Wassim Zhani Chapter 4 Corporate Dictributions Stock Redemptions and Partial Liquidations.pdf

Corporate Distributions:
Stock Redemptions and
Partial Liquidations
Solutions to Tax Research Problems
TA X RE S E A R C H PR O B L E M S
4-33 Ms. J, an individual, owns 74 percent of the shares of the stock of D Corporation as computed below.
Ownership Shares
Direct 60
Indirect:
Partnership X (20% 20) 4
Partnership Y (70% 20) 14
Total 78/100 ¼ 78%
Under § 318(a)(2)(B), stock owned by a partnership is deemed to be owned proportionately by its partners
regardless of the partners’ interest in the partnership. (See p. 4-8.)
5- Partnership X owns 94 percent of the stock of D Corporation. Under the owner to entity attribution
rules of § 318(a)(3), stock owned by those having an interest in an entity is generally attributed in full to the
entity. In addition, under § 318(a)(5), the stock owned by partnership Y that is attributable to J under
§ 318(a)(2) (70% 20 ¼ 14) is deemed to be actually owned by J and thus may be reattributed to
Partnership X under § 318(a)(3). Note that § 318(a)(5) permits attribution under § 318(a)(2) to be followed
by an attribution under § 318(a)(3).
Ownership Shares
Direct 20
Indirect:
J’s direct interest 60
J’s indirect interest through
Partnership Y (70% 20) 14
Total 94/100 ¼ 94%
Partnership Y owns 84 percent of the stock of D Corporation. Under the owner to entity attribution rules
of § 318(a)(3), stock owned by those having an interest in an entity is generally attributed to the entity in
full. In addition, under § 318(a)(5), the stock owned by partnership X that is attributable to J under
§ 318(a)(2) (20% 20 ¼ 4) is deemed to be actually owned by J and thus may be reattributed to Partnership
Y under § 318(a)(3). Note that § 318(a)(5) permits attribution under § 318(a)(2) to be followed by an
attribution under § 318(a)(3).
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4-1

Ownership Shares
Direct 20
Indirect:
J’s direct interest 60
J’s indirect interest through
Partnership X (20% 20) 4
Total 84/100 ¼ 84%
4-34 Mr. R, an individual, owns 74 percent of the shares of the stock of C Corporation as computed below.
Ownership Shares
Direct 20
Indirect:
R’s indirect interest through X 0
R’s indirect interest through
Corporation Y (70% 20) 14
Total 74/100 ¼ 74%
Under § 318(a)(2)(C) stock owned by a corporation is deemed to be owned proportionately only by
shareholders owning at least 50 percent of the corporation’s stock. Consequently, because Mr. R owns
70 percent of the Y stock he owns his proportionate share of what Y owns, 14 percent (70% 20%). Mr. R
owns none of what X owns because he owns only 20 percent of X.
5- X Corporation owns 20 percent of the stock of C Corporation. Under the owner to entity attribution
entity. Stock owned by a shareholder is attributed to the corporation only if the shareholder owns either
directly or indirectly at least 50 percent of the corporation. Because Mr. R owns only 20 percent of X, none
of his direct or indirect interest in C is attributable to X.
5- Y Corporation owns 80 percent of the stock of C Corporation. Under the owner to entity attribution
entity. Stock owned by a shareholder is attributed to the corporation only if the shareholder owns either
directly or indirectly at least 50 percent of the corporation. Because Mr. R owns 70 percent of Y, all of his
60 percent direct interest in C is attributable to X.
4-35 The critical issue facing Bennie in this case is whether he will be treated as either retaining or acquiring the
so-called “prohibited interest” under § 302(c)(2)(A). If he is treated as having retained or acquired an
interest in ATF, the family attribution rules of § 318 cannot be waived, thus causing the redemption to be
treated as a dividend rather than a sale or exchange. In such case, Bennie would be denied favorable capital
gain treatment and would be unable to reduce his income by the basis in his stock.
5- Pursuant to § 302(b)(3), a redemption shall be treated as a sale if it “is in complete redemption of all of
the stock of the corporation owned by the shareholder.” In determining whether a complete termination of
interest has occurred, the constructive ownership rules must be taken into account. Under the constructive
ownership rules, Bennie is treated as owning all of the stock of his son [§ 318(a)(1)]. As a result, Bennie
owns 100 percent of ATF both before and after the redemption. Thus, under the general rules of
§ 302(b)(3), the redemption would not be considered a complete termination of the shareholder’s interest.
However, § 302(c)(2) permits waiver of the family attribution rules if certain conditions are satisfied.
5- Under § 302(c)(2), waiver of the family attribution rules is allowed if (1) immediately after the
distribution the redeeming shareholder has no interest in the distributing corporation (including an interest
as an officer, director, or employee) other than as a creditor; (2) the taxpayer does not acquire any interest
in the distributing corporation within 10 years, except stock acquired by bequest or inheritance; and (3) the
taxpayer agrees to notify the IRS of the acquisition of any interest.
5- According to the facts in this situation, Bennie has elected to take advantage of the family attribution
waiver. By so doing, the stock of his son Ted is not attributed to Bennie, and Bennie’s interest is considered
completely terminated. As a result, Bennie secures capital gain treatment assuming he has not retained a
prohibited interest and he does not acquire such an interest during the 10-year look-ahead period.
5- The first issue that must be considered is whether Bennie has retained an interest in the corporation as
contemplated under §§ 302(b)(3) and 302(c)(2)(A). In determining whether an interest has been retained, the
courts have attempted to determine whether the redemption has effectively severed the taxpayer’s
proprietary stake in the business otherwise evidenced in stock ownership. In Himmel [338 F.2d 815 (CA-2,
1964)], the court outlined the rights inherent in a shareholder’s interest. These are (1) the right to vote and
4-2 Chapter 4 Corporate Distributions: Stock Redemptions and Partial Liquidations

thereby participate in management of the corporation; (2) the right to participate in earnings of the
corporation; and (3) the right to share in the assets of the corporation upon liquidation. As identified, these
rights serve as criteria for determining whether the shareholder has retained an interest equivalent to stock
ownership notwithstanding the fact that he has divested himself of the stock itself. In effect, the redeemed
shareholder may be considered a stockholder indirectly. The IRS generally takes the view that any dealing
by the redeeming shareholder with the corporation, other than as a creditor, violates these criteria. For
example, the IRS has held that the performance of services for the corporation by the redeemed
shareholder represents acquisition of a prohibited interest, regardless of whether the redeemed shareholder
is paid for services rendered (Revenue Ruling 56-556, 1956-2 C.B. 177).
5- It appears from the facts that upon redemption of his stock, Bennie completely severed his relationship
with ATF except for his interest as a creditor. Although a creditor interest is expressly authorized by the
statute, the nature of the interest must be carefully scrutinized. Regulation § 1.302-4(d) states that a person
will be considered a “creditor only if the rights of such person with respect to the corporation are not
greater or broader in scope than necessary for the enforcement of the claim. Such claim must not in any
sense be proprietary and must not be subordinated to the claims of general creditors.” In addition, under
case law and § 385, if the debt instrument has too many incidents of beneficial ownership, it is deemed an
equity interest equivalent to stock. In such case, the prohibited interest would be considered present.
5- In determining whether the debt instrument is truly debt or merely disguised equity, the Service’s
position is that subordination by itself is sufficient to classify the instrument as equity [see Estate of
Lennard, 61 T.C. 554 (1974)]. However, in Estate of Lennard, the Tax Court indicated that subordination
must be coupled with a showing that the instrument was of a proprietary nature before an equity interest is
present. The issue was considered again in H.A. Dunn [615 F.2d 578 (CA-2, 1980) affg. 70 T.C. 715 (1978)].
In this case, it seemed clear that whether the debt was equity must be determined in light of § 385 and the
voluminous case law concerning the debt-equity controversy, rather than the Regulations of § 302.
5- Section 385 specifies various factors to be considered in determining whether a corporate interest is
debt or equity. Among the various factors stated, the most pertinent in this case is whether there is a
written unconditional promise to pay on demand or on a specified date a sum certain in money in return
for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest. Absent any
additional facts, it seems that this criterion is satisfied. Thus, it appears that Bennie will not be treated as
having retained an equity interest on account of the note.
5- The second issue to be addressed is whether Bennie will be treated as having acquired a prohibited
interest by supplying tennis frames to his old company. As suggested above, through the years the IRS has
frowned on any dealings by the redeeming shareholder with his former company. The basis for this
position is found in the Code’s expressed prohibition against an employer-employee relationship
[§ 302(c)(2)(A)]. The Service and the courts generally perceive employment as a means to access corporate
benefits and thus equivalent to a proprietary interest. In Revenue Ruling 70-104 1970-1 C.B. 66, the IRS
extended the definition of employee to include independent contractors. In this ruling, the Service held that
the redeeming shareholder held a prohibited interest where he entered into a five-year agreement to
perform services as a consultant and advisor to his former corporation. Several cases have considered
this issue.
5- In Estate of Lennard, the taxpayer as managing partner of an accounting firm performed accounting
services for the corporation. The Service, relying on their position in Revenue Ruling 70-104, argued that
the taxpayer performed substantial duties for compensation that greatly influenced the corporation. The
court distinguished the case from the ruling, holding that the services performed were no more substantial
than those that could have been performed by any other independent accountant. In effect, the services
were far broader and more general in nature than those performed by the taxpayer in the ruling. In
addition, the court emphasized that the services could be terminated at any time, since there was no
contractual relationship between the accounting firm and the corporation. According to the court, “it is
apparent that by the use of the word ‘interest,’ Congress had in mind a corporate involvement greater than
that attributable to a third party providing goods and services to the corporation.”
5- In Jack Chertkof [69 F .2d 264 (CA-4, 1981)], the taxpayer entered a management contract with the
redeeming corporation six months after the redemption. The contract permitted the taxpayer to negotiate,
procure, and execute all leases on behalf of the corporation. In addition, he had broad management
powers, including the power to collect rents, make necessary operating expenditures, keep books and
records, and distribute the net income to his own corporation as well as the redeeming corporation.
Further, the taxpayer’s management corporation could be discharged only after two years. Lastly, the
taxpayer and the redeeming corporation were co-owners of the property that he managed. According to the
court, “although the petitioner’s management fees were not keyed directly to the profits of ET, his
control over the profitability of the leases he negotiated did in effect give him a financial stake.”
Accordingly, the court held that he held a prohibited interest.
Solutions to Tax Research Problems 4-3

