Corporate Tax | Just Tax

Related Corporation Acquisitions (§ 304)

This checklist applies § 304 to recharacterize sales of stock among commonly controlled corporations as distributions rather than exchanges, identifies acquiring and issuing corporations, and computes the § 301 dividend, basis, and E&P consequences. Use it whenever one controlled corporation acquires stock of another controlled corporation for property.

Step 1. Scope and Purpose of § 304

Section 304 is applicable where a shareholder sells stock of one corporation to a related corporation as defined in section 304. Sales to which section 304 is applicable shall be treated as redemptions subject to sections 302 and 303. (Treas. Reg. § 1.304-1(a))

• Congress enacted § 304 to close a loophole exposed by Wanamaker Trust. In Wanamaker Trust v. Commissioner, 11 T.C. 365 (1948), aff'd per curiam, 178 F.2d 10 (3d Cir. 1949), the Tax Court held that a wholly owned subsidiary's purchase of its parent corporation's stock from a parent shareholder did not constitute a distribution substantially equivalent to a taxable dividend under former § 115(g). The Senate Report for the Revenue Act of 1950 explicitly cited Wanamaker Trust as the reason for enacting the predecessor to § 304(a)(2).
  • Wanamaker Trust involved a shareholder who owned virtually all parent stock and whose wholly owned subsidiary purchased that parent stock from the shareholder.
  • The court reasoned that because the subsidiary was the purchaser and the parent made no direct distribution, no constructive dividend resulted to the selling shareholder.
  • Congress rejected this result by treating related-corporation acquisitions as deemed redemptions of the acquiring corporation's stock (or the issuing corporation's stock in subsidiary acquisitions).
• § 304 creates a two-tier analytical framework for every covered transaction. First, the stock sale is recharacterized as a redemption under § 304(a). Second, the redemption is tested under § 302(b) to determine whether it qualifies for sale or exchange treatment or defaults to § 301 dividend treatment.
  • If a § 302(b) test is satisfied, the transferor recognizes capital gain or loss under § 302(a) and § 1001.
  • If no § 302(b) test is satisfied, the distribution is treated as a dividend to the extent of earnings and profits under § 304(b)(2), with any excess treated as basis recovery and then capital gain under § 301(c).
• The statute applies to two distinct transaction structures. § 304(a)(1) governs brother-sister acquisitions where the same person or persons control both the issuing corporation and the acquiring corporation. § 304(a)(2) governs parent-subsidiary acquisitions where the issuing corporation controls the acquiring corporation.
  • Treas. Reg. § 1.304-2 addresses brother-sister acquisitions under § 304(a)(1).
  • Treas. Reg. § 1.304-3 addresses parent-subsidiary acquisitions under § 304(a)(2).
  • Treas. Reg. § 1.304-2(a)(2) provides that § 304(a)(2) takes priority over § 304(a)(1) when both paragraphs could apply.

Step 2. Transaction Type Identification

For purposes of sections 302 and 303, if (A) one or more persons are in control of each of two corporations, and (B) in return for property, one of the corporations acquires stock in the other corporation from the person (or persons) so in control, then (unless paragraph (2) applies) such property shall be treated as a distribution in redemption of the stock of the corporation acquiring such stock. (§ 304(a)(1))

For purposes of sections 302 and 303, if (A) in return for property, one corporation acquires from a shareholder of another corporation stock in such other corporation, and (B) the issuing corporation controls the acquiring corporation, then such property shall be treated as a distribution in redemption of the stock of the issuing corporation. (§ 304(a)(2))

