired in an exchange to which Sec. 351 applies if the receipt of money (in lieu of stock) would have been treated as a dividend. Sec. 306 stock also includes stock, other than common stock, received in a tax-free corporate reorganization or corporate division if the effect of the transaction was substantially the same as the receipt of a stock dividend or if the stock was received in exchange for Sec. 306 stock. Finally, Sec. 306 stock is any stock whose basis is determined by reference to the basis of Sec. 306 stock (i.e., a substituted or transferred basis). Sec. 306 stock can only be issued by a corporation having E&P in the year of issuance. The Sec. 306 stock designation lapses upon inheritance since the basis of such stock is its FMV on the date of death (or alternative valuation date).Page Ref.: C:4-28Objective: 6


LO7: Stock Redemptions by Related Corporations

1) Two corporations are considered to be brother-sister corporations for purposes of the Sec. 304 redemption rules if one shareholder owns more than 50% of each corporation.Answer: TRUEPage Ref.: C:4-30Objective: 7

2) John owns 70% of the May Corporation stock and 60% of the June Corporation stock. John sells one-half of his interest in May Corporation to June Corporation for $45,000. The E&P accounts of May and June are $25,000 and $35,000, respectively. The result would be thatA) John has sold his stock and reports a capital gain or loss.B) John has sold his stock and reports a capital gain but no loss.C) the transaction is treated as a contribution to May's capital and a redemption of June stock.D) the sale is recast as a dividend paid to John, first by June and then by May.Answer: DPage Ref.: C:4-30 and C:4-31Objective: 7

3) Boris owns 60 of the 100 shares outstanding of Bread Corporation stock and 80 of the 100 shares of Butter Corporation stock. His basis in the Bread shares is $10,000 and his basis in his Butter shares is $5,000. Boris sells 30 of his Bread Corporation shares to Butter Corporation for $25,000. Bread Corporation has E&P of $20,000 and Butter Corporation has E&P of $40,000. In applying the substantially disproportionate test to determine if this is a sale or a dividend, Boris is treated as owning how many shares of Bread after the sale?A) 30 sharesB) 54 sharesC) 60 sharesD) 80 sharesAnswer: BExplanation: Boris owned 60 shares and sold 30. Since he owns 80% of the corporation that acquired the 30 shares, he is treated as owning 80% of their 30, or 24 shares. He owns in total 54 [(60 - 30) + 24] shares.Page Ref.: C:4-31; Example C:4-45Objective: 7

4) Rose has a $20,000 basis in the 60% of the Parent Corporation stock that she owns. Parent Corporation owns a 70% interest in Child Corporation. Parent and Child have current and accumulated E&P balances of $25,000 and $40,000, respectively. In return for $15,000, Rose sells 10% of the Parent Corporation stock to Child Corporation. What is the impact of the transaction on Rose?A) Rose will recognize a $5,000 capital gain.B) Rose will be treated as having received a $15,000 dividend distribution from Child Corporation.C) Rose will be treated as having sold stock to Parent Corporation and recognize a $15,000 capital gain.D) Rose will be treated as having received a $15,000 dividend from Parent Corporation.Answer: BPage Ref.: C:4-32Objective: 7


5) Which of the following statements is not true about redemptions?A) Redemptions of Sec. 306 stock are generally treated as dividends to the shareholder.B) A sale of stock from one controlled corporation to another controlled corporation is treated as a redemption.C) Redemptions to pay death taxes are treated as dividends to the shareholder.D) A distribution in redemption of stock is generally a dividend.Answer: CPage Ref.: C:4-33Objective: 7

6) Susan owns 150 of the 200 outstanding shares of Parent Corporation's stock. Parent owns 160 of the 200 outstanding shares of Subsidiary Corporation's stock. Susan sells 50 shares of her Parent stock to Subsidiary for $40,000. Susan's basis in her Parent shares is $15,000 ($100 per share). Subsidiary Corporation and Parent Corporation have E&P of $60,000 and $25,000, respectively, at the end of the year in which the redemption occurs.a) What is the amount and character of Susan's gain or loss on the sale?b) What is Susan's basis in her remaining shares of Parent stock?c) How does the sale affect the E&P of Parent and Subsidiary Corporations?d) What basis does Subsidiary Corporation take in the Parent shares it purchases?e) How would your answer to Part (a) change if Susan instead sells 100 of her Parent shares to Subsidiary Corporation for $80,000?Answer: a) The sale is recast as a redemption. Since Susan still owns more than 50% of Parent after the redemption, [100 shares directly and 20 (50% × 80% × 50) shares indirectly out of 200 outstanding shares], or 60% of Parent's stock, the $40,000 is taxed as a dividend to Susan.b) Susan's basis in her remaining 100 shares of Parent stock is $15,000.c) Subsidiary Corporation's E&P is reduced to $20,000 ($60,000 - $40,000).d) Subsidiary Corporation's basis in the Parent shares is $40,000.e) The recast redemption is substantially disproportionate {75% before the redemption and 70 [50 + 20 (25% × 80% × 100)] shares, or 35%, after the redemption}. Therefore, Susan has a capital gain of $70,000 [$80,000 - (100/150 × $15,000)].Page Ref.: C:4-30 through C:4-33Objective: 7