5- In Lynch, 86-2 USTC {9731 rev’g 83 TC 597 (19), the Tax Court reaffirmed its position in Lennard. In
this case, Lynch redeemed all of his shares in a corporation that specialized in leasing cast-in-place concrete
pipe machines. The redemption left his son as the sole owner of the corporation. Due to his son’s desire to
retain the taxpayer’s technical expertise, the taxpayer entered into a consulting agreement with the
corporation on the date of the redemption. The consulting agreement provided the taxpayer with payments
of $500 per month for five years, plus reimbursement for certain business expenses. After the redemption,
the taxpayer shared an office with his son and came to the office daily for about one year and then once or
twice a week thereafter. Upon review of the facts, the Tax Court concluded that Lynch was an independent
contractor rather than an employee because the corporation had no right under the consulting agreement
to control his actions. Moreover, the court found that Lynch had neither a financial stake in the
corporation nor managerial control after the redemption. As a result, the consulting arrangement was not
considered acquisition of a prohibited interest. On appeal, however, the Ninth Circuit Court saw the matter
quite differently.
5- According to the appellate court, the Tax Court’s approach did not serve the purpose of § 302, which
was to introduce a measure of certainty into an area of confusion. The court emphasized that in all of the
cases dealing with the issue, the taxpayers in question performed services for the redeeming corporation
either as employees or independent contractors. The court felt that in light of the purpose of § 302 it was
inappropriate to split hairs and draw distinctions depending on whether the services were performed by
employees or independent contractors. Such a distinction, it believed, would elevate form over substance.
Moreover, in the court’s view, the parenthetical language in § 302(c)(2)(A)(I) merely provided a subset of
prohibited interests from the universe of such interests, and in no way restricted the court from finding that
an independent contractor retained a prohibited interest. Based on such reasoning, the court concluded that
those who provide services in either an independent contractor or employee capacity have acquired a
prohibited interest. It emphatically stated that taxpayers who wish to receive sale treatment must
completely sever all non-creditor interests in the corporation.
5- In light of the decisions in Chertkof and Lennard, it seems clear that a prohibited interest will be found
whenever the taxpayer’s powers enable him to make corporate decisions. In Lennard, the taxpayer had no
power to make decisions, while in Chertkof the taxpayer was in fact in control. In Bennie’s situation, this
issue should not provide difficulty because he will be merely supplying his former corporation with tennis
frames. Nevertheless, the agreement should be drawn so that Bennie has no involvement in the
management of ATF.
5- Perhaps the more important concern is that under the proposed arrangement, Bennie could be viewed
as effectively having a right to participate in the earnings of ATF. Although a financial stake as a third
party supplier seems far removed from that of a shareholder, the proposed relationship with ATF could be
seen as a method to access the benefits of his former corporation. The proposed arrangement differs little
from simply having Bennie coming back to ATF to operate a new or expanded division. Moreover, since
the source of his business is closely tied to the profitability of ATF, it could be inferred that he has acquired
a financial interest in ATF. This would be particularly true if there is a long-term commitment by ATF to
Bennie or the agreement was not at arm’s length (e.g., terms found in contracts were not comparable to
those found in agreements with independent third parties). Some room for hope for Bennie’s proposal may
be found in Letter Ruling 82018164. In this ruling the redeeming shareholder proposed the establishment of
a sole proprietorship in the business of goldsmithing and jewelry design for various stores, including the
redeeming corporation. The taxpayer would provide services to the corporation on a job basis with no
contracts or long-term commitments between them. The amounts charged would represent arm’s-length
charges and would be at the same rates and under the same terms charged by the taxpayer to other stores
for which he would work. Given these facts, the Service indicated that the taxpayer would not be treated as
having acquired an interest. Thus, it would seem that as long as the agreement is carefully drawn to ensure
corporate involvement no greater than that found in a normal third-party arrangement, Bennie’s proposal
should not violate the requirements of § 302(c)(2)(A).
5- The Ninth Circuit’s recent decision in Lynch may undermine the significance of the favorable letter
ruling and previous case law. As noted above, the appellate court indicated that all non-creditor interest
must be severed in order to ensure sale treatment. Perhaps this decision will provide the IRS with enough
ammunition to take a tougher stand in future situations on what constitutes a prohibited interest.
4-36 In order to qualify for sale treatment for her redemption, Della must satisfy one of the following three tests
set forth in § 302:
Section 302(b)(1): the redemption is not essentially equivalent to a dividend;
Section 302(b)(2): the redemption is substantially disproportionate; or
Section 302(b)(3): the redemption results in a complete termination of the shareholder’s interest.

In determining whether the redemption satisfies any of these three tests, § 302(c)(1) provides that § 318(a)
and the constructive ownership rules contained therein must be applied in determining the shareholder’s
stock and ownership.
5- Strict application of the above rules would preclude sale treatment for Della’s redemption. Such a
conclusion is easily drawn, since Della’s interest would not change upon the redemption of any of her stock
due to operation of the constructive ownership rules. Under the family attribution rules of § 318, she would
be treated as owning all of the stock of her husband and thus would be deemed to own 100 percent of the
corporation’s stock both before and after any redemption. Despite this initial analysis, Della may still be
able to salvage sale treatment under the subjective test of § 302(b)(1).
5- As noted above, under § 302(b)(1), a taxpayer is able to obtain sale treatment for a redemption
transaction if it is not essentially equivalent to a dividend. The question of what constitutes a distribution
that is “not essentially equivalent to a dividend” has defied exact determination. Reg. § 1.302-2(b) provides
little insight, stating
5- The question whether a distribution in redemption of stock of a shareholder is not essentially equivalent to a
dividend under § 302(b)(1) depends on the facts and circumstances of each case. One of the facts to be
considered in making this determination is the constructive stock ownership of such shareholder under § 318(a).
5- Prior to the landmark decision by the Supreme Court in Davis, the Tax Court granted the taxpayer sale
treatment for his redemption under § 302(b)(1) by ignoring the attribution rules where hostility existed
between family members. In Estate of Squier, 35 TC 950 (1961) nonacq., the decedent owned 50.09 percent
of the stock of his corporation directly and another 12.21 percent through attribution from his wife
(8.13 percent) and grandchild (4.08 percent). Shortly after Squier’s death, the chief trust officer of the bank
handling his estate, Frederick Wilson, was elected to Squier’s position on the Board of Directors. Although
the election of Wilson to the board appeared consistent with the decedent’s wishes, a controversy between
him and the decedent’s wife developed. Soon after her husband’s death, Mrs. Squier demanded that Wilson
(acting as executor and majority shareholder) name her son-in-law as president of the corporation. Wilson
refused, believing that it would not be in the best interests of the corporation to do so.
5- In order to pay some of the estate’s debts, the estate redeemed a portion of its shares. After the
redemption, the estate owned 41.27 percent directly and an additional 15.55 percent through attribution
through the decedent’s wife and grandchild. Although the redemption did not qualify for sale treatment
under the mechanical test of § 302(b)(2), the estate claimed sale treatment under § 302(b)(1). According to
the estate, it had lost significant control over the corporation on the redemption of its shares. Due to the
redemption, the estate’s direct interest fell below that of another shareholder. Moreover, given the hostile
relationship between the executor and the decedent’s spouse, the estate did not have control over the wife’s
shares. The court shared the petitioner’s view, stating
5- Moreover, the record herein reveals a sharp cleavage between the executor and the members of the Squier
family, and in spite of the attribution rules as to stock “ownership,” the redemptions … resulted in a crucial
reduction of the estate’s control over the corporation. Accordingly, notwithstanding the attribution rules, the
redemptions in this case did result in a substantial dislocation of relative stockholdings in the corporation and
also in fact brought about a significant change in control.
5- Thus, in this case the court refused to assume that the shareholder’s interest as determined by direct and
indirect ownership was equivalent to the shareholder’s control over the corporation. Consequently, the
court held that sale treatment was appropriate.
5- Later the same year, the Tax Court examined a similar situation in Parker, 20 TCM 893 (1961). In this
case, differences arose between a father and son concerning the management of the family corporation.
Due to the differences, the father redeemed a portion of his shares, effectively transferring control of the
corporation to his son. Although the father’s ownership interest was unchanged in light of the family
attribution rules and could not qualify under § 302(b)(2), the taxpayer argued that the redemption should
qualify for sale treatment under the subjective test of § 302(b)(1). The Tax Court agreed, holding that in
light of the family disagreements there had been a significant shift in control.
5- The application of the attribution rules in cases involving family disharmony appeared settled when
the IRS acquiesced to the Tax Court’s decision in Squier. However, the Tax Court and the IRS revised
their positions after the Supreme Court’s landmark decision in Davis.
5- In Davis, the Supreme Court held that “to qualify for preferred treatment [under § 302(b)(1)] …, a
redemption must result in a meaningful reduction of the shareholder’s proportionate interest in the corpo-
ration.” In arriving at its conclusion, the Court seemed to imply that the constructive ownership rules must be
considered in determining dividend equivalency even when applying the subjective test of § 302(b)(1). Yet, the
meaningful reduction test by its own terms suggested a factual inquiry rather than an objective determination.

