†† Gain reported on the installment basis is 2/3 of the $100,000 payment in the year of sale. All of the gain of $600,000 is an increase in E & P in the year of sale. Thus, E & P is increased by an additional $533,334 over the amount recognized in taxable income.

Concept Summary 10-1

13. a. Sandpiper has a gain of $55,000 on the distribution, computed as follows: $135,000 (liability on the lot exceeds fair market value) - $80,000 (basis of the lot). Sandpiper's E & P is increased $55,000. E & P is decreased $135,000 (the new basis of the lot) less the $135,000 liability on the lot, or zero. Thus E & P is $215,000, computed as follows: $160,000 (beginning balance in E & P) + $55,000 (gain on the distribution).

b. Ananda has dividend income of zero, computed as follows: $135,000 (value of land based on liability) - $135,000 (liability on the lot). Ananda has a basis of $135,000 in the lot.

pp. 10-12 and 10-13

14. a. Dividend income to Orca is $80,000 [$110,000 (fair market value of the property) - $30,000 (liability assumed)]. The amount taxed to Orca is reduced by the dividends received deduction.

b. Orca's basis in the property is $110,000.

c. The distribution reduces Penguin's E & P account by $120,000 [$150,000 (adjusted basis of the property) - $30,000 (liability assumed by Orca)].

pp. 10-11 to 10-13

15. To determine the taxability of the $35,000 distribution, the balance of both accumulated and current E & P as of July 1 must be determined and netted. This is necessary because of the deficit in current E & P. One-half of the $30,000 loss, or $15,000, reduces E & P to $25,000 as of July 1 ($40,000 - $15,000). Thus, of the $35,000 distribution, $25,000 is taxed as a dividend and $10,000 represents a return of capital. Example 11

16. Snipe Corporation recognizes a gain of $70,000 on the distribution. Snipe's E & P is reduced by $75,000 [$90,000 (fair market value) - $15,000 (liability)]. Mary has a taxable dividend of $75,000 [$90,000 (fair market value) - $15,000 (liability)]. The basis of the equipment to Mary is $90,000. pp. 10-11 to 10-13

1. Homer has a taxable dividend of $60,000 and a basis in the land of $60,000. Gold Corporation does not recognize a loss on the distribution. Gold's E & P is reduced by $100,000.

pp. 10-11 to 10-13

18. What basis do Cybil and Sally have in their stock in Copper Corporation after their
initial transfers for stock?

• Does Sally's transfer qualify under § 351 of the Code as a nontaxable exchange?
• How is Copper Corporation taxed on the property distribution to Cybil?
• How do the distributions to Cybil and to Sally affect Copper's E & P?
• How will Cybil and Sally be taxed on the distributions?
• What is Cybil's basis in her stock when she sells it to Dana?
• How are Cybil and Dana taxed on the $80,000 distribution to each?
• pp. 10-2 to 10-10

19. a. The determination of the reasonableness of compensation paid to an employee who is not a shareholder but is related to the sole owner of the corporate-employer should be made in the same manner as that for salary paid the shareholder-employee. The degree of relationship between the sole owner of the corporation and the employee should be considered initially to determine if, in essence, the salary could be considered as having been paid to the owner. If so, the same factors used to determine the reasonableness of that paid to the owner should be used to determine the reasonableness of that paid to the related employee.

b. That the employee-shareholder never completed high school should be relevant only with respect to the nature and scope of the employee's work. Is education beyond high school required for the type of work performed by the employee-shareholder and the salary received for such work?

c. The fact that the employee-shareholder is a full-time college student might well cause any salary paid to be deemed excessive.

d. If the employee-shareholder was underpaid during the formative period of the corporation, this is evidence of reasonableness of the compensation if a portion thereof is for service rendered in prior years.

e. If a corporation has substantial E & P and pays only a nominal dividend each year, a constructive dividend may be found.

f. Year-end bonuses would be vulnerable to constructive dividend treatment, particularly if they are related to profit for the year, are paid only to shareholder-employees, and are determined at year-end on an arbitrary basis. p. 10-15

