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CHAPTER 5

CORPORATIONS: REDEMPTIONS AND LIQUIDATIONS

SOLUTIONS TO PROBLEM MATERIALS

Status: Q/PQuestion/ Present in Prior

Problem Topic Edition Edition

1 Tax treatment of returnfrom investment versus Newreturn ofinvestment

2 Corporate shareholder preference for dividend versus Unchanged 2stock redemption

3 Issue recognition Unchanged 34 Sale or exchange versus dividend treatment on Modified 4

redemption5 Definition of related parties in attribution Unchanged 5

rules; attribution fromand to entities

6 When stock attribution rules do not apply to stock Unchanged 6

redemptions7 Attribution to and from entities; reattribution Modified 7required

8 Basis of stock in a nonqualified stock redemption Unchanged 89 Disproportionate redemption requirements not met; Unchanged 9

possible not essentially equivalent redemption10 Issue recognition Modified 1011 Requirements for a partial liquidation Unchanged 1112 Advantages of a redemption to pay death taxes Unchanged 1213 Issue recognition Modified 1314 Gain/loss recognition to corporation on redemption Unchanged 14

distribution15 Issue recognition New

16 Sale of 306 stock Modified 1617 Comparison of preferred stock bailout to dividend Unchanged 17

distribution18 Sale of stock to related corporation Unchanged 1819 Corporate liquidation for tax purposes Unchanged 1920 Corporate loss limitations in complete liquidation Unchanged 20

5-1

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Corporations: Redemptions and Liquidations 5-3

Status: Q/PQuestion/ Present in Prior Problem Topic Edition Edition

48 Complete liquidation; distribution of disqualified Unchanged 48property to related parties

49 Complete liquidation; application of related-party Unchanged 49loss limitation50 Complete liquidation; disqualified and built-in Unchanged 50

loss property51 Complete liquidation; tax consequences to Unchanged 51

shareholder when installment notes distributed52 Liquidation of subsidiary; distribution of loss New

property to minority shareholder53 Liquidation of subsidiary; indebtedness of Unchanged 52

subsidiary to parent54 Liquidation of subsidiary; tax consequences to Unchanged 54

subsidiary and parent55 Nonapplicability of 332 to an insolvent subsidiary Unchanged 55

56 When not to make the 338 election Unchanged 56

ResearchProblem

1 Stock redemption in the context of a buy-sell Unchanged 1agreement

2 Complete termination of an interest under Unchanged 2 302(b)(3); consulting as a prohibited interestin corporation

3 Charitable contribution of 306 stock New4 Determination of complete liquidation status Unchanged 45 Internet activity Unchanged 56 Internet activity New

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5-4 2002 Annual Edition/Solutions Manual

CHECK FIGURES

28.a.

28.b.

28.c.

28.d.

28.e.

29.a.29.b.30.a.30.b.31.a.

31.b.31.c.32.a.32.b.33.a.33.b.33.c.34.a.34.b.34.c.35.36.a.36.b.36.c.36.d.37.a.

37.b.

38.a.

38.b.

38.c.

Teal taxable gain of $150,000; Gracedividend income of $250,000.Teal taxable gain of $150,000; Grace$250,000 of dividend, subject to the

dividends received deduction.Teal taxable gain of $150,000; Gracecapital gain of $170,000.Teal taxable gain of $150,000; Gracecapital gain of $170,000.Teal no preference; Grace prefersoption b., if corporation; option c., ifindividual.$18,000.$39,600.$30,600.$10,200.$30,000.

$3,000.Choose qualifying stock redemption.$30,000.$0.560 shares.470 shares.600 shares.Dividend income of $60,000.$110,000.$140,000.Capital gain of $35,000.Yes.No.No.Yes.Lori dividend income of $400,000;Swan reduces E & P by $400,000;Roberta capital gain of $375,000.Roberta capital gain of $375,000;Swan reduces E & P by $350,000.Helen capital gain of $1,800,000;Yellow dividend of $2,000,000;White gain of $3,000,000.Helen capital gain of $1,800,000 andbasis of $2,000,000; Yellow dividend

and basis of $2,000,000; White gainof $3,000,000.Helen and Yellow each have dividendand basis of $2,000,000; White gainof $3,000,000.

38.d.

39.

40.

41.a.41.b.42.43.a.

43.b.

43.c.

44.45.a.45.b.46.47.48.49.

50.

51.

52.

53.

54.a.54.b.54.c.54.d.54.e.

55.56.a.56.b.

Helen and Yellow each have dividendand basis of $250,000; White gain of$400,000.Qualifies under 303 to the extent of

$100,000.Red no loss recognized; E & Preduced by $800,000; estate $100,000gain on sale.Capital gain of $55,000.$90,000.$40,000.No tax consequences other thanallocation of stock basis.Ordinary income of $20,000, return ofcapital of $12,000, capital gain of$3,000.Dividend income of $35,000.

Bob taxable dividend of $30,000.$500,000 LTCG.$600,000 LTCG.$100,000.$60,000.$0.Pink should either distribute the landto Paul or sell it and distribute thecash.Pink should either distribute the landto Paul or sell it and distribute thecash.Helen must recognize $90,000 of gainin the year of liquidation.Magenta no gain or loss recognized;Fuchsia no gain or loss recognized andbasis of $620,000; Marta $20,000 gainrecognized and basis of $50,000.Green recognizes no gain; Orangerecognizes $50,000 gain.$0.$0.$90,000.$150,000.Carries over to Wren.

Section 332 does not apply; ordinaryloss allowed.Yes.No.

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DISCUSSION QUESTIONS

1. A nonliquidating distribution treated as a return from an investment is taxed as ordinarydividend income. Alternatively, a nonliquidating distribution treated as a return of aninvestment is taxed as a sale or exchange of the investment. Qualifying stock redemptionsare nonliquidating distributions that result in sale or exchange treatment. pp. 5-2 and 5-3

2. Because of the dividends received deduction available to corporate shareholders, acorporate shareholder would pay taxes on only a small portion of the proceeds if thedistribution is treated as dividend income. Thus, a dividend distribution normally providesmore favorable tax treatment to a corporate shareholder than sale or exchange treatment.p. 5-3

3. If Brown redeems Leonas shares, the remaining shareholders, Jacob and Ivan, are notrequired to use their own funds to purchase the stock.

If Brown redeems Leonas shares, Jacob and Ivan will be the only remainingshareholders, thereby possessing total control of the corporation. Other, outsideparties will not acquire an ownership interest.