7) Rich owns 60 of the 100 outstanding shares of Rainbow Corporation's stock and 80 of the 100 outstanding shares of Oz Corporation's stock. Rich's basis in his Rainbow shares is $12,000, and his basis in his Oz shares is $8,000. Rich sells 30 of his Rainbow shares to Oz Corporation for $50,000. At the end of the year of the sale, Rainbow and Oz Corporations have E&Ps of $25,000 and $40,000, respectively.a) What is the amount and character of Rich's gain or loss?b) What is Rich's basis in his remaining shares of the Rainbow and Oz stock?c) How does the sale affect the E&Ps of Rainbow and Oz Corporations?d) What basis does Oz Corporation take in the Rainbow shares it purchases?e) How would your answer to part (a) change if Rich owns only 50 shares of the 100 outstanding shares of Oz Stock?Answer: a) The sale is recast as a redemption of Oz stock issued as a result of Rich's capital contribution of the Rainbow stock to Oz. The Sec. 302 stock ownership is tested by looking at Rich's ownership of the Rainbow stock.

• Rich's ownership of Rainbow stock before the redemption: 60% of Rainbow stock.• Rich's ownership after the redemption: 30 shares directly and 80% × 30 shares

indirectly = 54 shares = 54% of Rainbow stock.The redemption is treated as a $50,000 dividend to Rich since the combined E&P of Rainbow and Oz Corporations is $65,000 ($25,000 + $40,000).b) Rich's basis in his remaining Rainbow stock is $6,000 (30/60 × $12,000). Rich's basis in his Oz stock is increased to $14,000 by his $6,000 basis in the redeemed Oz stock.c) Oz's E&P is reduced by the first $40,000 of the distribution, and Rainbow's E&P is reduced by the remaining $10,000 ($50,000 - $40,000) of the distribution.d) Oz's basis in its Rainbow shares is $6,000, the same as Rich's pre-sale basis.e) If Rich owned only 50% of the Oz stock before the sale, Rich owns 60% of the Rainbow stock before and 45% after the sale [30 shares + (50% × 30 shares)], so the redemption is treated as a sale under Sec. 302(b)(2). Rich has a capital gain of $44,000 ($50,000 - $6,000 basis).Page Ref.: C:4-31 through C:4-33Objective: 7

8) Alice owns 56% of Daisy Corporation's stock and 50% of May Corporation's stock. Alice sells one-half of her interest in May Corporation to Daisy Corporation for $30,000. The E&P balances of Daisy and May are $25,000 and $35,000, respectively. Alice's basis in her Daisy stock is $40,000 and her basis in the May stock is $38,000. What are the tax consequences of the transaction?Answer: The transaction is recast as a redemption by Daisy Corporation of Alice's Daisy stock that was received as a result of the capital contribution of the May stock. To test for exchange treatment, the Sec. 302(b) rules are applied to Alice's interest in May Corporation. Alice's interest in May Corporation after the distribution is 39% [25% direct ownership + 14% (56% × 25%) indirect ownership]. Since this is less than 80% of her pre-redemption ownership (50% × 0.80 = 40%), the transaction is treated as a substantially disproportionate redemption that is taxed as an exchange. This results in an $11,000 [$30,000 - (0.50 × $38,000)] capital gain being recognized by Alice.Page Ref.: C:4-31 and C:4-32; Examples C:4-45 and C:4-46Objective: 7