20. a. The result of this transaction is, in effect, a realized loss of $7,000 (the difference between basis of $30,000 and fair market value of $23,000) and a constructive dividend of $8,000 (the difference between the $23,000 fair market value and the $15,000 paid for the lot). Due to the application of § 267, Emu cannot recognize the realized loss. However, the loss does reduce Emu's E & P. The constructive dividend also reduces E & P. Thus, E & P is reduced by $15,000 (the sum of the $7,000 disallowed loss and the $8,000 constructive dividend).

b. The loan to Cameron will generate imputed interest since no interest was charged. The amount of imputed interest will be $11,275 [($110,000 X 10% X ½ year) + ($115,500 X 10% X ½ year)]. This amount will be deemed paid as interest from Cameron to the corporation. The deductibility of the interest by Cameron will depend upon how the loan proceeds are used. Emu will have taxable interest income of $11,275. Finally, Emu will be deemed to pay a dividend to Cameron equal to the amount of interest. Emu's E & P will be increased by the amount of interest income and reduced by the amount of deemed dividend payment.

c. Bargain rentals create constructive dividends to shareholders. In the present case, the amount of constructive dividend to both Cameron and Connor equals the fair rental value of the cottage. Thus, both shareholders will receive dividend income of $7,000 ($3,500 X 2 weeks) and Emu's E & P will be reduced by the same amount.

d. The $5,000 excess amount ($12,000 - $7,000) paid to Cameron by Emu over the fair rental value of the truck will be treated as a constructive dividend, taxable to Cameron. The dividend will also reduce Emu's E & P. pp. 10-14 to 10-18

21. a. Taxable income to Paul is $450,000 [$500,000 (value of the property) - $50,000 (liability assumed)]. pp. 10-11 to 10-12

b. Corporate E & P after the distribution is $555,000 computed as follows:

c. The tax basis of the property to Paul is $500,000.

pp. 10-2 to 10-13

22. a. Verdigris Corporation has dividend income of $10,000 [$60,000 (fair market value of the land) less $50,000 (liability on the land)]. The $10,000 is subject to the dividends received deduction under § 243 of $8,000, so that only $2,000 is taxed to Verdigris Corporation. Verdigris Corporation has a basis of $60,000 in the land.

b. Rust Corporation may not deduct the loss on the land. Its E & P is reduced by $40,000, the $90,000 basis of the land (which is greater than the fair market value) less the $50,000 liability on the land.

pp. 10-11 to 10-13

23. Taxable income:

pp. 10-3 to 10-12

24. The shareholder has a return of capital of $60,000. The $60,000 reduces the basis in the Green Corporation stock; any excess over basis is capital gain. There is no taxable dividend because the accumulated E & P account is brought up to date on the date of the sale. On the date of the sale, E & P is a negative $10,000 [$200,000 (beginning balance in accumulated E & P) - $200,000 (existing deficit in current E & P from sale of the asset) - $10,000 (one-half of $20,000 negative E & P not related to asset sale)]; thus, the $60,000 distribution constitutes a return of capital. Generally, deficits are allocated pro rata throughout the year unless the parties can prove otherwise. Here the shareholder can prove otherwise. (If the $220,000 deficit in E & P were prorated throughout the year, there would have been a taxable dividend of $60,000 because E & P would have a positive balance of $90,000 [$200,000 (beginning balance in accumulated E & P) - $110,000 (one-half the $220,000 deficit for the year)]. Examples 11

25. The shareholder has a taxable dividend of $5,000 and a return of capital of $10,000. Indigo Corporation had no accumulated E & P at the time of the distribution. The shareholder is taxed on the current E & P of Indigo Corporation, which was only $5,000. The balance of the distribution, $10,000, is applied against and reduce the adjusted basis of the stock in Indigo Corporation. To the extent that the $10,000 exceeds the basis in the stock, a capital gain results. pp. 10-6 to 10-9

26. Red Corporation and Fred each have a taxable dividend of $45,000. White Corporation's current E & P is $105,000; thus, the entire distribution is a taxable dividend even though White Corporation had no accumulated E & P. Red Corporation is entitled to a dividends received deduction of $36,000 (80% of $45,000) as Red Corporation owns more than 20% of the stock in White Corporation. Thus, Red Corporation is only taxed on $9,000.