If Brown makes the purchase, no effort will be required to develop or cultivate anoutside market for Leonas interest.

pp. 5-4 and 5-31

4. Kanishas redemption failed to qualify for sale or exchange treatment and was insteadtaxed as a dividend at her marginal tax rate (i.e., $5,400 = 36% X $15,000). Kwansredemption, however, satisfied the terms of one of the qualifying redemption provisionsand was taxed at the more favorable tax rate for long-term capital gains. That is, $1,400 =20% X [$15,000 (amount realized) - $8,000 (basis in shares)]. Example 2

5. Attribution from entities applies in the following manner. Stock owned by a partnership isdeemed to be owned by a partner to the extent of the partners proportionate interest inthe partnership. Stock owned by a corporation is deemed to be owned proportionately bya shareholder owning 50% or more of the corporations stock. Finally, stock owned by anestate or trust is deemed to be owned by a beneficiary or heir to the extent of thebeneficiary or heirs proportionate interest in the estate or trust.

Attribution to entities applies in the following manner. Stock owned by a partner isdeemed to be owned in full by a partnership. Stock owned by a 50% or more shareholderin a corporation is deemed to be owned in full by the corporation. Finally, stock ownedby a beneficiary or heir of an estate or trust is deemed to be owned in full by the estate ortrust.

Exhibit 5-1

6. Thefamily attribution rules do not apply to a complete termination redemption when theformer shareholder does not hold a prohibited interest for ten years after the redemptionand files the required notification agreement with the IRS. All other attribution rules stillapply to complete termination redemptions, however. pp. 5-9 and 5-10

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dividend, with reference to the effect of the distribution on the corporation, or thedistribution must be pursuant to the termination of an active business. pp. 5-10, 5-11, andExample 16

The stock attribution rules do not apply in satisfying the requirements of a redemption topay death taxes. p. 5-12

7. This problem requires the use of several of the attribution rules. Zina owns 400 sharesdirectly, 140 shares indirectly from Wren (70% X 200 shares), and 20 shares indirectlyfrom Waxwing (10% X 200 shares), for a total of 560 shares in Cardinal. Wren owns 200shares directly and 420 shares indirectly from Zina (400 shares owned directly plus 20shares owned indirectly from Waxwing), for a total of 620 shares in Cardinal. Waxwingowns 200 shares directly and 540 shares indirectly from Zina (400 shares owned directlyplus 140 shares owned indirectly from Wren), for a total of 740 shares in Cardinal.Exhibit 5-1

8. The basis attaches to the shareholders remaining stock basis or, if that shareholder has noremaining direct stock ownership, to stock the shareholder owns constructively. p. 5-7 andExample 9

9. The redemption does not qualify as a disproportionate redemption. After the redemption,Jacques ownership interest of 43% (600 shares/1,400 shares) does not satisfy the 80%test [43% is not less than 40% (80% X 800 shares/1,600 shares)]. The redemption mayqualify as a not essentially equivalent redemption. To qualify, the reduction in Jacquesownership, from 50% to 43%, would have to satisfy the meaningful reduction test. If thattest is met, sale or exchange treatment would result. Otherwise, the distribution isdividend income to Jacque. pp. 5-7 to 5-9

10. Whether the transfer of Polly's property to Flycatcher Corporation qualifies as anontaxable exchange under 351.

Polly's basis in her stock.

Whether the redemption qualifies for sale or exchange treatment.

Whether Polly is related to any shareholder of Flycatcher Corporation.

If Polly is related to a shareholder of Flycatcher, will she continue as a director ofFlycatcher or as a consultant to the corporation?

What is Flycatchers E & P at the time of the distribution?

Whether Flycatcher has a recognized gain (or unrecognized loss) as a result of thedistribution.

What is the effect of the distribution on Flycatchers E & P?

Whether Flycatcher incurred any (nondeductible) redemption expenditures as a resultof the distribution.

pp. 5-9, 5-10, 5-13, 5-14, and Chapter 3

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11. In determining whether a distribution is not essentially equivalent to a dividend for thepartial liquidation rules, the test is applied at the corporate level (rather than theshareholder level, as is the case of a not essentially equivalent redemption). The testrequires a genuine contraction of the corporations business and is based on the facts andcircumstances of each case. A safe harbor rule provides that a distribution pursuant to thetermination of an active trade or business will satisfy the not essentially equivalent to a

dividend test. To qualify for the termination of an active business rule, the distributionmust consist of the assets (or the proceeds from the sale of the assets) from a trade orbusiness that was actively conducted throughout the five-year period ending on the date ofthe distribution. In addition, the corporation must continue to actively conduct anotherfive-year-old trade or business immediately after the distribution. Finally, neither of theactive businesses must have been acquired in a taxable transaction within that same five-year period. pp. 5-10, 5-11, and Concept Summary 5-1

12. Section 303 provides two principal advantages to redemptions of decedent-shareholdersstock. First, the provision allows for sale or exchange treatment without regard to thestock attribution rules. This exception is particularly advantageous when the stock is thatof a family-owned corporation and the beneficiaries of the decedents estate are familymembers. Under 303, the stock of these beneficiaries is not attributed to the estate;

thus, sale or exchange treatment is available for redemptions that might not qualify under 302. The second advantage of 303, relative to redemptions qualifying under 302, isthat there is generally no gain recognized by the estate in a redemption to pay death taxes.This is because the stocks basis is stepped up to the fair market value at death (oralternative valuation date, if elected). p. 5-12

13. Valuation of Angies estate. Chapter 17

Whether the executor should elect the alternative valuation date. Chapter 17

Whether Angies lifetime gifts to Ann included stock in Bluebird Corporation and, ifso, the facts surrounding that transfer (e.g., dates, motivation).

Whether a redemption of the estate's shares in Redbird Corporation will qualify under 303.

Whether a redemption of the estates shares in Bluebird will qualify under 303(redemption to pay death taxes) or 302 (complete termination redemption) .

If a redemption of Bluebird stock is advantageous, whether noncash property shouldbe distributed in the redemption and, if so, which property.

Whether Ann should purchase the estate's shares in Bluebird.