5- Shortly after Davis, the Tax Court had an opportunity to reconsider the effect of family hostility in
determining dividend equivalency under § 302(b)(1). In Robin Haft Trust, 75-1 USTC {9209 (CA-1), rev’g
and rem’g 61 TC 398 (1973), the Tax Court indicated that the rationale applied in Squier was no longer valid.
Apparently, the Tax Court believed that the attribution rules applied regardless of family hostility.
5- According to the Tax Court, the application of the attribution rules was not affected by family
hostility. The Tax Court interpreted the decision in Davis as an attempt to eliminate the uncertainty
previously surrounding the treatment of redemptions. For this reason, it believed that a decision that would
approve a factual inquiry as to the effect of family relationships in each case would be inconsistent with the
Supreme Court’s view. As a result, the Tax Court applied the constructive ownership rules without regard
to the family hostility that existed.
5- Upon appeal, the First Circuit Court of Appeals reversed the Tax Court’s decision, reasoning that it
was appropriate to consider family hostility for several reasons. In contrast to the Tax Court’s view, the
appellate court believed that the meaningful reduction test established in Davis was not a mere mechanical
test but rather a subjective determination requiring an examination of the facts surrounding the
redemption. In support of this view, the court referred to the Senate Finance Committee Report, which
explained that § 302(b)(1) was retained because the elimination of the “essentially equivalent” test would be
unnecessarily restrictive. Apparently, the retention of such test suggested to the court that Congress was
willing to accept some uncertainty if equity could be achieved. In addition, the court noted that Reg.
§ 1.302-2(b) stated that the application of § 302(b)(1) depended on the facts of each case and constructive
ownership was only one of the facts to be considered. For these reasons, the court believed that the Squier
rationale was still valid despite the Supreme Court’s holding in Davis.
5- Prior to the First Circuit’s reversal in Robin Haft Trust, the Tax Court again rejected the Squier
rationale in Niedermeyer, 62 T.C. 280 (1974), aff’d 76-1 USTC {9417 (CA-9). Moreover, the Ninth Circuit
affirmed the Tax Court’s decision. In this case, however, the family hostility existed between the taxpayer’s
two sons rather than between the taxpayer and either of the sons. Consequently, the case was not a true test
of the Ninth Circuit’s view on the role of family hostility.
5- Since the decision in Niedermeyer, the IRS has made its feelings clear on the role of family hostility. In
Rev. Rul. 80-26, 1980-1 CB 66, it indicated that the constructive ownership rules must be mechanically
applied in all situations. The Service indicated that the facts and circumstances of a particular case cannot
preclude application of the attribution rules. Consistent with this view, it announced that it would not
follow the First Circuit’s decision in Haft.
5- In 1981, the Tax Court once again considered the role of family hostility in David Metzger Trust, 76
TC 42 aff’d 82-2 USTC {9718 (CA-5, 1982). Although the court reaffirmed its previous position, it did
state that in the case of a non-pro rata redemption, family discord may be a factor to be considered in
determining dividend equivalency. In this case, however, the redemption was pro rata, and consequently
the court denied the taxpayer sale treatment. Hoping for the same treatment that the Haft trust found in
the First Circuit, the taxpayer appealed to the Fifth Circuit.
5- On appeal, the Fifth Circuit rejected the First Circuit’s view in Haft. According to the court, the Davis
decision required determination of dividend equivalency after application of the constructive ownership
rules. Moreover, the court did not believe that the meaningful reduction test espoused in Davis or the
retention of the dividend equivalency test mandated a subjective inquiry. Echoing the sentiment of previous
Tax Court decisions, the Fifth Circuit believed that the purpose of § 302 was to introduce certainty into a
previously uncertain area. In the court’s view, to hold that family hostility should be considered would be
inconsistent with such purpose, since it would require a subjective inquiry in each case regarding the
relationships between the related taxpayers.
5- The view of the Fifth Circuit in Metzger is clearly at odds with that of the First Circuit in Haft. As a
result, the ultimate fate of Della’s redemption may depend on where her decision might be appealed. One
important fact that apparently would operate in her favor is the nature of her redemption. Since the
redemption would be non-pro rata, the Tax Court—based on its comment in Metzger—may now be
willing to consider the impact of family hostility.
4-37 In order for a redemption of JC Enterprises (JCE) to qualify for sale treatment under § 303, the value of
the stock included in Julie’s estate generally must exceed 35 percent of the adjusted gross estate. In this
case, the adjusted gross estate is $2,000,000 computed as follows.
Gross estate
Checkers stock $ ,900,000
JC Enterprises stock ,100,000
Other Assets 1,500,000
Total gross estate $2,500,000

Deductions under § 2053 and 2054
Funeral and administrative expenses , (50,000)
Claims against the estate (
,450,000)
Adjusted gross estate $2,000,000
Thus, in order to qualify the value of JCE must exceed $700,000 (35% $2,000,000). Because the value of
JCE is only $100,000, it would seem that the 35 percent test is not met. Moreover, it would also appear that
the aggregation rule of § 303(b)(2)(B) is also inapplicable. This provision allows the aggregation of two or
more stocks “with respect to each of which there is included in determining the value of the decedent’s gross
estate 20 percent or more in value of the outstanding stock.” If JCE can be aggregated with Checkers and
treated as a single stock, the 35 percent test is easily met. In this case, however, it appears that the 20 percent
threshold cannot be met since the estate includes only a 15 percent interest. Although it seems clear that
neither the 35 percent test nor the 20 percent test can be met, there is at least one possible solution. The estate
might argue that the estate effectively includes 20 percent in value (1) by virtue of its 100 percent inclusion of
the stock of Checkers which owns 75 percent of the stock of JCE or (2) through attribution under § 318
which, if applicable, would treat the estate as owning 100 percent of JCE.
5- The courts have considered these arguments. In Estate of Otis E. Byrd 68-1 USTC {9139 aff’g 46 T. C.
25, the taxpayer argued that § 318 should apply in determining whether the 20 percent test is met. The
taxpayer first asserted in a somewhat convoluted (or perhaps ingenious) fashion that the failure to cross
reference § 318 in § 303 was not a legislative oversight nor an expression of Congressional intent that § 318
should not apply. The taxpayer argued that such a provision was deemed necessary by Congress because
§ 302(d) is the provision that indicates how a distribution is treated if it does not meet one of the exceptions
of § 302(b) to which § 318 applies. According to the taxpayer, one of the exceptions to § 302(d) happens to be
contained in § 303 and, thus, § 318 should apply. Beyond this, the taxpayer argued that the aggregation rules
of § 303(b)(2)(B) permit attribution since the requisite value is included in the gross estate, 90 percent here,
albeit indirectly. The court rejected these arguments, however, saying that § 318 makes it clear that it applies
only to those provisions to which it is expressly made applicable. The court noted that there is nothing in
§ 303 about § 318 and, therefore, despite the taxpayer’s argument, held that the constructive ownership rules
could not be used to meet the 35 percent test. The court went on to emphasize that § 318 was designed
primarily to prevent tax avoidance and is completely unrelated to § 303 which is a self-contained provision.

Test Bank
True or False
1. M Corporation has 100 shares of outstanding stock, all of which are owned by B. Assuming
M Corporation redeems 70 of B’s shares, the redemption does not qualify for exchange treatment.
2. K owns 40 of the 100 shares outstanding of L Corporation. The remaining shares are owned by
unrelated individuals. Assuming L redeems 10 shares of K’s stock, the redemption will be treated as a
dividend under the safe harbor tests.
3. Corporate taxpayers favor sale treatment in stock redemptions as opposed to dividend treatment.
4. Under the constructive ownership rules of § 318 an individual is considered to own the stock owned by
his or her spouse and other family members, including parents, brothers, sisters, children, and
grandchildren.
5. Mr. Y owns 40 percent of R Corporation and 20 percent of the YT Partnership. YT owns
30 percent of R. Under the constructive ownership rules of § 318, Mr. Y is treated as owning
46 percent of R.
6. Mr. Y owns 40 percent of R Corporation and 20 percent of the YT Partnership. YT owns
30 percent of R. Under the constructive ownership rules of § 318, YT is treated as owning 30 percent
of R.
7. Mr. S owns 40 percent of R Corporation and 60 percent of T Corporation. T owns 30 percent of R.
Under the constructive ownership rules of § 318, Mr. S is treated as owning 58 percent of R.
8. Mr. S owns 40 percent of R Corporation and 60 percent of T Corporation. T owns 30 percent of R.
Under the constructive ownership rules of § 318, T Corporation is treated as owning 54 percent of R.
9. M owns 60 percent of B Corporation and 40 percent of C Corporation. C Corporation owns
20 percent of B Corporation. Under the constructive ownership rules of § 318, M is treated as owning
60 percent of B.
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10. M owns 60 percent of B Corporation and 40 percent of C Corporation. C Corporation owns
20 percent of B Corporation. Under the constructive ownership rules of § 318, C Corporation is
treated as owning 80 percent of B.
11. Mr. Smooth owns directly 70 percent of the stock of Mellow Corporation and 60 percent of the stock
of Calm Corporation. Mellow owns 30 percent of Calm. During the year, Calm redeemed all
60 percent of Mr. Smooth’s stock. Mr. Smooth may waive the constructive ownership rules and secure
sale treatment for the redemption.
12. During the year, Mr. T redeemed 20 shares of the stock of D Corporation for $15,000. The basis of
the shares redeemed was $8,000. Assuming the redemption does not qualify for sale treatment, Mr. T
will have a dividend of $7,000.
13. In determining whether a redemption distribution qualifies for sale treatment under the facts and
circumstances tests of § 302, one factor typically considered is whether the redemption was motivated
by a valid business purpose.
14. Ed has decided to retire and completely terminate his interest in his closely held business. Currently, he
owns 60 percent of the corporation while his son owns the remaining 40 percent. His son received his
40 percent over 20 years ago as a gift from his father. Ed will not be able to secure exchange treatment
for a redemption of his stock because he will be treated as owning all of the stock of his son.
15. Baxter died this year with a gross estate of $2,000,000, consisting primarily of stock in his family-
owned corporation. A redemption of the estate’s stock will not qualify if Baxter’s interest in the
corporation which is included in his estate is 8 percent.
16. Hedi and her daughter own all of the stock of C Corporation equally. This year Hedi died, leaving all
of her stock to her daughter. Her gross estate was $700,000, consisting primarily of C stock. Funeral
and administrative expenses were $20,000. Other claims against the estate were $60,000. A redemption
of the estate’s stock will qualify for exchange treatment, at least in part, if Hedi’s interest in the
corporation which is included in her estate is valued at not less than $238,001.
17. Clothing Inc. and Mr. Red Button formed Apparel Corp. in 1960. It is engaged in the manufacture
and sale of shirts and ties. Apparel acquired the tie business from Silk Inc. Now it desires to get out of
the tie business but continue in the shirt business. The primary assets of the tie business are:
Assets
Adjusted
Basis
Fair Market
Value
Plant $60,000 $200,000
Equipment 20,000 45,000
Truck 15,000 8,000
Assume all necessary requirements are satisfied unless otherwise stated or implied.
Both of the shareholders of Apparel are assured of sale treatment assuming they exchange a portion of
their stock in exchange for the proceeds from the sale of the tie business.
Assets
Adjusted
Basis
Fair Market
Value
Plant $60,000 $200,000
Equipment 20,000 45,000
Truck 15,000 8,000
Apparel generally will recognize gain but not loss on the sale of the tie assets assuming the proceeds
are promptly distributed.