First, White Corporation's current E & P of $105,000 is reduced by the $90,000 distributed to the shareholders. This leaves a positive current E & P balance of $15,000, which is then netted with the deficit of $150,000 in accumulated E & P, to yield a deficit of $135,000 in accumulated E & P as of January 1 of the following year.

pp. 10-6 to 10-9

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

5101 Madison Road

Cincinnati, Ohio 45227

November 15, 1998

Cardinal Corporation

1010 Keystone Street

Middleton, PA 17057

Dear President of Cardinal Corporation:

This letter is in response to your question concerning the tax consequences on the sale of Cardinal Corporation's stock in Quail Corporation to Plover Corporation. Our conclusion is based upon the facts as outlined in your November 1 letter. Any change in facts may cause our conclusion to be inaccurate.

Cardinal Corporation was the sole shareholder of Quail Corporation. Cardinal was willing to sell its stock in Quail corporation for $350,000. Plover Corporation wanted to buy the stock in Quail but could only pay $300,000. Quail Corporation distributed $50,000 cash to Cardinal, and Cardinal then sold its stock to Plover for $300,000. Quail had sufficient E & P to cover the $50,000 cash distribution to Cardinal. Cardinal's basis in the Quail stock was $100,000.

Because Cardinal Corporation was the sole shareholder of Quail Corporation at the time it received the $50,000 cash dividend, Cardinal Corporation will have a 100% dividends received deduction on the $50,000 distribution. Thus, the $50,000 will not be taxed to Cardinal Corporation. Cardinal Corporation will have a gain on the sale of its stock in Quail in the amount of $200,000, which is the difference between the selling price of $300,000 and Cardinal's $100,000 basis in the stock.

Sincerely yours,

Marilyn C. Seago, CPA

Partner

November 13, 1998

TAX FILE MEMORANDUM

FROM: Marilyn C. Seago

SUBJECT: Cardinal Corporation

Today I talked to Cardinal Corporation with respect to its November 1, 1998 letter. Cardinal Corporation wants to know the tax consequences of its sale of stock in Quail Corporation, a wholly owned corporation. Cardinal sold the stock for $300,000 to Plover Corporation. Cardinal had a tax basis of $100,000 in the Quail stock. Prior to the sale, Quail Corporation distributed $50,000 to Cardinal Corporation as a dividend. Quail had sufficient E & P to cover the $50,000 distribution. Cardinal wanted to sell the stock for $350,000, but Plover could only pay $300,000.

At issue: What are the tax consequences to Cardinal Corporation on the sale of its stock in its wholly owned subsidiary and how does the dividend distribution affect its tax position?

Conclusion: Because Cardinal was the sole shareholder of Quail Corporation, it will have a 100% dividends received deduction of the $50,000 cash distribution. Cardinal Corporation will have a gain on the sale of its stock in Quail of $200,000 [$300,000 (selling price of the stock) - $100,000 (basis in the Quail stock)].

28. Wren Corporation is deemed to have made a dividend to James in the amount of the imputed interest on the loan, determined by using the Federal rate and compounded semiannually. Thus, Wren Corporation is deemed to have made a dividend to James in the amount of $20,500. Although James has dividend income of $20,250, he may be permitted to offset the income with a $20,250 deemed interest payment to Wren. Wren has deemed interest income of $20,500, but has no corresponding deduction. The deemed payment from Wren to James is a nondeductible dividend. Example 23

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

5101 Madison Road

Cincinnati, Ohio 45227

August 20, 1998

Crow Corporation

1400 Boone Street

Baton Rouge, LA 70803

Dear President of Crow Corporation:

This letter is in response to your question with respect to the stock dividend distributed to your shareholders. Our conclusion is based upon the facts as outlined in your August 10 letter. Any change in facts may cause our conclusion to be inaccurate.

Your shareholders will have taxable income in the amount of the fair market value of the stock dividend. Distributions that are payable either in stock or property cause the stock dividends to be taxable even if all shareholders elect to take stock dividends.

Should you need more information or need to clarify our conclusion, do not hesitate to contact me.