• § 304(a)(1) applies to brother-sister acquisitions. The same person or persons must be in control of both the issuing corporation and the acquiring corporation. The property received by the transferor is treated as a distribution in redemption of the acquiring corporation's stock.
  • Treas. Reg. § 1.304-2(a)(3) provides that if § 301 applies to the deemed redemption, the transferor and acquiring corporation are treated as if the transferor had transferred the issuing corporation stock to the acquiring corporation in exchange for acquiring corporation stock in a § 351(a) transaction, and then the acquiring corporation had redeemed the stock it was treated as issuing.
  • The 1997 amendment (Pub. L. 105-34, § 1013(a)) changed the last sentence of § 304(a)(1) from a contribution-to-capital model to the current § 351(a) exchange plus redemption model.
• § 304(a)(2) applies to parent-subsidiary acquisitions. The acquiring corporation must be controlled by the issuing corporation, and the stock must be acquired from a shareholder of the issuing corporation. The property received is treated as a distribution in redemption of the issuing (parent) corporation's stock.
  • Treas. Reg. § 1.304-3(a) states that if a subsidiary acquires stock of its parent corporation from a shareholder of the parent, the acquisition shall be treated as though the parent had redeemed its own stock.
  • A corporation is a parent corporation for this purpose if it meets the 50 percent ownership requirements of § 304(c). (Treas. Reg. § 1.304-3(a))
• § 304(a)(2) takes priority if both paragraphs could apply. Treas. Reg. § 1.304-2(a)(2) expressly states that paragraph (2) of § 304(a) applies and paragraph (1) does not apply if the requirements of both paragraphs are satisfied.
  • Practitioners must first test whether § 304(a)(2) applies before testing § 304(a)(1).
  • If § 304(a)(2) applies, the redemption is treated as a redemption of the issuing (parent) corporation's stock, not the acquiring (subsidiary) corporation's stock.

Step 3. The § 304 Control Test

For purposes of this section, control means the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote, or at least 50 percent of the total value of shares of all classes of stock. If a person (or persons) is in control (within the meaning of the preceding sentence) of a corporation which in turn owns at least 50 percent of the total combined voting power of all stock entitled to vote of another corporation, or owns at least 50 percent of the total value of the shares of all classes of stock of another corporation, then such person (or persons) shall be treated as in control of such other corporation. (§ 304(c)(1))

• Control under § 304 is a 50-percent vote-or-value test. This is materially lower than the 80-percent vote-and-value test in § 368(c).
  • § 368(c) explicitly excludes § 304. It states that its definition applies "For purposes of part I (other than section 304), part II, this part, and part V."
  • § 304(c)(1) requires only 50 percent of voting power OR 50 percent of total value. The test is disjunctive.
  • § 368(c) requires at least 80 percent of voting power AND at least 80 percent of all other classes. The test is conjunctive.
• Constructive ownership under § 318 applies to the control determination. § 304(c)(3)(A) provides that § 318(a) shall apply for purposes of determining control under § 304.
  • See Step 4 for the critical modifications that § 304(c)(3)(B) makes to § 318.
  • Continental Bankers Life Insurance Co. v. Commissioner, 93 T.C. 52 (1989), held that the constructive ownership rules of § 318(a) with the § 304(c)(3) modifications must be applied to determine whether control exists.

Step 3A. The 50% Vote-or-Value Standard

• The control test requires at least 50 percent of total combined voting power or at least 50 percent of total value. A person satisfies the test by meeting either threshold. The two thresholds are not cumulative.
  • All classes of stock entitled to vote are aggregated for the voting power test.
  • All classes of shares are aggregated for the value test.
  • Non-voting preferred stock counts toward the value test even though it does not count toward the voting power test.
• The test is applied after giving effect to constructive ownership. A person who directly owns less than 50 percent may still be treated as in control if § 318 attribution pushes the total over the threshold.
  • See Fehrs Finance Co. v. Commissioner, 58 T.C. 174 (1972), aff'd, 487 F.2d 184 (8th Cir. 1973), cert. denied, 416 U.S. 938 (1974), where the Eighth Circuit affirmed that the Fehrs were in constructive control of Finance Company through § 318 family attribution even though their daughters were the sole shareholders.
  • Family attribution under § 318(a)(1) can cause parents to constructively own stock held by children and grandchildren, creating control for § 304 purposes.