Assets
Adjusted
Basis
Fair Market
Value
Plant $60,000 $200,000
Equipment 20,000 45,000
Truck 15,000 8,000
Sale treatment is assured for some shareholders if the tie business has been operated by Apparel for
three years and Silk for three years.
Assets
Adjusted
Basis
Fair Market
Value
Plant $60,000 $200,000
Equipment 20,000 45,000
Truck 15,000 8,000
Sale treatment is assured for some shareholders if the tie business was acquired in a nontaxable merger
three years ago.
Assets
Adjusted
Basis
Fair Market
Value
Plant $60,000 $200,000
Equipment 20,000 45,000
Truck 15,000 8,000
Assuming that Apparel distributed the assets of the tie business in redemption of all of the stock of
Red Button, Apparel would recognize a gain of $165,000 and a loss of $7,000.
Assets
Adjusted
Basis
Fair Market
Value
Plant $60,000 $200,000
Equipment 20,000 45,000
Truck 15,000 8,000
Assume Apparel purchased the tie business from Silk four years ago for $250,000 cash. A pro rata
distribution attributable to a sale of the tie business should qualify for sale treatment under the
meaningful reduction test.
Test Bank 4-11

Assets
Adjusted
Basis
Fair Market
Value
Plant $60,000 $200,000
Equipment 20,000 45,000
Truck 15,000 8,000
This year Red Button and Clothing had a disagreement on the direction of the company.
Consequently, Red has decided that he would like to take the tie business and go his separate way.
The most logical form that this transaction should take is a partial liquidation.
24. Twelve years ago, F persuaded his daughter to join in the family business by giving her 40 percent of
the stock. He has retained the remaining 60 percent until now to ensure control. F now wishes to turn
the business over to his daughter. A redemption of all of F’s shares can qualify for capital gain or loss
treatment.
25. In order for a redemption or partial liquidation to qualify for exchange treatment, the distribution
must not be essentially equivalent to a dividend. The approach used by the governing provisions in
determining dividend equivalency is the same whether the transaction is a redemption or partial
liquidation.
26. A distribution in partial liquidation is not considered equivalent to a dividend if it is attributable to a
genuine contraction of the corporation’s business.
27. T Corporation manufactures handbags and belts. The belt business was acquired from S, who
established the business in her home three years ago. S contributed the business to T in a nontaxable
transaction under § 351. The handbag business has been operated by T since 1970. Assuming T sells
the belt business and distributes the proceeds, the distribution qualifies for partial liquidation
treatment.
28. T, the sole shareholder of R Corporation, wants to retire. To this end, he sold all of his stock in R to
X Corporation, which is a wholly owned corporation of his son. T is assured of exchange treatment
on the sale.
29. S owns 60 percent of the 100 shares of LMN, Inc. stock outstanding. His dad owns 20 shares, and his
friend J owns the remaining 20 shares. S also owns 50 percent of OPQ’s 100 shares outstanding while
J owns the other 50 percent. Assuming S sells 40 shares of LMN to OPQ for a gain of $5,000, he is
assured of exchange treatment.
30. T owns all shares of outstanding common stock of W Corporation. V Corporation and W agree to a
merger whereby V will absorb W. T receives common and preferred stock in V, and her stock in W is
canceled. T’s receipt of the preferred stock has the same effect as a nontaxable stock dividend.
31. B owns 30 shares of MNO Corporation preferred stock that he received as a nontaxable stock
dividend two years ago when the corporation had a deficit of $7,000 in EP. Currently, MNO has
substantial EP. Assuming B sold the preferred stock to an unrelated third party, he is assured of sale
treatment.
32. T redeems her § 306 stock. The amount realized is treated as a dividend to the extent that T would
have a dividend if at the time of the distribution cash had been distributed in lieu of stock.

Multiple Choice
33. F Corporation has 100 shares of outstanding stock, all owned by J. J bought the shares 10 years ago
for $20,000, or $200 per share. During the year, the corporation redeemed 10 shares of J’s stock for
$30,000. Which of the following is true?
a. J must report a capital gain of $28,000.
b. J must report a capital gain of $10,000.
c. J must report dividend income of $28,000.
d. J must report dividend income of $30,000.
34. The 100 shares of outstanding stock of Majestic Corporation are owned by Jim and Bob, 40 and
60 shares respectively. Neither shareholder is related to the other. Each has a basis in his stock of $100
per share. During the year, Jim sold 10 of his shares back to the corporation for $10,000. Assuming
the corporation has substantial earnings and profits, Jim’s A.G.I. will increase by
a. A capital gain of $10,000
b. A dividend of $10,000
c. A capital gain of $9,000
d. A dividend of $9,000
e. None of the above
35. The 100 shares of outstanding stock of Flash Corporation are owned by Barbara and Kelly, 70 and
30 shares respectively. Neither shareholder is related to the other. Each has a basis in her stock of
$200 per share. During the year, Barbara sold 35 of her shares back to the corporation for $20,000.
Assuming the corporation has substantial earnings and profits, Barbara’s A.G.I. will increase by
a. A dividend of $20,000
b. A capital gain of $13,000
c. A dividend of $13,000
d. A capital gain of $20,000
36. C, an individual, owns 80 of the 100 shares of T Corporation stock outstanding while the remaining
shares are owned by unrelated parties. T’s basis in the 80 shares is $1,600, or $20 per share. This year
T redeemed 10 shares of C for $4,000. Assuming the redemption does not qualify for sale treatment
and T has substantial EP, C’s dividend income and basis in his remaining shares will be
a. A dividend of $4,000 and a basis of $1,600
b. A dividend of $3,800 and a basis of $1,400
c. A dividend of $4,000 and a basis of $1,400
d. A dividend of $3,800 and a basis of $1,600
37. If a redemption fails to qualify for sale treatment, the full amount received by the shareholder for the
stock
a. Qualifies for exchange treatment
b. Qualifies for exchange treatment after deducting the stock’s basis
c. Qualifies as a property distribution after deducting the stock’s basis, and thus is a dividend to the
extent that it is out of EP
d. Qualifies as a property distribution and thus is a dividend to the extent that it is out of EP
38. In the determination of dividend equivalency, an individual is considered as owning the stock owned
by his or her
a. Spouse, children and grandchildren
b. Brothers and sisters
c. Parents
d. Both a. and c.
e. All of the above
Test Bank 4-13

39. Which of the following is not a “relative” under the constructive ownership rules?
a. A 60 percent owned corporation
b. A sister
c. A partnership in which the taxpayer owns 20 percent
d. A trust of which taxpayer is the sole beneficiary
e. All of the above are considered relatives.
40. Pennypincher Corporation has 100 shares of stock outstanding owned by the following taxpayers.
Shareholder
Shares
Owned
Mr. Penny 30
Mrs. Penny (Mr. Penny’s wife) 10
John (the Pennys’ son) 10
Abby (the Pennys’ granddaughter) 10
Buddy Penny (Mr. Penny’s brother) 20
PP Partnership (Mr. Penny is a 20% partner) 10
PPP Corporation (Mr. Penny is a 40% shareholder) 10
100
None of Mr. Penny’s relatives nor the partnership or corporations are partners in PP or shareholders
in PPP. Under the constructive ownership rules of § 318, what percentage of Pennypincher
Corporation does Mr. Penny own?
a. 52 percent
b. 60 percent
c. 62 percent
d. 66 percent
e. 82 percent
f. Some other amount
41. Nickel Dime Corporation has 100 shares of stock outstanding owned by the following taxpayers.
Shareholder
Shares
Owned
Mr. Nickel 50
Mrs. Nickel (Mr. Nickel’s wife) 10
Brian (the Nickels’ son) 10
Lisa (the Nickels’ daughter) 10
NN Partnership (Mr. Nickel is a 20% partner) 10
NNN Corporation (Mr. Nickel is a 60% shareholder) 10
100
Brian Nickel has decided to sell some of his shares back to the corporation in order to pay for his
college tuition. Other than Brian’s father, none of Brian’s relatives nor the partnership or corporations
are partners in NN or shareholders in NNN. Under the constructive ownership rules of § 318, what
percentage of Nickel Corporation does Brian Nickel own?
a. 70 percent
b. 72 percent
c. 78 percent
d. 80 percent
e. 82 percent
42. The 100 shares of Yankee Corporation were owned as shown below:
Shareholder Shares
George 10
Bucky 20
GD Partnership 40
Stein Corporation 30

George and Bucky are unrelated. George is a 50 percent partner in the GD partnership. In addition,
George owns 70 percent of Stein Corporation. Stein Corporation plans to redeem some of its stock in
Yankee. What is Stein Corporation’s direct and indirect interest in Yankee before the redemption?
a. 37 percent
b. 40 percent
c. 51 percent
d. 60 percent
43. R, an individual, owns 50 percent of the stock of P Corporation and 30 percent of the stock of Y
Corporation. The remaining 70 percent of Y’s stock is owned by P Corporation. Because of his stock
ownership in P, R is considered as owning
a. 80 percent of Y
b. 75 percent of Y
c. 65 percent of Y
d. none of Y
44. In which of the following situations would the redemption most likely be treated as a sale under the
subjective dividend equivalency test of § 302(b)(1)?
a. A shareholder’s interest drops from 89 percent to 70 percent.
b. A shareholder’s interest drops from 55 percent to 45 percent.
c. A shareholder’s interest drops from 40 percent to 35 percent and there is a valid business purpose
for the redemption.
d. Both b. and c.
45. SOS Corporation has 200 shares of outstanding stock (one class of voting common), which are owned
by three unrelated individuals as follows: A owns 120 shares, B owns 60 shares, and C owns 20 shares.
During the year, SOS has redeemed a portion of A’s shares for $20,000. In order for the redemption
to qualify for sale treatment the lowest number of shares that SOS must redeem must exceed
a. 20
b. 24
c. 46
d. 60
46. B, his wife W, and his two sons, G and H, own all of the stock of C Corporation equally. B is
planning to sell all of his stock to C but only if he can secure exchange treatment. Which of the
following may occur without jeopardizing B’s goal?
1. B will step down from his position of chief executive officer but will continue to be a member
of the board of directors of C after the redemption.
2. W will take B’s place as CEO and continue her stake (25% stock ownership) in C which she
received from B as a gift seven years ago.
3. B will exchange his stock for a $100,000 note payable over 20 years bearing 10 percent interest.
4. G has no children and has willed all of his stock to his father.
a. 1., 3. and 4.
b. 3. and 4.
c. 2., 3. and 4.
d. 3.
47. SSS Corporation has 200 shares of outstanding stock, which are owned by three unrelated individuals
as follows: A owns 120 shares, B owns 60 shares, and C owns 20 shares. During the year SSS
redeemed 50 percent of A’s shares for $60,000. SSS had EP before the redemption of $100,000. The
EP of SSS will decrease by
a. $50,000
b. $60,000
c. $20,000
d. $30,000
Test Bank 4-15