Effect of Angies lifetime gifts for her estate as to the unified tax credit. Chapter 17

Marital and other estate deductions. Chapter 17

Due date of estate tax return. Chapter 17

Income tax return for estate. Chapter 19

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14. Corporate distributions in redemption of stock are governed under 311. That provisionprovides that gains, but not losses, are recognized on the distribution of noncash propertywhen the propertys fair market value differs from its basis. As such, the distribution ofProperty A would result in a $3,000 recognized gain [$10,000 (fair market value) - $7,000(basis)] to Indigo. The $4,000 loss inherent in Property B [$10,000 (fair market value) -$14,000 (basis)] would not be recognized on the distribution of that property. Indigo

could distribute the cash, as neither gain nor loss is recognized by Indigo on a cashdistribution. However, a sale of Property B to recognize the $4,000 loss and adistribution of the sales proceeds to Linda produces more favorable results. (To avoid therelated party loss disallowance rules of 267, the sale must not be to Linda.) p. 5-13

15. Whether Kackie should distribute cash and/or property in the redemption(s).

Whether Kackie would have a recognized gain (or unrecognized loss) on a distributionof property in the redemption(s).

Whether the distribution(s) would result in a qualifying stock redemption to theshareholder(s).

What would be the effect of the redemption distribution(s) on Kackies E & P?

Whether Kackie would incur any (nondeductible) redemption related expenditures(e.g., fees related to transfer of title in a property distribution).

pp. 5-13 and 5-14

16. Section 306 may apply to the sale of the preferred stock if the preferred stock is 306stock. To be 306 stock, the stock must have been received as a nontaxable stockdividend, acquired tax-free in a corporate reorganization, acquired in an exchange for 306 stock, or have a basis determined by reference to the basis of 306 stock. If thepreferred stock is 306 stock, some or all of Petes gain on the sale of the stock may betreated as ordinary income. The ordinary income portion of the gain would be limited tothe corporations E & P balance at the time the 306 stock was issued.

The underlying purpose of 306 is to preclude the use of preferred stock as a means ofbailing out corporate profits without the loss of voting power. Since Pete also sold anequal amount of common with the preferred stock, it is difficult to see how the taxavoidance at which 306 is aimed is present. Therefore, it is possible that the dispositiondescribed would not be caught by the onerous provisions of 306 [see 306(b)(4)]. Inany event, the sale would not create any problems if the preferred stock was not 306stock.

pp. 5-15 and 5-16

17. The sale of 306 stock generates ordinary income, but not dividend income. Sincedividends are not being distributed, the issuing corporation cannot reduce its E & P by theamount of the income recognized by the shareholder. Thus, the parties may have beenbetter off paying a dividend in the first place because E & P would be reduced in that case.pp. 5-15, 5-16, and Example 21

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18. Under 304, when a shareholder sells stock she owns in one corporation to a relatedcorporation, the sale is treated as a redemption subject to 302 and 303. Twocorporations are related if the shareholder has at least a 50% ownership in bothcorporations. p. 5-17 and Figure 5-1

19. For tax purposes, a corporate liquidation exists when a corporation ceases to be a going-

concern. The corporation continues solely to wind up affairs, pay debts, and distributeany remaining assets to its shareholders. Retention of a nominal amount of assets to payremaining debts and preserve legal status will not defeat liquidation status. Legaldissolution under state law is not required for a liquidation to be complete for taxpurposes. p. 5-19

20. Corporate losses arising from complete liquidations are disallowed in four situations.First, a loss is disallowed on the distribution of property to a related person if suchdistribution either is not pro rata or it consists of disqualified property. Second, a loss isdisallowed on the sale, exchange, or distribution of property that was contributed to thecorporation (in a 351 transaction or as a contribution to capital) with a built-in lossshortly before the adoption of a plan of liquidation. This disallowance applies when thecorporations acquisition of the property was part of a plan whose principal purpose was

to recognize a loss on that property by the liquidating corporation. The last twodisallowance rules apply in the case of a liquidation of a subsidiary corporation. Inliquidation, a subsidiary corporation does not recognize losses on the distribution ofproperty to its parent shareholder. Similarly, losses on the distribution of property to anyminority shareholders of a liquidating subsidiary are also not recognized. pp. 5-21 to 5-23, 5-26, and 5-27

21. The general rule under 331 provides for sale or exchange treatment to the shareholder.The shareholder is treated as having sold his or her stock to the corporation beingliquidated. Thus, the difference between the fair market value of the assets received fromthe corporation and the adjusted basis of the stock surrendered is the gain or lossrecognized. Typically, the stock is a capital asset in the hands of the shareholder andcapital gain or loss results.

A shareholder's gain on the receipt of installment notes obtained by a liquidatingcorporation on the sale of its assets may be deferred to the point of collection under 453(h). The shareholder must allocate stock basis among the various assets received fromthe corporation. With respect to the notes received, the shareholder may defer gain untilthe notes are collected.

p. 5-25, Example 35, and Footnote 36

22. a. The date of the adoption of a plan of complete liquidation is crucial in determiningwhether 332 applies. The parent corporation must own 80% or more of thesubsidiary's voting stock and 80% or more in value of all its other stock (other

than nonvoting preferred) at the time the plan of liquidation is adopted (and untilall property is distributed), or the liquidation will not qualify under 332.

b. The period of time in which the corporation must liquidate also is crucial indetermining whether 332 applies. The subsidiary must distribute all its propertyin complete redemption of all its stock within the taxable year in which the firstdistribution is made or within three years from the close of the tax year in which

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the first distribution occurred pursuant to the adoption of a plan by thecorporation. Otherwise, the liquidation will not qualify under 332.

c. The subsidiary must be solvent, or 332 will not apply. If the subsidiary isinsolvent, the parent corporation will have a deductible loss for its worthless stockin the subsidiary.

p. 5-26 and Footnote 41

23. If a minority interest is involved in a 332 liquidation, the nonrecognition provisions of 337 will only apply to distributions to the parent. A distribution to a minorityshareholder is treated in the same manner as one made pursuant to a nonliquidatingredemption. Gain (but not loss) is recognized to the distributing corporation on theproperty distributed to the minority shareholder. The minority shareholder is subject to thegeneral rule of 331. p. 5-27

24. When 332 applies, the subsidiary does not recognize gain or loss upon the transfer ofproperty to the parent. This is the case even if the transfer satisfies a debt. The parentcorporation may recognize a gain or loss on the receipt of property in satisfaction of

indebtedness, however. Examples 37 and 38

25. Condor will recognize no gain or loss and will have a carryover basis of $500,000 inDove's assets. Doves tax attributes (e.g., E & P) carry over to Condor. Condors basisin the Dove stock disappears. Dove recognizes no gain or loss on the liquidation. pp. 5-26 and 5-28