Step 3B. Parenthetical Ownership Under § 304(c)(1)

• § 304(c)(1) contains a parenthetical ownership rule for tiered structures. If a person is in control of a corporation, and that corporation in turn owns at least 50 percent of the vote or value of another corporation, the person is treated as in control of the second corporation.
  • This is a 50-percent-of-50-percent rule. Corporation A owns 50 percent of Corporation B. Shareholder X owns 50 percent of A. X is treated as controlling B.
  • The parenthetical rule applies the same 50-percent vote-or-value standard at each tier.
  • There is no direct equivalent to this parenthetical rule in § 368(c), which does not apply to § 304 in any event.
• Practitioners must map direct and indirect ownership through all tiers. A shareholder at the top of a multi-tier structure may be treated as controlling every corporation in the chain through repeated application of the parenthetical rule.
  • Treas. Reg. § 1.304-5(a) restates the § 304(c)(1) control requirement and notes that § 304(c)(3) makes § 318(a) applicable with the § 304(c)(3)(B) modifications.
  • The parenthetical rule does not require that the intermediate corporation itself be "controlled" by the top shareholder under the § 304(c)(1) test. It requires only that the intermediate corporation own at least 50 percent of the lower-tier corporation.

Step 3C. Stock Acquired in the Transaction Under § 304(c)(2)

• § 304(c)(2)(A) requires counting stock received in the transaction toward the control test. Where one or more persons in control of the issuing corporation transfer stock of that corporation in exchange for stock of the acquiring corporation, the stock of the acquiring corporation received shall be taken into account in determining whether such persons are in control of the acquiring corporation.
  • The acquiring corporation stock received by the transferor is counted as if it were already owned when testing post-transaction control.
  • This prevents transferors from avoiding § 304 by receiving so much acquiring corporation stock that they would appear to lack control after the transaction.
• § 304(c)(2)(B) defines the control group for multi-transferor transactions. Where two or more persons in control of the issuing corporation transfer its stock to the acquiring corporation and the transferors are in control of the acquiring corporation after the transfer, the control group for each corporation includes each of the persons who transferred stock.
  • Treas. Reg. § 1.304-5(b)(2) explains that § 304(c)(2)(B) extends the control group to include persons who do not acquire property but solely stock, provided the transferors are in control of the acquiring corporation after the transfer.
  • Treas. Reg. § 1.304-5(b)(3) provides an example. A owns 20 percent of T and transfers it to P solely in exchange for all P stock. P simultaneously acquires the remaining 80 percent of T from B (unrelated) for cash. Although A and B together controlled T before the transaction, § 304(a)(1) does not apply to B because B did not retain or acquire any proprietary interest in P. § 304(a)(1) also does not apply to A because A did not control both T and P after the transaction.

Step 4. Constructive Ownership Under § 318 as Modified by § 304(c)(3)

Section 318(a) (relating to constructive ownership of stock) shall apply for purposes of determining control under this section. (§ 304(c)(3)(A))

For purposes of subparagraph (A) (i) paragraph (2)(C) of section 318(a) shall be applied by substituting "5 percent" for "50 percent", and (ii) paragraph (3)(C) of section 318(a) shall be applied (I) by substituting "5 percent" for "50 percent", and (II) in any case where such paragraph would not apply but for subclause (I), by considering a corporation as owning the stock (other than stock in such corporation) owned by or for any shareholder of such corporation in that proportion which the value of the stock which such shareholder owned in such corporation bears to the value of all stock in such corporation. (§ 304(c)(3)(B))