48. Zap Corporation has 200 shares of outstanding stock, which are owned by three unrelated individuals
as follows: Q owns 120 shares, R owns 60 shares, and S owns 20 shares. During the year, Zap redeemed
30 shares from Q for $36,000. Zap had EP before the redemption of $35,000. The EP of Zap will
decrease by
a. $36,000
b. $5,250
c. $8,750
d. $35,000
49. During the year, Oak Corporation distributed land worth $100,000 (basis $20,000) to one of its
shareholders, T. The corporation will recognize gain if the distribution
a. Is treated as a dividend out of Oak’s EP
b. Qualifies for sale treatment under the basic redemption rules of § 302
c. Qualifies for sale treatment under the partial liquidation rules
d. More than one of the above answers is correct.
e. All of the above answers are correct.
50. During the year, Maple Corporation distributed land worth $10,000 (basis $15,000) to one of its
shareholders, R. The corporation will recognize loss if the distribution
a. Is treated as a dividend out of Maple’s EP
b. Qualifies for sale treatment under the basic redemption rules of § 302
c. Qualifies for sale treatment under the partial liquidation rules
d. More than one of the above answers is correct.
e. None of the above answers is correct.
51. During the year, Hickory Corporation distributed land worth $40,000 (basis $7,000) and equipment
worth $10,000 (basis $15,000) to one of its shareholders, R. Due to the distributions, the corporation
will report
a. Net income of $28,000 if the distributions are treated as a dividend out of Maple’s EP
b. Net income of $33,000 if the distributions qualify for sale treatment under the basic redemption
rules of 302
c. No gain or loss if the distribution qualifies for sale treatment under the partial liquidation rules
d. None of the above answers is correct.
52. Grains Galore, Inc. has manufactured cereals and granola bars for 15 years. The corporation has
decided to terminate the granola bar business and concentrate on cereals. The primary assets of the
granola bar business are shown below.
Assets
Adjusted
Basis
Fair Market
Value
Manufacturing facility $50,000 $30,000
Equipment $60,000 $25,000
Other fixtures $15,000 $12,000
The Great K Corporation has indicated an interest in acquiring the assets shown above. Grains is
entertaining the following plans:
1. Sell all of the assets to K and distribute the sales proceeds to its shareholders in a transaction
qualifying as a partial liquidation.
2. Distribute all of the assets to the shareholders in exchange for their stock in a transaction
qualifying as a partial liquidation. The shareholders will subsequently sell the assets to K.
From a tax perspective,
a. Plan number 1 is more beneficial and should be followed.
b. Plan number 2 is more beneficial and should be followed.
c. The corporation should adopt either plan number 1 or number 2 based on nontax considerations
because the tax consequences of adopting either plan are essentially the same.

53. Which of the following redemptions normally will not qualify for sale treatment?
a. A partial liquidation with the stock redeemed from a corporate shareholder
b. A redemption from an estate to provide cash to pay death taxes
c. A redemption that reduces taxpayer ownership from 30 percent to 20 percent
d. A redemption of all the stock that the taxpayer owns
54. Technically, § 302(b)(4) grants sale treatment only when the redemption distribution is to a
noncorporate shareholder and is in partial liquidation of the distributing corporation. A distribution is
likely to be considered in partial liquidation if
a. It is essentially equivalent to a dividend.
b. It is due to the termination of one of two or more “qualified” businesses.
c. It follows the death of the major shareholder.
d. None of the above
55. TU Unlimited, Inc. has been in the hot tub and spa business since 1970. Several years ago it decided it
should get into the patio enclosure business because many customers were purchasing tubs and then
enclosing them on their patio. Three years ago, the company acquired the franchise from a local
proprietor for $100,000 to allow it to sell prefabricated enclosures manufactured by another
corporation specializing in this type of activity. The proprietor had six years of experience in the
business. The enclosure business has had incredible growth, and this year the company decided to get
out of the hot tub business. It sold all of the assets of the hot tub business and distributed the proceeds
pro rata to its shareholders in redemption of 5 percent of their stock. The distribution will
a. Qualify for sale treatment for both corporate and noncorporate shareholders alike
b. Qualify for sale treatment for only noncorporate shareholders
c. Not qualify for sale treatment for any shareholders
d. Qualify for sale treatment for only corporate shareholders
56. For purposes of the dividend equivalency test for partial liquidations, there must be a termination of a
“qualified business.” A business is qualified if it satisfies certain conditions. These include which of the
following?
a. The undertaking is engaged in for profit and constitutes an investment activity or a business
activity.
b. The business is conducted throughout a five-year period ending prior to the distribution.
c. The business was acquired in a taxable transaction in the five-year period before the date of the
distribution.
d. Both b. and c.
e. All of the above are requirements.
57. Under § 303, concerning redemptions to pay death taxes, which of the following conditions must be
satisfied in order to qualify for sale treatment?
a. The value of the redeeming corporation’s stock must be more than 50 percent of the adjusted
gross estate.
b. The shareholder’s interest in the corporation that is included in his or her gross estate must be at
least 20 percent.
c. The estate must be subject to some type of federal, state or local estate, inheritance or other death
tax.
d. More than one of the above are true.
e. None of the above are true.
58. J died this year. His sole asset was 80 shares of D Corporation stock, which were worth $800,000
(basis $200 per share). The remaining 20 shares of the stock were owned by J’s son. In J’s will, he
provided that all of the stock go to his son. Estate taxes were $123,000, and funeral and administrative
expenses were $27,000. In order to pay the death taxes, the corporation redeemed 20 shares of stock
from J’s estate for $200,000. Assuming the corporation has substantial EP, the estate will report
a. No gain or loss or other income from the redemption distribution
b. $196,000 capital gain
c. $150,000 capital gain and $50,000 dividend
d. $50,000 dividend
Test Bank 4-17

59. For many years, Howdy and his son, Doody, owned and operated Buffalo Corporation. Howdy
owned 1,000 shares of the corporation while the remaining 400 shares outstanding were owned by
Doody. Howdy had a basis of $20,000 in the stock before he died. On June 1 of this year, Howdy
died. Howdy’s gross estate of $1,500,000 was comprised of various assets, including stock in Buffalo.
Deductions for funeral and administrative expenses were $10,000 and Federal and state death taxes
were $200,000. Of the remainder, $100,000 was left as a charitable contribution to the United Way
and the balance, including the stock, was transferred to Howdy’s sole heir, Doody. In order to pay off
the death taxes and other expenses, Howdy’s estate sold some of the stock back to the corporation. In
order for the estate’s exchange to qualify for sale treatment, the lowest value that can be placed on the
estate’s 1,000 shares is
a. $525,001
b. $451,501
c. $455,001
d. $300,001
e. Some other amount
Doody. Howdy had a basis in the stock before he died of $20,000. On June 1 of this year, Howdy
the death taxes and other expenses, Howdy’s estate sold some of the stock back to the corporation.
The maximum amount of stock that the estate may exchange that would qualify for sale treatment is
a. Whatever the value of the stock is that is included in the gross estate
b. $310,000
c. $210,000
d. $200,000
e. Some other amount
Doody. Howdy had a basis in the stock before he died of $20,000. On June 1 of this year, Howdy
the death taxes and other expenses, Howdy’s estate sold some of the stock back to the corporation. If
the corporation distributed property in exchange for the estate’s shares:
a. Any increase or decrease in value on property used to redeem the stock would escape tax because
the property got a step-up or step-down in basis at death.
b. Under current law, the corporation would recognize no gain or loss on the distribution based on
the General Utilities doctrine.
c. The corporation must recognize gain and loss on the distribution of property in a redemption that
meets the requirements of § 303 relating to redemptions to pay death taxes.
d. The corporation must recognize gain, but not loss, on the distribution.
e. More than one of the above are true.
62. Mr. R owns 60 of the 100 outstanding shares of B Corporation while the remaining shares are owned
by unrelated parties. He also owns 80 of the 100 outstanding shares of S Corporation. During the
year, R sold 40 shares of B to S for $30,000. In applying the rules governing redemptions through
related corporations, the critical pre- and post-redemption ownership interests are:
a. 80 percent and 40 percent
b. 60 percent and 52 percent
c. 80 percent and 52 percent
d. 60 percent and 40 percent
e. Some other percentages

63. According to brother-sister redemption rules,
a. The sale by the shareholder to the acquiring corporation is recast as an exchange transaction with
the acquiring corporation.
b. The sale by the shareholder to the acquiring corporation is recast as a redemption by the acquiring
corporation of its own stock.
c. The stock of the issuing corporation actually obtained by the acquiring corporation is treated as a
contribution to the acquiring corporation’s capital in exchange for some of the acquiring
corporation’s stock.
d. Both a. and c.
e. Both b. and c.
64. T owns all of the stock of both B and S Corporations. T, desiring to bail EP out of B Corporation,
sold stock of B with a basis of $16,000 to S for $50,000. Unfortunately, the sale did not qualify for
sale treatment due to the special provisions of § 304 concerning redemptions by related corporations.
Assuming B has EP of $40,000 and S has a deficit in EP of ($25,000), T will report a dividend of
a. $50,000
b. $34,000
c. $40,000
d. $15,000
65. TH Inc. has been in the storage business for 10 years. Prior to a stock redemption, TH has 100 shares
of stock outstanding. The stock owned and the number of shares redeemed from each shareholder are
as follows:
Name
Shares Owned
before Redemption
Adjusted
Basis
L 3 $4,000
E 12 3,000
D 60 6,000
G 5 1,000
MMM Corp. 20 2,000
100
L is E’s mother and D owns 40 percent of MMM Corp; otherwise the parties are unrelated. TH has
$100,000 in accumulated and current earnings and profits. All of the parties have owned their stock
since the inception of the corporation. During the year TH redeemed 25 shares of D’s stock for
$30,000. D’s gain is
a. $30,000 dividend
b. $27,500 dividend
c. $30,000 capital gain
d. $27,500 capital gain
as follows:
Name
Shares Owned
before Redemption
Adjusted
Basis
L 3 $4,000
E 12 3,000
D 60 6,000
G 5 1,000
MMM Corp. 20 2,000
100
Test Bank 4-19