Sincerely yours,

Marilyn C. Seago, CPA

Partner

August 18, 1998

TAX FILE MEMORANDUM

FROM: Marilyn C. Seago

SUBJECT: Crow Corporation

Today I conferred with the President of Crow Corporation with respect to his August 10 letter. The corporation asked whether their shareholders would have any taxable gain on the receipt of a stock dividend. Crow Corporation declared a dividend permitting its shareholders to elect to receive $20 per share or 4 additional shares of stock in the corporation for every 10 shares held at the time of the dividend declaration. All shareholders elected to receive stock.

At issue: Is the distribution of a stock dividend taxable if shareholders have an election to receive either stock or cash when all the shareholders elect to receive stock?

Conclusion: The shareholders will have taxable income in the amount of the fair market value of the stock dividend. Distributions that are payable either in stock or property cause the stock dividends to be taxable even if all the shareholders elect to take stock dividends. Section 305 governs the taxability of stock dividends. It provides that stock dividends are not taxable if they are pro rata distributions, or stock rights, on common stock. But the general rule that stock dividends are nontaxable has five exceptions. One is for distributions that are payable either in stock or property. Because the shareholders can elect to receive either stock or property, the stock dividend will be taxable.

pp. 10-18 to 10-20

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

5101 Madison Road

Cincinnati, Ohio 45227

February 20, 1998

Myrtle Adams

14009 Pine Street

Dover, DE 19901

Dear Ms. Adams:

This letter is in response to your question with respect to your sale of the Petrel Corporation stock you received as a nontaxable stock dividend. Our conclusion is based upon the facts as outlined in your February 10 letter. Any change in facts may cause our conclusion to be inaccurate.

You paid $180,000 for 15 shares of stock in Petrel Corporation five years ago. In 1997, a nontaxable stock dividend of 5 additional shares in Petrel Corporation was received. The 5 shares were sold in March of 1998 for $60,000. Your gain on the sale of the 5 shares is $15,000, computed as follows: [$60,000 (selling price) - $45,000 (tax basis in the 5 new shares)]. [The tax basis in the 5 shares is arrived at by dividing your $180,000 cost of the original 15 shares by 20 (to include the 5 new shares). Your basis then would be $9,000 per share ($180,000 20)]. The $15,000 gain on the sale is a long-term capital gain.

Should you need more information or need to clarify our conclusion, do not hesitate to contact me.

Sincerely yours,

Marilyn C. Seago, CPA

Partner

February 15, 1998

TAX FILE MEMORANDUM

FROM: Marilyn C. Seago

SUBJECT: Myrtle Adams

Today I conferred with Myrtle Adams as to her February 10 letter. Ms. Adams paid $180,000 for 15 shares of stock in Petrel Corporation five years ago. In November of 1997, she received a nontaxable stock dividend of 5 additional shares in Petrel Corporation. She sold the 5 shares in March of 1998 for $60,000. She inquires as to the gain she has on the sale and how it is taxed.

At issue: How is the gain on the sale of shares of stock received as nontaxable stock dividends determined and how is it taxed?

Conclusion: The shareholder's basis in the original 15 shares, $180,000, is reallocated to the 20 shares she held after the nontaxable stock dividend of 5 shares. Her basis per share after the stock dividend is $9,000 per share ($180,000 20). Her gain on the sale of the 5 shares is $15,000 [$60,000 (selling price) - $45,000 (basis in 5 shares)]. The gain is a long-term capital gain even though Ms. Adams sold the shares less than a year after she received them. The holding period of the original shares tacks on to the shares received as a nontaxable stock dividend.

pp. 10-18 to 10-20

31. Because the fair market value of the rights is 15% or more of the value of the old stock, Karen must allocate her basis in the stock between the stock and the stock rights. Karen allocates basis as follows:

Basis of stock: $3,000 X 8/10 = $2,400

Basis of rights: $3,000 X 2/10 = $ 600 = $6 per right

There is a capital gain on the sale of the rights of $510, computed as follows:

Basis of the new stock is $3,960, computed as follows:

Holding period of the 60 new shares begins on the date of purchase. Example 29

32. Partridge should recognize the loss as soon as possible and immediately thereafter make the cash distribution. For example, assume these two steps took place on January 2. Because current E & P would be a deficit, accumulated E & P would be brought up to date. At the time of the distribution, the combined E & P balance would be zero [$300,000 (beginning balance in E & P) - $300,000 (existing deficit in current E & P)], and the entire $180,000 would be a return of capital. Current deficits are allocated pro rata throughout the year unless the parties can prove otherwise. Here they can. Example 12

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

5101 Madison Road

Cincinnati, Ohio 45227

April 15, 1998

Diver Corporation

1010 Oak Street

Oldtown, MD 20742

Dear President of Diver Corporation:

This letter is in response to your question concerning the tax consequences on the planned distribution of $400,000 to your shareholders over the next four yours. Our conclusion is based upon the facts as outlined in your April 1 letter. Any change in facts may cause our conclusion to be inaccurate.