26. For 338 to apply, the parent must purchase within a 12-month period at least 80% ofthe voting power and at least 80% of the value of the acquired corporation. Purchase isdefined by 338(h)(3) to include all acquisitions of stock except the following: (1) atransaction where basis of the stock is the same as in the hands of the transferor, (2) anacquisition of stock by inheritance, (3) a transaction where 351 applies, and (4) anacquisition of stock from a related party where ownership of the stock would have beenattributed to the transferee under 318. The acquiring corporation must then make the 338 election by the 15th day of the ninth month following the qualified stock purchase.p. 5-29

27. Upon a 338 election, the subsidiary is treated as having sold its assets on the date of thequalified stock purchase. The deemed selling price is determined with reference to theparents basis in the subsidiary stock plus liabilities of the subsidiary. The subsidiaryrecognizes gain (or loss) as a result of the deemed sale. Then, as of the day following thequalified stock purchase date, the subsidiary is treated as a new corporation thatpurchased those same assets for a similarly computed amount. The deemed purchase ofthe assets thus results in a stepped-up (or -down) basis in the assets. Since the subsidiaryis treated as a new corporation, its tax attributes (e.g., E & P) start anew as of such date.

If the subsidiary is liquidated, it recognizes no gain (or loss) as a result of the liquidation(except for gain on distributions to minority shareholders).

The parent corporation incurs no gain (or loss) as a result of the 338 election, and itretains its basis in the subsidiary stock. If, however, the subsidiary is liquidated, thesubsidiary stock basis disappears and the parent takes the stepped-up (or -down) basis inthe assets acquired. The parent recognizes no gain (or loss) on the liquidation.

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pp. 5-29 and 5-30

PROBLEMS

28. a. Teal Corporation would have a taxable gain of $150,000. The gain would beordinary or capital depending on the type of property distributed. The E & P of

Teal Corporation would be increased by $150,000 (the amount of gain to Teal)and decreased by $250,000 (the FMV of the property distributed). Teals E & Palso would be decreased by the amount of tax due on the gain recognized. Gracewould have dividend income of $250,000 and a basis in the asset of $250,000.

b. The tax consequences to Teal Corporation would be the same as in a. GraceCorporation would have dividend income of $250,000, but only 20% of the$250,000, or $50,000, would be taxed to Grace. Because Grace Corporation hasa 20% or more ownership in Teal Corporation, the 80% dividends receiveddeduction is applicable. Grace Corporation would have a basis of $250,000 in theproperty.

c. The tax consequences to Teal Corporation would be the same as in a. Grace

would have a capital gain of $170,000 [$250,000 (value of the property) - $80,000(basis in stock)] and a basis of $250,000 in the property received.

d. The tax consequences to Teal Corporation would be the same as in a. GraceCorporation would have a capital gain of $170,000 [$250,000 (value of theproperty) - $80,000 (basis in stock)] and a basis of $250,000 in the propertyreceived.

e. Assuming Grace is an individual, she would choose the qualifying stockredemption, option c. If the distribution is a qualifying stock redemption, she has acapital gain of $170,000. If the distribution is a dividend as in option a., she wouldhave dividend income of $250,000. Her basis in the property received is the samewhether the transaction is a dividend or a qualifying stock redemption. If Grace isa corporation, it would prefer that the distribution be a dividend because only 20%of the dividend would be taxed. Thus, it would prefer option b. Teal Corporationitself would have no preference because the tax consequences to it are the sameunder each option.

pp. 5-3 to 5-5, and 5-13

29. a. Julio's tax liability would be $18,000, computed as follows: $100,000 (amountrealized) - $10,000 (basis in the 200 shares redeemed) = $90,000 (long-termcapital gain) X 20% = $18,000.

b. Julio's tax liability would be $39,600, computed as follows: $100,000

(dividend) X 39.6% = $39,600.Example 2

30. a. Tax liability for a corporate shareholder would be $30,600, computed as follows:$100,000 (amount realized) - $10,000 (basis in the stock) = $90,000 (long-termcapital gain) X 34% = $30,600. Corporations do not receive a preferential tax rateon long-term capital gains.

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b. Tax liability for a corporate shareholder on a $100,000 dividend from acorporation in which it has a 15% interest would be $10,200, computed asfollows: $100,000 (dividend) - $70,000 (dividends received deduction of 70% of$100,000) = $30,000 X 34% = $10,200.

Example 4

31. a. Julio may deduct the entire $30,000 capital loss carryover to offset the $90,000long-term capital gain. Thus, Julio would be taxed on only $60,000 of gain. Taxliability on the $60,000 long-term capital gain would be $12,000 ($60,000 X20%).

b. Julio could only deduct $3,000 of the $30,000 capital loss carryover. Julio's taxliability on the $100,000 dividend received would be $39,600 ($100,000 X39.6%).

c. The preferred outcome in this situation is that which provides sale or exchangetreatment (part a). With a qualifying stock redemption, Julios tax liability is$27,600 less ($39,600 - $12,000) than if the redemption is treated as a dividend.

Example 3

32. a. The corporation could offset the entire $30,000 capital loss carryover against the$90,000 long-term capital gain. Thus, only $60,000 of the gain would be taxed.The tax liability would be $20,400 ($60,000 X 34%).

b. The corporation could not deduct any of the $30,000 capital loss carryover.Corporations may only offset capital losses against capital gains. Thus, thecorporation would have dividend income of $100,000 less a dividends receiveddeduction of $70,000. The remaining $30,000 would be taxed at 34%, for a taxliability of $10,200.

Chapter 2 and Example 4

33. a. Beatrice owns 560 shares, 300 shares directly and 260 shares indirectly, in Silver.Beatrice constructively owns the stock of her mother (120 shares) and her son (50shares) and 60% of the 150 shares, or 90 shares, owned by Maroon Corporation.Beatrice is not deemed to own her brothers stock.

b. The stock attribution rules do not apply to stock held by a corporation if theshareholder owns less than 50% of the stock in that corporation. Thus, Beatricewould only own 470 shares, 300 shares directly and 170 shares owned by hermother (120 shares) and son (50 shares).

c. Beatrice would now own 600 shares in Silver, the 560 shares as computed in a.above plus 40 shares as a result of her 40% partnership interest [100 (sharesowned by Yellow Partnership) X 40% (Beatrices interest in the partnership)].