$100,000 in accumulated and current earnings and profits. All of the parties have owned their stock since
the inception of the corporation. Assuming that TH redeemed all of G’s stock for $8,000, its EP will
a. Decrease by $8,000
b. Decrease by $5,000
c. Neither increase nor decrease
d. Decrease by $4,000
as follows:
Name
Shares Owned
before Redemption
Adjusted
Basis
L 3 $4,000
E 12 3,000
D 60 6,000
G 5 1,000
MMM Corp. 20 2,000
100
since the inception of the corporation. Assuming all of L’s stock is redeemed, by using the mechanical
determinations provided by the safe harbor tests, the distribution will not qualify for sale treatment if
a. L receives notes in exchange for her stock
b. L inherits TH stock within the next two years
c. L remains as the only woman on the board of directors
d. Both a. and c.
as follows:
Name
Shares Owned
before Redemption
Adjusted
Basis
L 3 $4,000
E 12 3,000
D 60 6,000
G 5 1,000
MMM Corp. 20 2,000
100
since the inception of the corporation. If in an independent transaction TH distributes a warehouse
used in the storage business worth $10,000 (basis $8,000) and land worth $15,000 (basis $20,000) in
redemption of stock,
a. No gain or loss will be recognized.
b. A $2,000 gain will be recognized.
c. A $2,000 gain and a $5,000 loss will be recognized.
d. None of the above are true.
69. Section 306 stock includes
a. Preferred stock received as a nontaxable stock dividend
b. Common stock received as a nontaxable stock dividend
c. Stock inherited from a decedent in whose hands the stock was § 306 stock
d. Both a. and c.
e. All of the above

70. In 20X5, R received 20 shares of preferred stock as a distribution with respect to his XYZ common.
The preferred was worth $10,000 and R assigned a basis of $6,000 to it. At the time of distribution,
the corporation had substantial earnings and profits. XYZ redeemed R’s preferred stock for $13,000
this year when its earnings and profits were $8,000. R will report
a. Capital gain of $7,000, and his basis for common will be unaffected.
b. Dividend income of $7,000, and his basis for common will increase.
c. Dividend income of $8,000, and his basis for common will increase.
d. Dividend income of $7,000, and his basis for common will be unaffected.
71. On June 1 of this year, R Corporation redeemed 200 of its 1,000 shares of common stock outstanding
for $300,000. R’s EP immediately before the redemption was $500,000. Due to the redemption, R’s
EP will decrease by
a. $300,000
b. $60,000
c. $100,000
d. $200,000
Test Bank 4-21

Solutions to Test Bank
True or False
1. True. The redemption distribution has not substantially affected B’s interest in the corporation. Although
B has redeemed 70 shares, his percentage ownership in the corporation after the redemption remains the
same as it was before the redemption, 100 percent (70/70). As a result, the distribution is treated as a
dividend to the extent of M’s EP. (See Example 1 and pp. 4-3 and 4-4.)
2. True. K’s post-redemption ownership must be less than 80 percent of his pre-redemption ownership, or
32 percent (80% 40%). In this case, his post-redemption ownership drops only to 33 percent (30/90),
and thus does not qualify for sale treatment. Note that the number of shares owned drops to less than
80 percent of what he owned (40 to 30 shares), but the test focuses on his percentage ownership. (See
Example 9 and p. 4-11.)
3. False. Corporate shareholders have traditionally found dividend treatment more to their liking because of
the dividends-received deduction available to them. (See p. 4-6.)
4. False. Under § 318, an individual does not constructively own the stock owned by his or her brothers,
sisters, or grandparents. (See Example 6 and p. 4-7.)
5. True. Under § 318, a partner owns whatever his or her partnership owns in proportion to the value of the
partner’s interest in the partnership. This is true regardless of the partner’s interest in the partnership.
Thus Mr. Y owns 40 percent directly and 6 percent indirectly through YT (20% 30%). (See p. 4-8.)
6. False. Under § 318, a partnership owns all of whatever its partners own regardless of the individual
partner’s interest in the partnership. Thus, YT is treated as owning 70 percent of R, 30 percent directly
and 40 percent indirectly through its partner, Mr. Y. (See Example 8 and p. 4-9.)
7. True. Under § 318, a shareholder owns whatever his or her 50 percent owned corporation owns in proportion
to the value of the shareholder’s interest in the corporation. Therefore, Mr. S owns 58 percent of R,
40 percent directly and 18 percent indirectly through T (60% 30% = 18%). (See Example 7 and p. 4-9.)
8. False. Under § 318, a corporation owns in total whatever its 50 percent shareholders own. Therefore, T
owns 70 percent of R, 30 percent directly and 40 percent through S. (See Example 8 and p. 4-9.)
4
4-23

9. True. Under § 318, a shareholder owns whatever his or her 50 percent owned corporation owns in
proportion to the value of the shareholder’s interest in the corporation. Because M does not own at least
50 percent of C, he does not own any of the stock that C owns. Therefore, M is treated as owning only his
direct interest of 60 percent. (See Example 7 and p. 4-8.)
10. False. Under § 318, a corporation owns in total whatever its 50 percent shareholders own. Because M does
not own at least 50 percent of C, C is not deemed to own any of what shareholder C owns. Therefore, C is
treated as owning only its direct interest in B of 20 percent. (See Example 8 and p. 4-9.)
11. False. Taxpayers may only waive the family attribution rules. (See Example 12 and p. 4-12.)
12. False. Mr. T will have a dividend of $15,000. When a redemption is treated as a dividend, the basis of the
shares surrendered is not offset against the distribution. Instead, the basis of the surrendered shares is
added to the remaining shares. (See Example 3 and p. 4-5.)
13. False. According to the Supreme Court’s decision in Davis, the factors motivating the redemption are
irrelevant in determining whether or not the effect of the distribution is essentially equivalent to a
dividend. Under this decision, the sole test is whether there has been a meaningful reduction in the
shareholder’s interest. (See p. 4-10.)
14. False. Ed may waive the family attribution rules if he completely terminates his interest. If he does so,
none of his son’s stock would be attributed to him and the redemption would qualify for sale treatment.
(See Example 12 and p. 4-12.)
15. False. Section 303 applies when the value of the shareholder’s interest that is included in the estate exceeds
35 percent of the adjusted gross estate. The focus of this test is on the value of the interest. The percentage
of the stock outstanding that the shareholder’s interest represents is irrelevant. Note that the special rules
allowing aggregation of stocks for purposes of the 35 percent test does not permit aggregation of less than
20 percent owned stocks. (See Examples 18 and 20 and pp. 4-16 and 4-17.)
16. False. The value of the stock must be more than 35 percent of the decedent’s adjusted gross estate. The
adjusted gross estate is defined as the gross estate less funeral and administrative expenses, claims against the
estate, debts and casualty loss. In this case, the adjusted gross estate is $620,000. Accordingly, the value of
the stock must exceed $217,000 (35% $620,000). (See Examples 18 and 20 and pp. 4-16 and 4-17.)
17. False. Assuming that the transaction meets the other requirements the exchange would qualify as a partial
liquidation for noncorporate shareholders but not for corporate taxpayers. As a qualifying partial liquidation,
Red Button would be assured sale treatment but Apparel Corporation would not. Corporate shareholders are
subject to the other tests under Section 302(b). For a corporate shareholder, if the distribution is treated as a
dividend, it is considered an extraordinary dividend and subject to special rules. (See Example 17 and p. 4-15.)
18. False. The corporation would recognize both gain and loss on a sale of the assets. Had the assets been
distributed and subsequently sold, the corporation would recognize gain, but not loss. (See Example 22
and pp. 4-17 and 4-18.)
19. True. Under the partial liquidation rules, a noncorporate shareholder receives sale treatment if the
distribution is attributable to the termination of a qualified business. Among the requirements that must be
satisfied to reach this safe harbor is that both the retained and the distributed businesses be operated for at
least five years prior to the date of the distribution. It is unnecessary that the distributing corporation
operate the business for at least five years. It is sufficient if the business is operated by anyone for five years.
Note this problem assumes, consistent with the instructions, that the businesses were not obtained in a
taxable transaction within the last five years. (See Example 16 and pp. 4-14 and 4-15.)
20. True. Under the partial liquidation rules, a noncorporate shareholder receives sale treatment if the
corporation terminates a qualified business. Among the requirements that must be satisfied to reach this
safe harbor is that neither the retained nor the distributed or sold businesses may have been acquired in a
taxable transaction during the last five years. Because the business was acquired in a nontaxable
transaction, the special rule is satisfied. (See Example 16 and pp. 4-14 and 4-15.)

21. False. Under § 311, the corporation recognizes gain, but not loss, on the distribution of property as part of
any nonliquidating distribution such as a redemption. (See Example 22 and pp. 4-17 and 4-18.)
22. False. Because the tie business was acquired for cash within the last five years, the safe harbor rules
allowed for partial liquidation distributions attributable to a termination of a qualified business are
unavailable. Nevertheless the transaction may qualify as a partial liquidation if there is a genuine
contraction of the corporate business. This test is applied at the corporate level. The meaningful reduction
standard is applied in determining whether a redemption may be considered a sale. In this case, the
distribution is pro rata so that the only hope for obtaining sale treatment is through the partial liquidation
rules. (See pp. 4-13 and 4-14.)
23. False. A partial liquidation will be a taxable transaction. The same result can be obtained through a
nontaxable split-off. (See Chapter 7.)
24. True. The constructive ownership rules would normally preclude F from receiving sale treatment because
he would be deemed to own all of the corporation’s stock through his daughter after the exchange.
However, F may waive the family attribution rules if all of his direct interest is redeemed and he does not
retain any interest in the corporation. (See Example 12, and p. 4-12.)
25. False. In a redemption, dividend equivalency is determined at the shareholder level, which means
there must be a meaningful reduction in the shareholder’s interest. In a partial liquidation, it is determined
at the corporate level, which means there must be a genuine contraction of the corporate business. (See
pp. 4-9 and 4-13.)
26. True. Sale treatment is apparently justified in this case on the theory that the redemption proceeds
represent a portion of the shareholder’s capital that was formerly employed in the business (before the
contraction) rather than a return on capital. (See p. 4-13.)
27. False. The belt business is not a qualified business because it has not been conducted for five years. (See
Example 15 and pp. 4-14 and 4-15.)
28. False. Under § 304, this transaction is treated as a brother-sister redemption. Because T is deemed to own
all of the stock of his son immediately after the exchange, he is considered as owning the stock held by his
son’s corporation, which includes all of the stock of R. Thus, the ownership tests of § 302 are failed and
the distribution is treated as a § 301 distribution. (See Example 26 and pp. 4-21 through 4-23.)
29. False. Under § 304, this transaction is treated as a redemption. The tests of § 302 are applied to S’s interest
in the issuing corporation, LMN. Immediately before the redemption, he owns 80 percent of LMN
(60 percent directly and 20 percent through his dad). After the redemption, he owns 60 percent [20 percent
directly, 20 percent through his dad, and 20 percent through OPQ (40% 50%)]. Because his ownership
does not drop below 50 percent, the distribution is treated as a § 301 distribution rather than a sale. (See
Example 26 and pp. 4-21 through 4-23.)
30. True. The preferred stock is § 306 because this is a nontaxable reorganization. (See Example 33 and p. 4-26.)
31. True. The stock is not § 306 stock because the corporation had a deficit in EP at the date the stock was
distributed. (See Example 35 and p. 4-27.)
32. False. The amount realized by T for the § 306 stock is treated as a dividend to the extent of the
corporation’s EP at the time of the redemption. (See Example 38 and p. 4-28.)
Multiple Choice
33. d. The effect of this $30,000 distribution to J is the same as a dividend: J’s ownership interest and control
of the corporation remained unchanged after the stock redemption. (See Example 3 and
p. 4-5.)
Solutions to Test Bank 4-25