Diver Corporation has a deficit in accumulated E & P of $200,000 as of January 1, 1998. Starting this year, Diver Corporation expects to generate annual E & P of $100,000 for the next four years and would like to distribute this amount to its shareholders. The corporation's objective is to distribute the $400,000 over the next four years in a manner that would provide the least amount of dividend income to its shareholders.

Diver Corporation should not make a distribution in 1998. It should then distribute $200,000 on December 31, 1999. It should again make no distribution in 2000. Then it should distribute the remaining $200,000 on December 31, 2001. By distributing $200,000 every other year, only half of the distribution, or $200,000, is taxed to your shareholders as dividend income. This is because E & P for 1998 of $100,000 is netted with the deficit in E & P of $200,000. At the end of 1998, there will be a deficit in E & P of $100,000. When a distribution of $200,000 is made in 1999, only $100,000 of that amount is taxed as the amount of dividend income is limited to the current E & P of $100,000. This is again the case in 2000 and 2001. On the other hand, if $100,000 is distributed each year, your shareholders are taxed on the entire distribution because the corporation will generate that amount of current E & P. The deficit in E & P does not cause part of the distribution to be nontaxable.

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

Sincerely yours,

Marilyn C. Seago, CPA

Partner

April 13, 1998

TAX FILE MEMORANDUM

FROM: Marilyn C. Seago

SUBJECT: Diver Corporation

Today I talked to the president of Diver Corporation with respect to the April 1, 1998 letter. Diver Corporation has a deficit in its accumulated E & P of $200,000 as of January 1, 1998. Starting in 1998, Diver Corporation expects to generate annual E & P of $100,000 for the next four years and would like to distribute this amount to its shareholders. Diver Corporation wants to know how it should distribute the $100,000 over a four year period (for a total distribution of $400,000) to provide the least amount of dividend income to its shareholders (all individuals).

At issue: When a corporation has a deficit in accumulated E & P, is it possible to structure a corporate distribution so that a part of the distribution will not constitute dividend income even though current E & P is sufficient to cover the distribution?

Conclusion: Yes. If Diver Corporation distributes $100,000 annually to its shareholders, the entire distribution constitutes dividend income because current E & P is sufficient to cover the entire distribution. Thus, Diver's shareholders have total dividend income of $400,000 over the four year period. However, if Diver Corporation does not make a distribution in 1998 or in 2000, only half of the $400,000 total distribution, or $200,000, constitutes dividend income. This is the case because in 1998 the $100,000 current E & P is netted with the $200,000 deficit in E & P to reduce the deficit in accumulated E & P to $100,000 as of December 31, 1998. In 1999, when Diver Corporation distributes $200,000 to its shareholders, only $100,000 of the distribution is dividend income. This is so because there is a $100,000 deficit in accumulated E & P, but the distribution is taxed to the extent of current E & P. As current E & P is only $100,000, only this amount is dividend income. The remaining $100,000 is a return of capital to the shareholders. After the distribution in 1999, accumulated E & P will remain a deficit of $100,000 since the distribution cannot increase a deficit in E & P. In 2000, Diver Corporation would not make a distribution. Thus, at the end of 2000, accumulated E & P is zero (the $100,000 deficit would be netted with the $100,000 current E & P for 2000). In 2001, Diver Corporation would have current E & P of $100,000. It would then make a distribution of $200,000 to its shareholders, but only $100,000 of the distribution will represent dividend income. The remaining $100,000 will again be a return of capital.