Exhibit 5-1

34. a. Shonda must report the $60,000 as dividend income. The redemption does notqualify as a not essentially equivalent redemption. Shonda owned 55% of the

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stock of Hawk Corporation prior to the redemption (110 200). After theredemption, Shonda owns 50% of the stock of Hawk [90 (Shonda's remainingshares in Hawk) 180 (remaining outstanding shares in Hawk)]. Shonda still hasthe dominant control of Hawk; thus, there has not been a meaningfulreduction in her interest in Hawk. Further, her remaining ownership interestfails the 50% test of a disproportionate redemption. pp. 5-7, 5-8, and Example

7

b. The basis in the 20 shares redeemed attaches to Shondas remaining stock.Shondas basis in her remaining 90 shares is therefore $110,000. p. 5-7

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

35. Hoffman, Raabe, Smith, and Maloney, CPAs5101 Madison Road

Cincinnati, OH 45227

May 10, 2001

Lana Pierce1000 Main StreetOldtown, MN 55166

Dear Lana:

This letter is in response to your question concerning the tax consequences of theredemption of 100 shares of stock you own in Stork Corporation. You were paid$45,000 for the shares and you have a tax basis of $10,000 in the stock. Your mother,Lori, owns 100 shares in Stork, and the remaining shares are owned by an unrelatedindividual. Our conclusion is based upon the facts as outlined in your May 5 letter. Anychange in facts may cause our conclusion to be inaccurate.

You will have a capital gain of $35,000 on the redemption. Stork Corporation redeemed100 of the 200 shares you owned in the corporation. For purposes of this transaction, youare deemed to own all of Loris 100 shares. Prior to the redemption, you had a 30%ownership (20% direct ownership + Loris 10% constructively owned) in the corporationas Stork Corporation had 1,000 shares outstanding. After the redemption you have only a22.22% ownership [200 (your remaining 100 shares in Stork + Loris 100 shares) 900(remaining outstanding shares in Stork)]. Because, after the redemption, you owned lessthan 50% of the stock in Stork Corporation and less than 80% of your original ownership[22.22% is less than 24% (80% X 300 shares/1,000 shares)], the redemption qualifies forcapital gain treatment.

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

Sincerely,

Marilyn C. Jones, CPAPartner

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TAX FILE MEMORANDUM

DATE: May 8, 2001

FROM: Marilyn C. Jones

SUBJECT: Lana Pierce

Today I talked to Lana Pierce with respect to her May 5 letter. She received a cashpayment of $45,000 from Stork Corporation in exchange for 100 of the 200 shares sheowned in the corporation. Lanas mother, Lori, owns 100 shares of Stork, and theremaining shares are owned by an unrelated individual. She wants to know the taxconsequences of the redemption.

At issue: Will the stock redemption qualify for capital gain treatment or will the $45,000be treated as a taxable dividend?

Conclusion: Lana Pierce has a capital gain of $35,000. Lana is deemed to own Loris 100shares before and after the redemption. Lana's percentage ownership in Stork

Corporation was 30% (300 shares/1,000 shares) before the redemption and 22.22% (200shares/900 shares) after the redemption. Because the 80% and 50% tests set out in 302(b)(2) are met, the stock redemption qualifies for capital gain treatment.

pp. 5-8 and 5-9 and Exhibit 5-1

36. a. The redemption qualifies under 302(b)(3). A shareholder can reacquire aninterest in the corporation by bequest or inheritance.

b. The redemption will not qualify under 302(b)(3). To qualify for the familyattribution waiver, filing the agreement to notify the IRS of any acquisition ofstock in the redeeming corporation in the next 10 years is mandatory. After theredemption, Jos is, therefore, deemed to own 100% of Thrushs stock and adividend distribution results.

c. The redemption will not qualify under 302(b)(3). To qualify for the familydistribution waiver, the shareholder may not have any interest in the corporation(other than a creditor) including an interest as a director. After the redemption,Jos is, therefore, deemed to own 100% of Thrushs stock and a dividenddistribution results.

d. The redemption qualifies under 302(b)(3). The prohibited interest (i.e., that asdirector) relates to Jos, not Jos's daughter.

p. 5-9 and Examples 12 and 13

37. a. With respect to the distribution, Lori would have ordinary dividend income of$400,000 and Swan Corporation would reduce its E & P by $400,000. As a resultof the stock transaction, Lori would have a basis of $400,000 in the newlyacquired 100 shares and become the sole shareholder of Swan. Roberta wouldhave a capital gain of $375,000 [$400,000 (amount realized) - $25,000 (basis instock)] on the sale. The stock transaction would not affect Swan.

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b. The transaction would constitute a complete termination redemption and result ina capital gain of $375,000 [$400,000 (amount realized) - $25,000 (basis in stock)]to Roberta. Lori would become the sole shareholder as a result of the redemption.Swan would reduce its E & P by $350,000 [$700,000 (E & P at time ofredemption) X 50% (interest redeemed)].

pp. 5-9, 5-13, and Chapter 4

38. a. The redemption will qualify as a partial liquidation under 302(b)(4) as to Helenbut not as to Yellow Corporation. Section 302(b)(4) permits sale or exchangetreatment only to noncorporate shareholders. The distribution should qualify as apartial liquidation as to Helen because it is a genuine contraction of a part of thebusiness of White Corporation. Since the genuine contraction test is satisfied,there is no need to meet the 5-year requirement under the termination of an activebusiness test. Partial liquidation redemptions may be pro rata with respect to theshareholders.

Helen has a capital gain of $1,800,000 [$2,000,000 (insurance proceeds) -$200,000 (basis in 20 shares of stock in White Corporation)].

Yellow Corporation will have dividend income of $2,000,000 (insuranceproceeds), reduced by the dividends received deduction of $1,600,000 (80% X$2,000,000). The basis of the redeemed shares ($200,000) is added to the basis ofYellows remaining 80 shares of White stock.

White Corporation will have a taxable gain on the farm machinery of $3,000,000[$4,000,000 (insurance proceeds) - $1,000,000 (basis in the farm machinery)]. E& P for White Corporation will be increased $3,000,000 (gain on the farmmachinery) and will be decreased $2,900,000 [10% X $9,000,000 E & P as of thedate of the redemption (representing the partial liquidation to Helen), plus$2,000,000 (representing the dividend distribution to Yellow Corporation)].

b. The redemption will again qualify as a partial liquidation as to Helen but not as toYellow Corporation. The distribution represents the termination of an activebusiness that has been in existence for at least five years. White Corporationcontinues to manufacture widgets, a business that also has been in existence for atleast five years.