34. b. To secure sale treatment under the substantially disproportionate test of § 302(b)(2), Jim’s interest must
drop to less than 50 percent and less than 80 percent of what it was before the redemption or 32 percent
(80% 40%). Because his interest dropped to only 33 percent [(40 10)/(100 10)], the distribution is
treated as a dividend. The amount of the dividend is the gross amount of the distribution, $10,000. It is
not reduced by the basis of the stock surrendered which in this case is $1,000 (10 shares $100/share).
(See Examples 3 and 9 and pp. 4-10 and 4-11.)
35. a. To secure sale treatment under the substantially disproportionate test of § 302(b)(2), Barbara’s interest
must drop to less than 50 percent and less than 80 percent of what it was before the redemption or
56 percent (80% 70%). Because her interest did not drop below 50 percent but dropped only to
53.85 percent [(70 35)/(100 35)], the distribution is treated as a dividend. The amount of the dividend
is the gross amount of the distribution, $20,000. It is not reduced by the basis of the stock surrendered
which in this case is $7,000 (35 shares $200/share). (See Examples 3 and 9 and pp. 4-10 and 4-11.)
36. a. The entire amount of the distribution of $4,000 is treated as a dividend and none of the basis is
recovered. The dividend is not the net of the distribution and the basis of the shares redeemed. (See
Example 3 and p. 4-5.)
37. d. If the redemption does not qualify for sale treatment, the full amount received by the shareholder for
the stock (not just the excess over basis) is considered a property distribution and thus dividend to the
extent that it is out of EP. The basis of the shareholder’s remaining shares is increased by the basis of
the shares given up. (See Example 3 and p. 4-5.)
38. d. Under § 318 an individual does not constructively own the stock owned by his or her brothers, sisters,
or grandparents. (See Example 6 and p. 4-7.)
39. b. Siblings are not considered family members under § 318. (See p. 4-7.)
40. c. Under § 318, an individual is deemed to own the stock owned by his or her spouse, children,
grandchildren, and parents. However, the taxpayer does not own the stock of a brother, sister, aunt or
uncle. In addition, a partner owns whatever his or her partnership owns in proportion to the value of
the partner’s interest in the partnership. Similarly, a shareholder owns whatever his or her 50 percent
owned corporation in proportion to the value of the stock owned in the corporation. Using these rules,
Mr. Penny’s stock ownership is shown below.
% Owned
Directly 30
Indirectly:
Wife 10
Son 10
Granddaughter 10
PP Partnership (20% 10) 2
62
41. c. Under § 318, an individual is deemed to own the stock owned by his or her spouse, children,
grandchildren, and parents. However, the taxpayer does not own the stock of a brother, sister, aunt or
uncle. In addition, a partner owns whatever his or her partnership owns in proportion to the value of
the partner’s interest in the partnership. Similarly, a shareholder owns whatever his or her 50 percent
owned corporation in proportion to the value of the stock owned in the corporation. Using these rules,
Mr. Nickel’s stock ownership is shown below.
% Owned
Directly 10
Indirectly:
Father 50
Mother 10
Partnership (20% 10) 2
Corporation (60% 10) 6
78

42. d. Stein Corporation owns 60 percent of the stock of Yankee Corporation. It owns 30 percent directly and
under the constructive ownership rules of § 318(a)(3) is deemed to own all of the stock of its 50 percent
shareholder, George, or in this case 30 percent. George owns 10 percent directly and 20 percent
through his partnership interest in GD (50% 40%). (See Example 8 and pp. 4-8 through 4-9.)
43. c. R owns 65 percent, 30 percent directly and 35 percent (50% 70%) indirectly through P. (See Example
7 and p. 4-8.)
44. b. Under Davis, the subjective dividend equivalency test of § 302(b)(1) requires that the shareholder’s
interest must be meaningfully reduced in order to qualify for sale treatment. In Davis, a valid business
purpose was considered irrelevant, therefore item c is incorrect. In b, the redemption is not substantially
disproportionate because it does not reduce the shareholder’s interest to below 80 percent of what it
was before the redemption or 44 percent (80% 55%). However, it does reduce the shareholder’s
interest such that he apparently is no longer in control. This would probably be considered a
meaningful reduction. (See pp. 4-9 and 4-10.)
45. c. In order for the redemption to be considered substantially disproportionate, A must own less than
80 percent of what he owned before the redemption or 48 percent (120/200 80%). The number that A
must surrender is determined as follows:
120 x
200 x
48%
x ¼ number of shares that must be surrendered
Solving for x results in 46.15. Therefore, A must surrender more than 46 shares (e.g., 47) in order to obtain
sale treatment. In such case, he would be deemed to own 47.71 percent [(120 47)/(200 47)] which is
less than the 48 percent threshold. (See Example 9 and pp. 4-10 and 4-11.)
46. b. B can secure exchange treatment for his redemption only if he completely terminates his direct interest in
the corporation, waives the family attribution rules, and agrees not to obtain an interest other than a
creditor for 10 years after the redemption. Because a creditor interest is allowed, B may redeem his stock
for a note, and, therefore, item (3) may occur. In addition, B may inherit stock and such inheritance is
not considered the acquisition of a prohibited interest. Thus item (4) may occur. Section 302(c)
specifically prohibits B from being on the board of directors. Thus, (1) cannot occur. Section 302(c)(2)
generally does not allow the waiver of the family attribution rules when the redeeming shareholder has
transferred stock to a family member within 10 years of the date of redemption. Thus item (2) cannot
occur. (See Example 12 and p. 4-12.)
47. d. Upon a redemption qualifying for sale treatment, the distributing corporation reduces its EP by the
percentage of the stock redeemed but not to exceed the amount of the redemption. In this case, SSS
redeemed 30 percent (60/200) of its outstanding stock when it redeemed 50 percent or 60 of A’s 120
shares. This results in a tentative charge to EP of $30,000 (30% $100,000). Because this amount is
less than the $60,000 distribution, the charge to EP is $30,000. (See Example 23 and p. 4-18.)
48. d. In this case, the redemption does not qualify for sale treatment because Q owns more than 50 percent
of the stock after the redemption (90/170 = 52.94%). Therefore, the distribution is treated as a dividend
to the extent of EP. Because Zap’s EP of $35,000 is less than the amount of the distribution, the
distribution eliminates all of Zap’s EP. (See Example 23 and p. 4-18.)
49. e. Under § 311(b), a corporation must recognize gain on the distribution of appreciated property in any
type of nonliquidating distribution. (See Example 21 and p. 4-18.)
50. e. Under § 311 a corporation must recognize gain, but not loss, on the distribution of property. This rule
applies to any type of nonliquidating distribution. (See Example 21 and p. 4-18.)
51. b. Under § 311 a corporation must recognize gain, but not loss, on the distribution of property. Therefore
the corporation recognizes the $33,000 gain ($40,000 $7,000) but not the $5,000 loss ($10,000
$15,000). This rule applies to any type of nonliquidating distribution. (See Examples 21 and 22 and
p. 4-18.)

52. a. Under § 311 a corporation must recognize gain, but not loss, on the distribution of property. Because the
corporation would be denied deduction for the losses realized on distribution of the property in partial
liquidation, it should opt to sell the assets. By so doing, the losses would be recognized. (See Example 22
and p. 4-18.)
53. a. A distribution in partial liquidation is not treated as a sale for a corporate shareholder. [See p. 4-15 and
§302(b)(4).]
54. b. In addition, a distribution in partial liquidation must be made pursuant to a plan and must be made
within the taxable year that the plan is adopted or in the following taxable year. (See p. 4-13.)
55. c. The distribution does not qualify as a partial liquidation because the corporation is not engaged in a
qualified business immediately after the exchange. The enclosure business is not qualified because it
was acquired in a taxable transaction within the last five years. (See pp. 4-14 and 4-15.)
56. b. Investment activities are not considered business activities. Business must have been conducted
throughout the five-year period ending on the date of the distribution. (See p. 4-14.) The business
cannot be acquired in a taxable transaction.
57. e. The value of the redeeming corporation’s stock must exceed 35 percent of the adjusted gross estate.
There is no requirement that the stock interest included in the gross estate exceed some minimum
threshold percentage. (Such a rule does apply which enables a taxpayer to aggregate two or more
stocks together for purposes of the 35 percent test.) The estate need not be subject to any death tax in
order for § 303 to apply. Section 303 treatment would still be available to the extent of any funeral and
administrative expenses. (See pp. 4-16 and 4-17.)
58. d. The redemption qualifies for sale treatment under § 303 because the stock is more than 35 percent of J’s
adjusted gross estate. The maximum amount that qualifies for § 303 treatment is limited to the sum of
death taxes and funeral and administrative expenses, or $150,000 ($123,000 þ $27,000). In effect,
$150,000 was paid for 15 shares of stock that had a basis equal to their fair market value at death,
$150,000. Thus, no gain is recognized on this portion of the exchange. In this case, the estate is deemed
to own 100 percent of the stock because all of the stock of the son is attributed to the estate. Thus, the
remaining $50,000 is all dividend income. (See Example 20 and pp. 4-16 and 4-17.)
59. b. The value of the stock must exceed 35 percent of the adjusted gross estate or $451,500 [35 percent
($1,500,000 $10,000 $200,000)]. (See Example 18 and pp. 4-16 and 4-17.)
60. c. The amount that qualifies for § 303 treatment is limited to the sum of funeral and administrative
expenses and death taxes or $210,000 ($10,000 þ $200,000). (See Example 19 and pp. 4-16 and 4-17.)
61. d. Under § 311, the corporation recognizes gain but not loss on any type of nonliquidating distribution.
(See Example 21 and pp. 4-17 and 4-18.)
62. b. Under § 304 (relating to redemptions through related corporations), the hypothetical redemption is
tested by examining the shareholder’s interest in the issuing corporation. In this case, the issuing
corporation is B Corporation. Before the sale of stock to S, R owns 60 percent of B (60% B directly
and none indirectly). After the sale R owns 52 percent of B [20% directly and 32% indirectly through S
(80% 40/100 = 32%)]. (See Example 26 and p. 4-22.)
63. e. Only b. and c. describe the brother-sister redemption rules that Congress enacted to defeat capital gain
treatment on “sale” of stock by shareholders through their related corporations. (See pp. 4-21 and
4-22.)
64. c. The distribution is treated as a dividend to the extent of the EP of the acquiring corporation and
subsequently to the extent of the EP of the issuing corporation. The EP of the two corporations
are not simply netted to determine the total amount of EP available. (See Examples 26 and 27 and
pp. 4-22 and 4-23.)
65. d. D’s pre-redemption ownership is 60 percent (the 60 shares owned directly_none of MMM’s stock is
attributed to D, since he does not own at least 50 percent of MMM). His post-redemption ownership is