Example 29

34. The payments probably constitute taxable income to Wes. The original agreement provided that Wes would purchase Edna's stock in Bunting Corporation. The agreement created an obligation for Wes and not for Bunting Corporation. The amended order did not represent the intention of the parties at the time the original judgment was entered but rather effected a change in the obligations imposed by the judgment. In Mary R. Hayes, 101 T.C. 593 (1993), a case with facts similar to this problem, the Court noted that the issue of whether the corporation had satisfied a shareholder's obligation, thus giving rise to a constructive dividend, was a question of fact. The Court in Hayes decided that, when the corporation later agreed to redeem the wife's stock, it was simply undertaking to perform a primary and unconditional obligation imposed on the husband by the original agreement and judgment. The Court ruled that, to prevent the redemption being a constructive dividend to the husband, the corporation would have had to obligate itself to redeem the wife's stock prior to the husband's agreement to do so. In John A. Arnes, 102 T.C. 522 (1994), the Tax Court ruled that a taxpayer-husband did not have an unconditional obligation to purchase his former wife's shares; only the corporation did. As a result, the Court found no constructive dividend to the husband.

35.

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

5101 Madison Road

Cincinnati, Ohio 45227

November 15, 1998

Mr. Jaime Martinez

509 Maple Street

Camden, NJ 08102

Dear Jaime:

This letter is in response to your question with respect to the IRS's disallowance of your election to use the option set forth in § 1341 in reporting your repayment, in 1997, of a bonus your employer, Black Corporation, paid you in 1995. Our conclusion is based upon the facts as outlined in your November 1 letter. Any change in facts may cause our conclusion to be inaccurate.

You are the president and majority shareholder of Black Corporation. In 1995, you were paid a salary of $50,000 and you received a year-end bonus of $200,000. Upon audit of Black Corporation in 1996, the IRS disallowed $150,000 of the bonus paid to you as being unreasonable. Upon a repayment agreement, you reimbursed Black Corporation for the $150,000 in 1997. You included the $150,000 on your 1995 tax return as income. You did not deduct the repayment of the $150,000 in 1997, but rather elected the option set out in § 1341(a)(5) of the Internal Revenue Code. Thus, you claimed a credit for the amount of tax you paid on the $150,000 in 1995. The IRS disallowed your election under § 1341. Because you were in a higher tax bracket in 1995 than you were in 1997, the IRS has calculated a tax deficiency against you for 1997.

You should challenge the tax deficiency. In our opinion, you may use the special relief provisions of § 1341, whereby you may either deduct the amount repaid ($150,000) in 1997 or you may claim a credit equal to the decrease in tax for 1995 had you not reported the $150,000 as income in that year.

Sincerely yours,

Marilyn C. Seago, CPA

Partner

b. TAX FILE MEMORANDUM

November 13, 1998

FROM: Marilyn C. Seago

SUBJECT: Jaime Martinez

Today I talked to Jaime Martinez with respect to his November 1, 1998, letter. Jaime is the president and major shareholder of Black Corporation. He wishes to know whether he may elect to use the option set out in § 1341(a)(5) with respect to his repayment of $150,000 of a $200,000 bonus paid him by Black Corporation in 1995. The IRS denied the corporation a deduction for $150,000 of the $200,000 because the IRS contended that amount was "unreasonable." Under a repayment agreement, Jaime reimbursed Black Corporation for the $150,000 in 1997. On his 1997 tax return, Jaime deducted none of the repayment, but elected instead the option set forth in § 1341(a)(5). Thus, he claimed a credit for the amount of tax he paid on the $150,000 when he reported it as income on his 1995 return. The IRS did not accept the credit approach but did permit him a deduction of $150,000 for 1997. Because Jaime was in a higher tax bracket in 1995, a deficiency resulted for 1997.

At issue: Can Jaime elect the option in § 1341(a)(5) with respect to the repayment of the $150,000 bonus in 1997 and claim a credit against his income tax in 1995 equal to the amount of income tax he paid on the $150,000 when he reported it as income in 1995?

Conclusion: The Sixth Court of Appeals has ruled that an employee may use the special relief provisions of § 1341, whereby the taxpayer may either deduct the amount repaid in the year of repayment or may claim a credit equal to the decrease in the year of receipt if the repaid item is not claimed as a tax deduction in the year of repayment. Van Cleave v. U.S., 84-2 USTC ¶ 9620, 52 AFTR2d 84-6071, 718 F.2d 193 (CA-6, 1983).