Helen will have a capital gain of $1,800,000 [$2,000,000 (fair market value ofone-half of the farm machinery) - $200,000 (basis in stock)]. Helen will have abasis of $2,000,000 in the farm machinery.

Yellow Corporation will have dividend income of $2,000,000 (fair market value ofone-half of the farm machinery), reduced by the dividends received deduction of

$1,600,000 (80% X $2,000,000). Yellow Corporation will have a basis of$2,000,000 in the farm machinery. The basis of the redeemed shares ($200,000) isadded to the basis of Yellows remaining 80 shares of White stock.

White Corporation will have a taxable gain of $3,000,000 [$4,000,000 (fair marketvalue of the machinery) - $1,000,000 (basis in the machinery)]. E & P of WhiteCorporation will be increased $3,000,000 and decreased $2,900,000 [10% X$9,000,000 E & P as of the date of the redemption (representing the partial

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liquidation to Helen), plus $2,000,000 (representing the property dividenddistribution to Yellow Corporation)].

c. The distribution will not qualify as a partial liquidation either to Helen or toYellow Corporation. White Corporation has not engaged in the active conduct oftwo or more trades or businesses for at least five years. The distribution is,

therefore, not pursuant to the termination of an active trade or business. Thedistribution is a dividend both to Helen and to Yellow Corporation.

Helen and Yellow Corporation will each have a dividend of $2,000,000 (one-halfof the fair market value of the machinery). Yellow Corporation will have adividends received deduction of $1,600,000 (80% X $2,000,000). Helen andYellow Corporation will each have a basis of $2,000,000 in the machinery. Thetwo shareholders each will add the basis of the redeemed shares ($500,000) to thatof their remaining shares of White stock.

White Corporation will have a gain of $3,000,000 [$4,000,000 (fair market valueof farm machinery) - $1,000,000 (basis in the farm machinery)], which willincrease its E & P to $9,000,000. E & P of White Corporation will then be

decreased $4,000,000, the fair market value of the machinery.

d. The distribution will not qualify as a partial liquidation to Helen because WhiteCorporation has not satisfied either the not essentially equivalent to a dividendrequirement or the termination of an active business requirement. The stock itholds for investment purposes does not constitute a trade or business.

Both Helen and Yellow Corporation will have dividend income of $250,000representing one-half of the fair market value of the stock distributed to them byWhite Corporation. Yellow Corporation will have a dividends received deductionof $200,000 (80% X $250,000). Each shareholder will have a basis of $250,000 inthe stock received. The two shareholders each will add the basis of the redeemedshares ($100,000) to that of their remaining shares of White stock.

White Corporation will have a gain of $400,000 [$500,000 (value of the stock) -$100,000 (basis in the stock)]. E & P of White Corporation will be increased$400,000 (gain) and decreased by $500,000 (the value of the stock).

Note: White Corporations E & P has not been adjusted for any taxes due on the gainrecognized in each of these solutions.

pp. 5-10, 5-11, and Examples 14 to 16

39. The redemption qualifies under 303 to the extent of $100,000, the amount of deathtaxes and funeral and administration expenses. Since Debra owned a 20% or more

interest in both Lark and Owl, the values of the two stocks can be combined to satisfy the35% of adjusted gross estate test [i.e., ($150,000 + $250,000)/$900,000 = 44%]. Theestates basis in the Lark shares is stepped-up to fair market value; thus, the estate has nogain or loss on this portion of the transaction [i.e., $100,000 (proceeds qualifying for 303 treatment) - $100,000 (estates basis in shares)]. To receive sale or exchangetreatment on the $50,000 distribution for the remaining Lark shares, the transaction mustqualify under the 302 redemption rules. If the estate is not deemed to own anyadditional Lark stock under the 318 attribution rules, this portion of the transaction

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would qualify as a complete termination redemption. Assuming sale or exchangetreatment is available, the estate would have no gain or loss [i.e., $50,000 (proceedsqualifying for 302 treatment) - $50,000 (estates basis in shares)]. If sale or exchangetreatment is not available, the estate would have a $50,000 dividend. (In such case, theestates basis in the redeemed shares would presumably attach to the shares attributed tothe estate under 318.) pp. 5-9, 5-12, and Examples 17 and 18

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40. Losses are not recognized in nonliquidating corporate distributions; thus, Red Corporationwill not recognize the $200,000 loss inherent in the land distributed to the estate. RedCorporations E & P is reduced by $800,000 (limited to 20% X $4 million) as a result ofthe distribution. The estate will have a basis in the land equal to its fair market value, or$1,000,000. When it sells the land for $1,100,000, the estate recognizes a gain of$100,000. pp. 5-12 and 5-13

41. a. Ann would have a capital gain of $55,000 [$80,000 (amount realized) - $25,000(basis in the 25 shares)]. The redemption qualifies as a disproportionateredemption. Ann had a 50% (50 shares/100 shares) ownership in TealCorporation prior to the redemption and a 33.33% (25 shares/75 shares)ownership after the redemption. Both the 50% and the 80% [33.33% is less than40% (80% X 50%)] tests are met. p. 5-8 and Example 10

b. E & P of Teal Corporation will be $90,000 after the redemption: $100,000(accumulated E & P) + $20,000 (current E & P) - $30,000 [25% (the percentagestock redemption) X $120,000 (the balance in E & P)]. Example 20

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

5101 Madison RoadCincinnati, OH 45227

November 10, 2001

Loon Corporation506 Wall StreetWinona, MN 55987

Dear President of Loon Corporation:

This letter is in response to your question concerning the reduction to Loon Corporation'sE & P account as a result of a stock redemption that resulted in a sale or exchange for theshareholder. Loon Corporation had 500 shares of stock outstanding when it redeemed 50shares for $90,000. Loon had paid-in capital of $300,000 and E & P of $400,000 at thetime of the redemption. Our conclusion is based upon the facts as outlined in yourNovember 1 letter. Any change in facts may cause our conclusions to be inaccurate.

Loon Corporation would reduce its E & P account in the amount of $40,000 as a result ofthe redemption. This represents a 10% decrease in the amount of the E & Pcorresponding to the 10% stock redemption. The E & P account of a corporation isreduced by a stock redemption in an amount not in excess of the ratable share of the E &P of the distributing corporation attributable to the stock redeemed. The $50,000 balancepaid for the stock would reduce paid-in capital.