9) Ameriparent Corporation owns a 70% interest in Flag Corporation. The corporations have current and accumulated E&Ps of $25,000 and $40,000, respectively. Taxpayer, who has a $20,000 basis in her 40% ownership interest of Ameriparent Corporation, sells sufficient stock to Flag to reduce her interest in Ameriparent from 40% to 20%. Taxpayer receives $20,000 for the stock she surrenders. What are the tax consequences of the transaction for Taxpayer?Answer: The transaction is recast under Sec. 304 as a distribution from Ameriparent in redemption of Taxpayer's stock. The $20,000 purchase is a dividend under Sec. 301 since Taxpayer's interest was not less than 80% of what it was prior to the redemption [20% direct + 14% indirect = 34%,which is not less than the 32% (40% × 80% = 32%) minimum needed for substantially disproportionate treatment]. The redemption might be eligible for capital gain treatment if the distribution is considered to be not essentially equivalent to a dividend. It is possible that this interpretation will be accepted, since Taxpayer goes from one minority position to another minority position.Page Ref.: C:4-31Objective: 7

LO8: Tax Planning Considerations

1) Marie owns one-half of the stock of Starke Corporation and serves as its President. The remaining stock is owned by 10 investors, none of whom owns more than 10% of the outstanding shares. Marie entered a hedge agreement with the corporation three years ago about salary payments that are declared unreasonable compensation by the IRS. Two years ago, the Corporation paid Marie a salary and bonus of $500,000. The IRS subsequently held that $200,000 of the salary is unreasonable compensation. Last year, Starke Corporation and the IRS agreed that $150,000 of the compensation is, in fact, unreasonable. This year, the $150,000 is repaid by Marie to the corporation.A) The entire $500,000 is taxable to Marie in the year of receipt and $150,000 of the compensation is deductible by Marie last year.B) Marie must amend the return of two years ago to adjust her taxable compensation to the agreed- upon reasonable amount.C) The entire $500,000 is taxable to Marie in the year of receipt and $150,000 of the compensation is deductible by Marie this year.D) Marie must not include the agreed-upon amount in her return since it is not deductible.Answer: CPage Ref.: C:4-34; Example C:4-49Objective: 8


2) Van owns all 1,000 shares of Valley Metal Corporation stock. The stock has a $100,000 FMV. Karen wants to purchase the stock from Van but has only $70,000. Valley Metal has ample cash, which is not needed for operations. Which of the following best qualifies for bootstrap redemption treatment and no constructive dividends to the purchaser?A) Karen contracts to acquire all the stock of the corporation on an installment plan and then uses corporate funds to pay the installment obligations.B) Karen buys 70 shares from Van for $70,000 and Van causes Valley Metal Corporation to redeem his remaining shares for $30,000.C) Karen buys 70 shares from Van for $70,000 and then contracts to buy the remaining 30 shares from Van. She then causes Valley Metal Corporation to redeem Van's 30 shares.D) Karen buys 70 shares from Van for $70,000 and obtains an option to purchase Van's remaining stock for $50,000. Karen then assigns the option to Valley Metal Corporation. The corporation subsequently exercises the option.Answer: BPage Ref.: C:4-34; Example C:4-50Objective: 8

3) Which of the following statements best describes a bootstrap acquisition?A) The shareholder sells part of his or her stock to a purchaser and then the corporation redeems the original shareholder's remaining stock.B) The shareholder sells his stock in exchange for cash and debt.C) The shareholder exchanges his stock for stock of a different corporation.D) none of the aboveAnswer: APage Ref.: C:4-34Objective: 8

4) Good Times Corporation has a $60,000 accumulated E&P balance at the beginning of the year and incurs a $100,000 deficit during the year. Because of its poor operating performance, Good Times pays only three of its usual $10,000 quarterly dividend payments to its sole shareholder: those ordinarily paid March 31, June 30, and September 30. How are the March 31, June 30, and September 30 payments of $10,000 treated?A) dividend; dividend; return of capitalB) dividend; return of capital; return of capitalC) return of capital; dividend; dividendD) return of capital; return of capital; dividendAnswer: BPage Ref.: C:4-35 and C:4-36; Example C:4-52Objective: 8


LO9: Compliance and Procedural Considerations

1) What must be reported to the IRS by corporations when nondividend distributions are made to its shareholders?Answer: The basic purpose of Form 5452, Corporate Report of Nondividend Distributions, is to report the E&P of the distributing corporation so that the IRS can determine whether the distributions are indeed nontaxable to shareholders. The corporation must include its current and accumulated E&P, the amounts paid to shareholders during the year and the percentage of each payment that is taxable and nontaxable, and a detailed computation of the corporation's E&P since incorporation.Page Ref.: C:4-36Objective: 9


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Chapter c4