Jaime can elect the option in § 1341(a)(5).

Note: Shareholder-employees who repay excessive compensation to their corporations have been denied deductions for the repayments when there was no agreement to reimburse the corporation for that portion of the compensation that was disallowed as a deduction to the corporation. George L. Blanton, 46 T.C. 527 (1966). However, if the employment contract or a corporate bylaw requires a corporate employee to return any salary deemed to be excessive, the employee may take a deduction for the salary repayment since the employee then has an obligation to restore the payment. Vincent E. Oswald, 49 T.C. 645 (1968).

36.

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

5101 Madison Road

Cincinnati, Ohio 45227

November 20, 1998

Bill Gateson

601 Pittsfield Dr.

Champaign, IL 61821

Dear Bill:

This letter is written to provide you with our firm's opinion regarding the likely tax consequences of the planned distribution of $4,000,000 of cash and securities from Egret Corporation to Aqua Corporation, followed by sale of Egret for $5,500,000. You expect the distribution to be taxed as a dividend since it is equal to the E & P of Egret Corporation. In addition, you expect to recognize no gain on the sale of Egret, since Aqua's basis in the Egret stock equals the projected sales price. As you indicated in our phone conversation, the purpose of this plan is to (1) reduce the price of Egret stock, thereby facilitating a sale and (2) avoid tax on the sale of Egret.

After much research, our firm has identified two cases that are similar to your situation. In the first case, a distribution was made after an offer was received for the subsidiary stock. In that situation, the court held that the dividend was, in substance, part of the sales price received for the subsidiary. Dividend treatment was disallowed and the distribution was taxed as a capital gain to the parent corporation.

In the second case, which more closely resembles your situation, a distribution was made to the parent corporation in anticipation of a future sale of the subsidiary (no offer had yet been received). In this context, since no sale was in progress, the court allowed dividend treatment and the parent corporation had no taxable income or gain on the transaction.

Provided that you do not publicly announce your intent to sell Egret Corporation or enter into any negotiations regarding a sale until after you make the $4,000,000 distribution, it is our opinion that you will receive the tax treatment you desire. In particular, the distribution will be treated as a dividend subject to the 100% dividends received deduction and no gain will be recognized on subsequent sale of Egret.

If you have any additional questions regarding this matter, please do not hesitate to call me.

Sincerely yours,

Jon S. Davis, CPA

Partner

1. TAX FILE MEMORANDUM

November 20, 1998

From: Jon S. Davis

Subject: Proposed distribution, followed by sale of Egret Corporation

Facts: Aqua Corporation is the sole shareholder of Egret Corporation. Aqua's basis in Egret stock is $5.5 million. Egret has E & P of $4 million. The assets of Egret consist of software patents worth $5 million and cash and marketable securities of $4.5 million. For strategic business reasons, Aqua is planning on selling Egret Corporation sometime in the next two years. In anticipation of the sale, Aqua has considered two possibilities:

(1) Sell Egret for its current fair market value of $9.5 million. This would generate a gain on sale of $4 million.

(2) Distribute $4 million in cash and securities to Aqua as a dividend. The dividend would be tax free since Aqua is entitled to a 100% dividends received deduction. Then, sell Egret for $5.5 million, resulting in no taxable gain on sale.

After considering these two possibilities, Aqua executives have decided the latter is preferable, provided that the expected tax consequences are correct. They have contacted our office to confirm the expected tax treatment of the distribution and subsequent sale.

At issue: Is the distribution of $4 million in cash and securities properly treated as a dividend subject to the dividends received deduction, and is the subsequent sale of stock tax free?

Discussion: Waterman Steam Ship Corporation, 50 T.C. 650 (1968), rev'd by 70-2 USTC ¶9514, 26 AFTR2d 70-5185, 430 F.2d 1185 (CA-5, 1970) involves a similar situation. In Waterman, a corporation received an offer to purchase the stock of its wholly-owned subsidiary. After receiving the offer, the subsidiary paid a dividend equal to the fair market value of the subsidiary's stock less the parent corporation's adjusted basis in the stock. The parent corporation argued that the dividend resulted in no taxable income (due to the 100% dividends received deduction under § 243(a)(3)), and no gain was recognized on the sale since the stock was sold at its adjusted basis. The court recast the dividend as sales proceeds and treated it as long-term capital gain using substance over form as a basis for the decision.