Sincerely,

Marilyn C. Smith, CPAPartner

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TAX FILE MEMORANDUM

DATE: November 5, 2001

FROM: Marilyn C. Smith

SUBJECT: Loon Corporation

Today I talked to the President of Loon Corporation with respect to its November 1letter. Loon Corporation had 500 shares of stock outstanding. It redeemed 50 shares for$90,000 when it had paid-in capital of $300,000 and E & P of $400,000. The redemptionqualified for sale or exchange treatment for the shareholder.

At issue: What is the reduction in Loon Corporation's E & P as a result of theredemption?

Conclusion: The E & P account of a corporation is reduced by a qualifying stockredemption in an amount not in excess of the ratable share of the E & P of the distributingcorporation attributable to the stock redeemed. Because Loon redeemed 10% of its

stock, the reduction is 10% of the E & P account, or $40,000.

Example 20

43. a. There are no tax consequences upon receipt of the preferred stock. It is anontaxable stock dividend. However, the stock is classified as 306 stock. Thebasis of $60,000 in their original common shares is reallocated between thepreferred and the common stock based on the fair market value of each. The basisis reallocated as follows:

Fair market value of common: 200 X $400 = $ 80,000Fair market value of preferred: 100 X $200 = 20,000

$100,000

Basis of common: 80/100 X $60,000 = $48,000

Basis of preferred: 20/100 X $60,000 = $12,000

b. A sale of the preferred stock to Adam will produce $20,000 of ordinary income,which is the fair market value of the preferred stock on the date of distribution.However, the $20,000 will not be dividend income. Thus, the E & P of BlueCorporation will not be reduced. With respect to the remaining $15,000 of thesales price, $12,000 will reduce the basis of the preferred stock to zero (i.e., areturn of capital), and the remaining $3,000 will be capital gain.

c. The redemption is treated as a dividend distribution to the extent of BlueCorporations E & P on the date of the redemption; thus, Ahmad will have adividend of $35,000. The $12,000 basis of the preferred stock is added back tothe basis of Ahmads common stock. Blue Corporations E & P is reduced by$35,000 as a result of the distribution.

Examples 21 and 22

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44. Bob has a taxable dividend of $30,000. Pursuant to 304, the sale is treated as aredemption subject to 302. After the redemption, Bob continues to own all 1,000 sharesof Goose stock [800 (shares directly owned) + 200 (shares owned constructively throughhis sole ownership of Heron)]. As a result, the redemption satisfies none of the qualifyingstock redemption provisions. The amount of the dividend income is determined by the E& P of the acquiring corporation (Heron Corporation) and then by the E & P of the

acquired corporation (Goose Corporation).

The basis of the Goose Corporation stock to Heron Corporation is $5,000, the adjustedbasis of stock in the hands of Bob. Bobs $5,000 basis in the sold Goose stock is addedto his basis in the Heron Corporation stock.

p. 5-17 and Figure 5-1

45. a. Oriole Corporation would have a recognized gain of $500,000 [$600,000 (fairmarket value) - $100,000 (basis)]. Under the general rule of 336(a), the land istreated as if it were sold for its fair market value. Since the land was a capitalasset held for more than one year, Oriole has a $500,000 long-term capital gain.

b. Oriole Corporation has a recognized long-term capital gain of $600,000 on thedistribution. Under 336(b), when property distributed in a complete liquidationis subject to a liability of the liquidating corporation, the fair market value of thatproperty is treated as not being less than the amount of the liability. Thus, the$100,000 adjusted basis in the land is subtracted from the $700,000 liability for again of $600,000.

Example 25 and Chapter 2

46. A loss of $100,000 is recognized. Because the fair market value of the land exceeded itsbasis at the time of the 351 exchange, the built-in loss limitation does not apply.Further, the related-party loss limitation does not apply to a sale of property. The realizedloss of $100,000 [$400,000 (selling price) - $500,000 (carryover basis)] is, therefore, fullyrecognized. pp. 5-20 to 5-23 and Figure 5-2

47. A loss of $60,000 is recognized. The land was built-in loss property when it was acquiredin the 351 exchange. Further, the sale of the land occurred within 2 years of theexchange; thus, a tax avoidance purpose is presumed to exist. The realized loss of$100,000 [$400,000 (selling price) - $500,000 (carryover basis)] is disallowed to theextent of the $40,000 built-in loss [$460,000 (fair market value) - $500,000 (basis)].Therefore, the recognized loss is $60,000 ($100,000 - $40,000). The 2-year presumptiverule can be overcome and all of the loss recognized if there is a clear and substantialbusiness relationship between the contributed land and Grays business. The related-partyloss limitation does not apply to asale of property. Example 30 and Figure 5-2

48. No loss is recognized. The land is disqualified property that is distributed to a relatedparty (both Arnold and Beatrice are considered 100% shareholders under the 267attribution rules). Thus, the related-party loss limitation applies and none of the realizedloss of $100,000 [$400,000 (fair market value) - $500,000 (carryover basis)] isrecognized. Example 29 and Figure 5-2

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49. a. If Pink Corporation distributes all the land to Maria, none of the loss on thedistribution will be allowed since Maria is a related party and the land isdisqualified property.

b. If all the land is distributed to Paul, Pink Corporation will have a recognized lossof $1,200,000. The land was valued at more than its basis on the date of the

transfer to Pink; thus, the built-in loss limitation does not apply. Because Paul isan unrelated party, the related-party loss limitation does not apply.

c. Even though the distribution is pro rata, the property is disqualified property; thus,the loss on the distribution to Maria, a related party, would be disallowed. Of the$1,200,000 loss, 20%, or $240,000, would be allowed. For the reasons noted in b.above, the loss limitations do not apply to the distribution to Paul.

d. In this case, 50% of the loss, or $600,000, would be disallowed. The property isdisqualified property; thus, the loss on the distribution to Maria, a related party,would be disallowed. For the reasons noted in b. above, the loss limitations do notapply to the distribution to Paul.

e. Because the property does not have a built-in loss on the date of the transfer to thecorporation, the built-in loss limitation does not apply. Further, the related-partyloss limitation does not apply to a sale of property. Upon the sale, PinkCorporation would recognize a $1,200,000 loss [$600,000 (amount realized) -$1,800,000 (carryover basis)].