• § 318(a)(1) family attribution applies without modification. An individual is considered as owning stock owned by or for his spouse, children, grandchildren, and parents.
  • A legally adopted child is treated as a child by blood. (§ 318(a)(1)(B))
  • Family attribution can create § 304 control where a parent appears to have no direct interest in the acquiring corporation. (Fehrs Finance Co., 58 T.C. 174 (1972), aff'd, 487 F.2d 184 (8th Cir. 1973))
• § 318(a)(2) and (3) attribution from and to entities applies with critical modifications. § 304(c)(3)(B) changes the corporate attribution thresholds.
  • § 318(a)(2)(C) normally attributes stock owned by a corporation to a shareholder only if the shareholder owns 50 percent or more of the corporation's stock. For § 304 purposes, the threshold is reduced to 5 percent.
  • § 318(a)(3)(C) normally attributes stock owned by a shareholder to the corporation only if the shareholder owns 50 percent or more of the corporation's stock. For § 304 purposes, the threshold is reduced to 5 percent.
• The § 304(c)(3)(B)(ii)(II) proportionality rule limits the scope of modified corporate attribution. If § 318(a)(3)(C) would not have applied but for the 5-percent substitution, the corporation is considered as owning only that proportion of a shareholder's stock equal to the value of stock the shareholder owns in the corporation divided by the value of all stock in the corporation.
  • Example. Shareholder X owns 10 percent of Corp A. Under § 318(a)(3)(C) as modified, Corp A constructively owns X's other stock. But because the 5-percent substitution is what triggered the attribution, the proportionality rule limits Corp A's constructive ownership to 10 percent of X's other stock.
  • Treas. Reg. § 1.304-5(a) states that if the shareholder owns less than 50 percent, attribution is limited proportionally.
• § 318(a)(4) options attribution applies without modification. If any person has an option to acquire stock, such stock is considered as owned by that person.
  • An option to acquire an option is treated as an option to acquire the underlying stock.
  • This can create constructive ownership that triggers § 304 control even where no stock is actually outstanding.
• CAUTION. The 5-percent substitution makes § 304 constructive ownership dramatically more expansive than in other contexts. A minority shareholder who owns just 5 percent of a corporation's stock can cause the corporation to be attributed all of that shareholder's other stock (subject to proportionality).
  • This is one of the most dangerous traps in § 304 practice for closely held businesses.
  • In Fehrs Finance Co., the Eighth Circuit affirmed that the Fehrs constructively controlled their daughters' corporation through § 318 family attribution, even though the daughters were the sole shareholders.
• The Squier "bad blood" exception is of limited reliability. The Second Circuit in Estate of Squier v. Commissioner, 35 T.C. 950 (1961), held that family discord could negate the practical effect of § 318 attribution for § 302(b)(1) purposes. However, the Tax Court in Niedermeyer v. Commissioner, 62 T.C. 280 (1974), aff'd, 535 F.2d 500 (9th Cir. 1976), rejected the bad blood argument and suggested that after United States v. Davis, 397 U.S. 301 (1970), § 318 attribution may apply mechanically without regard to family estrangement.
  • Niedermeyer held that disagreements between the taxpayers' sons did not negate the taxpayers' constructive control of both corporations.
  • Most courts now treat § 318 attribution as mechanically applicable across all of § 302, limiting Squier to its specific facts.

Step 5. Application of § 302(b) Redemption Tests in § 304 Transactions

In the case of any acquisition of stock to which subsection (a) of this section applies, determinations as to whether the acquisition is, by reason of section 302(b), to be treated as a distribution in part or full payment in exchange for the stock shall be made by reference to the stock of the issuing corporation. In applying section 318(a) (relating to constructive ownership of stock) with respect to section 302(b) for purposes of this paragraph, sections 318(a)(2)(C) and 318(a)(3)(C) shall be applied without regard to the 50 percent limitation contained therein. (§ 304(b)(1))

• The § 302(b) redemption tests apply to § 304 transactions in the same manner as to actual redemptions. § 304(a)(1) and § 304(a)(2) both state that their rules apply "For purposes of sections 302 and 303."
  • If a § 302(b) test is met, the transferor receives sale or exchange treatment under § 302(a).
  • If no § 302(b) test is met, the distribution is treated as a distribution to which § 301 applies under § 302(d).
• The § 302(b) tests are applied by reference to the issuing corporation's stock. This is the critical reference rule of § 304(b)(1). The shareholder's ownership of issuing corporation stock is measured before and after the deemed redemption.
  • For purposes of applying § 318(a) to the § 302(b) tests, the 50-percent limitation in § 318(a)(2)(C) and § 318(a)(3)(C) is disregarded.
  • This means corporate attribution applies at the 50-percent level (not the 5-percent level) for § 302(b) testing, even though the 5-percent level applies for the § 304 control determination.
  • Treas. Reg. § 1.304-2(a)(2) confirms that in applying § 302(b), reference shall be had to the shareholder's ownership of stock in the issuing corporation, except that § 318(a) shall be applied without regard to the 50-percent limitation.