Several features of the current case differ from the facts in Waterman. First, there is a good business reason for Egret to make a distribution. In particular, distributing assets currently will reduce the corporation's value, thereby lowering any future sales price; this facilitates a business-motivated future sale. Second, and most important, no offer has yet been made to purchase Egret. Since no offer is outstanding, it would be difficult to argue that the dividend is properly treated as part of the sales price of Egret.

Another case, more similar to the Aqua and Egret situation, is Litton Industries, Inc., 89 T.C. 1086 (1987). In Litton, a large dividend was paid before the corporation attempted to sell its subsidiary. In particular, Litton did not announce its intention to sell the subsidiary until two weeks following the distribution. The Tax Court distinguished Litton from Waterman on these grounds and allowed dividend treatment, together with the 100% dividends received deduction.

Conclusion: Because the present situation is more similar to the facts in Litton Industries, we believe that Aqua is correct in its assessment of the tax consequences of the proposed transaction. The dividend should be properly offset by the 100% dividends received deduction and no gain should be recognized on the subsequent sale of the Egret stock.

37. Of main concern is the possibility of a constructive dividend from Crimson Corporation to Aaron. This is possible in a brother-sister corporate setting due to the common ownership of the entities. In this case, Crimson Corporation is deemed to have made a distribution to Aaron who, in turn, is treated as making a contribution to the capital of Azure Corporation. The $300,000 alleged loan from Crimson to Azure would be the constructive dividend.

An intercompany transfer of funds does not automatically result in a constructive dividend to the common shareholder. To ascertain whether a constructive dividend took place, two questions must be posed. First, does the shareholder control the funds involved? Second, does the shareholder benefit from the transfer? [Sammons v. Comm., 73 USTC ¶ 9138, 31 AFTR2d 73-497, 472 F.2d 449 (CA-5, 1972)].

In answering the first question, the shareholder is considered to be in control of the funds involved if the transfer is in the nature of an equity investme nt. Control will not be found if, conversely, the transfer created a bona fide debt. Although the issue of debt versus equity is not always easily resolved, the facts in the instant case lean toward an equity interpretation. At the time of the loan from Crimson Corporation, Azure was facing action by its existing creditors who, at long last, were no longer willing to refinance the debt. It is apparent, therefore, that Azure was unable to obtain funds from third-party (i.e., unrelated) sources. Also apparent is the fact that Azure was thinly capitalized from its creation. A $10,000 cash investment is not adequate capitalization when the funds had to be immediately used as the down payment for the purchase of the fabric business. In summary, Crimson's $300,000 outlay was not a bona fide loan but in the nature of risk capital.

Does the common shareholder benefit from the transfer from Crimson to Azure? In addition to providing Azure Corporation with a temporary reprieve (which preserves Aaron's investment), the advance allowed debts to be paid. Since Aaron had guaranteed these debts, he is spared the need to make good on his guarantee when, and if, Azure defaults. Consequently, Aaron clearly benefited from Crimson's transfer to Azure. [Wortham Machinery Co. v. U.S., 75-2 USTC ¶ 9665, 36 AFTR2d 75-5607, 521 F.2d 160 (CA-10, 1975)].

The benefit that the common shareholder received (i.e., Aaron) might be negated if the transferor (i.e., Crimson Corporation) had a justifiable business purpose for making the transfer. Arguably, the business purpose might be the attractiveness of the loan terms (i.e., interest rate of 2% above prime and payable on demand). However, an investment is not attractive if there is little likelihood of its terms being fulfilled by the obligor. Such is the case with Azure Corporation since it has a history of being unable to meet its obligations.

In all likelihood, Aaron has received a constructive dividend from Crimson Corporation. Aaron will be treated as making a contribution to the capital of Azure Corporation. As no bona fide creditor-debtor relationship existed, Crimson Corporation cannot claim a bad debt deduction. [Robert E. Davis, 69 TCM 3004, T.C.Memo. 1995-283.]

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