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

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

50. If the plan of liquidation is not adopted until 2002, there is no presumption that thetransfer of the land was in furtherance of a plan to utilize the loss to neutralize a gain uponliquidation. Thus, Pink Corporation will be permitted to recognize the loss, assuming theproperty is not distributed to a related party, if the corporation can show a business reasonfor acquiring the land. If it cannot, the built-in loss of $300,000 on the land would bedisallowed on a sale or a distribution.

a. The answer would not change. The land is disqualified property. Since it wasdistributed to a related party, all the loss is disallowed.

b. Because the property had a built-in loss of $300,000, that much of the loss will bedisallowed unless Pink Corporation can show a business purpose in acquiring theland. Because the land was acquired more than two years ago, there is nopresumption that the principal purpose was to generate a loss deduction upon

liquidation. Thus, Pink Corporation may be permitted to recognize the entire$1,200,000 loss.

c. The loss on the property distributed to Maria will be disallowed entirely becausethere is a distribution of disqualified property to a related party. If PinkCorporation cannot show a business purpose in acquiring the land, an additional$60,000 of the loss [$300,000 (built-in loss) X 20% (Paul's distribution)] will bedisallowed. In this case, $180,000 of the loss would be allowed [$900,000 (post

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351 exchange loss) X 20% (Paul's distribution)]. If Pink Corporation can show abusiness reason (there is no presumption of a prohibited purpose), $240,000 of theloss would be allowed [$1,200,000 (total loss) X 20% (Pauls distribution)].

d. Here again, the loss on the distribution of disqualified property to Maria will bedisallowed entirely. Of the remaining $600,000 loss, 50% of the built-in loss of

$300,000, or $150,000, will also be disallowed if Pink Corporation cannot show abusiness purpose for the acquisition. If Pink Corporation can demonstrate abusiness purpose, $600,000 of the loss, or the portion pertaining to the distributionto Paul, would be allowed.

e. If Pink Corporation cannot show a business purpose for the acquisition, the built-in loss of $300,000 would be disallowed. The remaining $900,000 loss would beallowed. If Pink Corporation can show a business purpose for the acquisition, theentire $1,200,000 loss would be allowed. The related-party loss limitation doesnot apply to asale of property.

Again, Pink Corporation should either distribute the land to Paul (option b.) or sell it anddistribute the cash (option e.).

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

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

Helen may defer gain on the receipt of the notes to the point of collection under theinstallment method.

Helen must allocate her $50,000 basis in the Purple Corporation stock between thecash and the installment notes. Using the relative fair market value approach, 20%[$100,000 (amount of cash)/$500,000 (total distribution)] of $50,000 (basis in thestock), or $10,000, is allocated to the cash, and 80% [$400,000 (FMV of the notes)/$500,000 (total distribution)] of $50,000 (basis in the stock), or $40,000, is allocatedto the notes.

Helen must recognize $90,000 [$100,000 (cash received) - $10,000 (basis allocated tothe cash)] in the year of the liquidation.

Since Helen's gross profit on the notes is $360,000 [$400,000 (FMV of notes) -$40,000 (basis allocated to the notes)], the gross profit percentage is 90% [$360,000(gross profit)/$400,000 (FMV of notes)]. Thus, Helen must report a gain of $72,000[$80,000 (amount of annual payment) X 90% (gross profit percentage)] on thecollection of each note over the next five years.

The interest element is accounted for separately.

Example 35

52. Magenta recognizes no gain on the distribution of assets to Fuchsia, its parentcorporation. The land distribution to Marta results in a $25,000 nonrecognized loss[$50,000 (fair market value) - $75,000 (basis)] to Magenta.

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

Marta recognizes a $20,000 gain [$50,000 (amount realized) - $30,000 (basis of stock)] inthe liquidation, and she has a basis in the land of $50,000.

Concept Summary 5-2

53. Green Corporation recognizes no gain on the transfer of the land to satisfy itsindebtedness to Orange Corporation. Transfers by a subsidiary corporation pursuant to a 332 liquidation are subject to the nonrecognition rules of 337. Orange Corporation,however, must recognize a gain of $50,000 [$500,000 (fair market value of the land) -$450,000 (basis in the bonds)]. Examples 37 and 38

54. a. $0. 337

b. $0. 332

c. $90,000. Cardinal Corporations basis will carry over to Wren.

d. $150,000. Cardinal Corporations basis will carry over to Wren.

e. Cardinals E & P of $200,000 will carry over to Wren. 381 and Chapter 7

pp. 5-26 and 5-28

55. Hoffman, Raabe, Smith, and Maloney, CPAs5101 Madison Road

Cincinnati, OH 45227

October 11, 2001

Quail Corporation1010 Cypress LaneCommunity, MN 55166

Dear President of Quail Corporation:

This letter is in response to your question as to the tax consequences to Quail Corporationif it liquidates its wholly owned subsidiary, Sparrow Corporation. Our conclusion is basedon the facts as outlined in your October 5 letter. Any change in facts may cause ourconclusion to be inaccurate.

Because Sparrow Corporation is insolvent (its liabilities exceed the value of its assets),Quail Corporation would have an ordinary loss deduction for its worthless stock inSparrow Corporation. The loss to Quail would be measured by the fair market value ofSparrow's net assets less Quail's basis in the Sparrow stock.


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Sincerely,

Larry C. Williams, CPAPartner

TAX FILE MEMORANDUM

DATE: October 8, 2001

FROM: Larry C. Williams

SUBJECT: Quail Corporation

Today I talked to the President of Quail Corporation with respect to his October 5 letter.Quail Corporation is considering liquidating its wholly owned subsidiary SparrowCorporation and wants to know the tax consequences upon a liquidation of SparrowCorporation.

At issue: What are the tax consequences of a liquidation of a wholly owned subsidiarywhen the subsidiary is insolvent?

Conclusion: Because Sparrow Corporation is insolvent, 332 does not apply to aliquidation. Quail Corporation would have an ordinary loss deduction for its worthlessstock in Sparrow Corporation under 165(g)(3).

p. 5-26 and Chapter 3

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

b. Canary Corporation should not elect 338. If 338 is elected, Falcon's assets(regardless of whether Falcon Corporation is liquidated) would receive a stepped-down basis. Falcon Corporation would recognize a loss on the deemed sale of itsassets; however, the loss probably could not be utilized since Falcon undoubtedlyhas had tax losses, rather than taxable income, in the past. Further, since Falconwould be treated as a new corporation as a result of the 338 election, any losscarryovers (e.g., NOL) would disappear. pp. 5-29 and 5-30

The answers to the Research Problems are incorporated into the 2002 Annual Edition of theInstructor's Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION:

CORPORATIONS, PARTNERSHIPS, ESTATES, AND TRUSTS.

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NOTES

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