47 percent (35/75). Since his post-redemption ownership is less than 50 percent and less than 80 percent
of his pre-redemption ownership, 48 percent (80% of 60%), the redemption qualifies as a sale. Thus, he
has sold 25 shares with a basis of $2,500 ($6,000/60 25). His realized gain is $27,500 ($30,000
$2,500). (See Example 9 and pp. 4-5 and 4-11.)
66. b. Earnings and profits are reduced by the percentage of the stock redeemed, 5 percent of $100,000, or
$5,000. This amount cannot exceed the amount of the redemption distribution, however. (See Example
23 and p. 4-19.)
67. c. In order to qualify under the safe harbor tests, L must waive the family attribution rules to avoid
ownership of her daughter’s stock [before the redemption she owned 15 percent and after the
redemption she owns 12.4 percent (12/97) through her daughter]. To waive the attribution rules, she can
retain an interest as a creditor as in statement a., receive stock as an inheritance as in statement b., but
cannot continue as a board member. (See Example 12 and p. 4-12.)
68. b. Under § 311, the corporation recognizes gain but not loss. (See Example 21, pp. 4-17 and 4-18 and
§ 311.)
69. a. Note that stock inherited from a decedent loses the § 306 taint since its basis is its fair market value on
date of death (no carryover basis). (See Example 34 and p. 4-26.)
70. c. A redemption of § 306 stock is treated as a § 301 distribution, and thus, in this case, a dividend to the
extent of EP, or $8,000. The remaining portion of the distribution of $5,000 is treated as a return of
capital. The unrecovered basis of $1,000 ($6,000 $5,000) is added to the common. (See Example 38
and p. 4-28.)
71. c. Upon a redemption, the corporation reduces its EP by the percentage of the stock redeemed but not
to exceed the amount of the redemption. In this case, R redeemed 20 percent of its stock for a tentative
charge to EP of $100,000 (20% $500,000). Because this amount is less than the $300,000
distribution, the charge to EP is $100,000. (See Example 23 and p. 4-18.)

Comprehensive Problems
1. Walter Bedd and Lester Lazyboy started Couch Potato Furniture 35 years ago. Since that time Walter has
brought his daughter, Emmie, and son-in-law, Chester, into the corporation, giving them stock 20 years ago.
On January 1, the 100 shares of outstanding stock of the corporation were owned as follows:
Name
Shares
Owned
Walter Bedd 30
Chester Dror 3
Emmie Dror 12
Lilly Dror 5
Lester Lazyboy 30
LZ Partnership 10
LLL Corporation 10
Walter is Emmie’s father. Chester and Emmie are happily married with one child, Lilly, who is 17 years old.
The couple gave Lilly her stock six years ago. Lester owns a 40 percent interest in the LZ partnership and
40 percent of the stock of LLL Corporation. All of the shareholders have a basis in each share of stock of
$1,000 per share. All of the individual shareholders currently work for the corporation, including Lilly who
works part-time. Couch Potato has $200,000 of EP. Answer the following questions.
a. On August 1 of this year, Walter decided to curb his involvement in the corporation. What is the
minimum number of shares that Walter must surrender in order to qualify for sale treatment? For
purposes of the redemption test, how many shares of the corporation does Walter own before and after
the redemption?
b. Assume the corporation distributed land (an outlot at a shopping mall held for future expansion) worth
$50,000 (basis $15,000) and a car worth $10,000 (basis $13,000) to Walter in redemption of his stock
that qualified for sale treatment. What amount of gain or loss, if any, must the corporation recognize?
c. Assume Walter redeems 20 shares of stock for $60,000 cash and the redemption qualifies for sale
treatment. What is the effect of the redemption distribution on the corporation’s EP?
d. Lilly is 17 and preparing to enter college next year. Her parents’ financial adviser has suggested that the
corporation redeem her stock and Lilly could use the proceeds to help pay her tuition. He suggests this
in lieu of a sale by the parents who would then use their proceeds to pay for her tuition. Comment on
the advantages and disadvantages of this plan. Your comments should include all the information that
you would want to convey to Lilly and her parents at an upcoming meeting.
e. Due to various poor investments Lester is short of cash and is considering selling some of his stock back
to the corporation. How many shares is he currently treated as owning in Couch Potato?
f. Lester has thought about solving his cash flow problems by selling some of his Couch Potato stock to
LLL Corporation. What issues, if any, must be addressed before giving Lester advice on this transaction?
4
4-31

Solutions to Comprehensive Problems
1. a. In order for Walter’s redemption to qualify as a sale under the substantially disproportionate tests of
§ 302, he must satisfy two tests. After the redemption he must own (1) less than 50 percent of the stock
and (2) less than 80 percent of what he owned before the redemption. Before the redemption, he is
treated as owning
Shares Owned
Directly 30
Indirectly:
Daughter (Emmie) 12
Granddaughter (Lilly) 5
Son-in-law (Chester) 0
47/100 ¼ 47%
Note that Walter does not own any of the stock of his son-in-law under the family attribution rules of
§ 318. Under these rules, a taxpayer owns the stock of his spouse, parents, children and grandchildren.
In order for the redemption to be considered substantially disproportionate, Walter must own less
than 37.6 percent (47% 80%). To determine the number that Walter must surrender requires a
straightforward algebraic determination as follows:
47 x
100 x
37:6%
x ¼ number of shares that must be surrendered
Solving for x results in 15.064. As a result, Walter must surrender 16 shares in order to obtain sale
treatment. In such case, he would be deemed to own 36.9 percent [(47 16)/(100 16)] which is less
than the 37.6 percent threshold. (See Example 9 and pp. 4-10 and 4-11.)
b. Under § 311(b), a corporation must recognize gain on the distribution of appreciated property in any
type of nonliquidating distribution. As a result, Couch Potato must recognize the $35,000 gain
($50,000 $15,000) but does not recognize the loss of $3,000 ($10,000 $13,000). (See Example 21
and pp. 4-17 and 4-18.)
c. Upon a redemption, the corporation reduces its EP by the percentage of the stock redeemed but not
to exceed the amount of the redemption. In this case, Walter redeemed 20 percent of his stock for a
tentative charge to EP of $40,000 (20% $200,000). Because this amount is less than the $60,000
distribution, the charge to EP is $40,000. (See Example 23 and p. 4-18.)
d. There are several points that should be made in answering this question:
(1) The redemption, if planned properly, effectively shifts income from the presumably high tax
bracket of the parents to the low bracket of the child. The kiddie tax does not apply because the
child is over 14.
(2) A redemption of only a few shares of Lilly’s stock will not qualify for sale treatment under the
substantially disproportionate test. In order to satisfy this test, her interest must fall below
80 percent of what she owned before the redemption or 16 percent (80% 20%). Because she is
deemed to own whatever her parents own due to the family attribution rules, any redemption
short of completely terminating her interest would not meet the 80 percent test. Although she may
be able to meet the facts and circumstances test, to be assured of sale treatment she must
completely terminate her interest and waive the family attribution rules. Under the family
attribution waiver, she is prohibited from having any interest in the corporation except as a
creditor, including that stemming from her employment. Consequently, she would be required to
quit her part-time job. (See Example 12 and p. 4-12.)
(3) Lilly cannot waive the family attribution rules under the lookback rule of § 302(e)(2)(B)(I). Under
this provision, the family attribution rules cannot be waived if any of the redeemed stock was
acquired from a related person within 10 years of the redemption. Thus, Lilly should wait until
10 years have passed before she redeems the stock in order to secure sale treatment. (See p. 4-29.)

e. Lester would be deemed to own 34 percent before any redemption determined as follows:
Shares Owned
Directly 30
Indirectly:
Partnership (40% 10) 4
Corporation 00
34/100 ¼ 34%
Under the constructive ownership rules of § 318, a taxpayer is deemed to own proportionately whatever
his or her partnership owns. However, a taxpayer owns only what his or her 50 percent owned
corporation owns. Because Lester does not own at least 50 percent of LLL, he does not own any of the
stock that LLL owns. (See Example 7 and p. 4-8.)
f. If the requirements are satisfied, the apparent sale could be treated as a redemption through a related
corporation. Section 304 requires the sale to be treated as a redemption subject to the tests of § 302
whenever a shareholder who controls two corporations sells stock of one to another. In this case, § 304
does not apply because Lester does not own 50 percent of either Couch Potato or LLL. (See Example
26 and pp. 4-21 through 4-23.)
Solutions to Comprehensive Problems 4-33

Wassim Zhani Chapter 4 Corporate Dictributions Stock Redemptions and Partial Liquidations.pdf

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