Step 5A. The Issuing Corporation Reference Rule Under § 304(b)(1)

• The issuing corporation is the reference point for all § 302(b) determinations. When testing whether a redemption is substantially disproportionate, completely terminates interest, or is not essentially equivalent to a dividend, the practitioner measures the shareholder's interest in the issuing corporation.
  • For § 304(a)(1) brother-sister transactions, this means the issuing corporation's stock is the measuring stick, not the acquiring corporation's stock.
  • For § 304(a)(2) parent-subsidiary transactions, this means the parent (issuing) corporation's stock is the measuring stick.
• The § 318 50-percent limitation is removed only for § 302(b) testing. § 304(b)(1) expressly states that § 318(a)(2)(C) and § 318(a)(3)(C) are applied without regard to the 50-percent limitation for § 302(b) purposes.
  • This is distinct from § 304(c)(3)(B), which substitutes 5 percent for 50 percent for the control test.
  • The interplay between these two different § 318 modifications is a frequent source of practitioner error.

Step 5B. § 302(b)(1) Not Essentially Equivalent to a Dividend

• The Supreme Court established the "meaningful reduction" test in United States v. Davis, 397 U.S. 301 (1970). The Court held that § 318(a) attribution applies to all of § 302, including § 302(b)(1). A redemption is always essentially equivalent to a dividend if it does not result in a meaningful reduction of the shareholder's proportionate interest in the corporation.
  • The Court rejected the business-purpose test that some circuits had applied. Business purpose is irrelevant under the Davis test.
  • The shareholder's proportionate interest is measured by considering voting control, ownership of all stock classes, and all other factors demonstrating a genuine reduction.
• In § 304 transactions, meaningful reduction is measured against the issuing corporation. Because of § 304(b)(1), the practitioner asks whether the shareholder's interest in the issuing corporation has been meaningfully reduced by the deemed redemption.
  • Fehrs Finance Co. v. Commissioner, 58 T.C. 174 (1972), aff'd, 487 F.2d 184 (8th Cir. 1973), held that a reduction from 98.2 percent to 88.69 percent (through attribution) was not a meaningful reduction under Davis.
  • Haserot v. Commissioner, 41 T.C. 562 (1964), remanded by Commissioner v. Haserot, 355 F.2d 200 (6th Cir. 1965), established that courts must separately determine dividend equivalency under § 302(b)(1) even when § 304 applies. The Sixth Circuit remanded because the Tax Court had not made this determination.
• CAUTION. Closely held family corporations will almost always fail the § 302(b)(1) test in § 304 transactions. Because § 318 family attribution is fully operative, a parent who sells stock to a child-controlled corporation will constructively retain the child's ownership.
  • Even actual ownership reductions below 50 percent may fail if constructive ownership through family members remains high.
  • The limited "bad blood" exception from Estate of Squier v. Commissioner, 35 T.C. 950 (1961), is unreliable after Davis and Niedermeyer.

Step 5C. § 302(b)(2) Substantially Disproportionate

• A redemption qualifies under § 302(b)(2) only if three mechanical tests are satisfied. First, the shareholder's ownership percentage of voting stock after the redemption must be less than 80 percent of the ownership percentage before the redemption. Second, the shareholder must own less than 50 percent of the total combined voting power after the redemption. Third, the same 80-percent test applies to common stock ownership if the corporation has common stock.
  • Because § 304(b)(1) applies the test by reference to the issuing corporation, the before-and-after ownership is measured in the issuing corporation.
  • § 318 attribution applies without the 50-percent limitation for § 302(b)(2) testing in § 304 transactions.
• The § 302(b)(2)(D) series-of-redemptions rule applies across both corporations. Treas. Reg. § 1.304-2(a)(2) states that a series of redemptions under § 302(b)(2)(D) includes acquisitions by either corporation of stock of the other and stock redemptions by both corporations.
  • A prior redemption by either the issuing or acquiring corporation within the relevant period can cause the current transaction to fail the substantially disproportionate test.
  • Practitioners must examine all stock acquisitions and redemptions by both corporations in the series.

Step 5D. § 302(b)(3) Complete Termination

• A redemption qualifies under § 302(b)(3) if all of the shareholder's stock in the corporation is redeemed. In § 304 transactions, this means all of the shareholder's interest in the issuing corporation must be terminated.
  • The redemption must be in complete redemption of all the stock of the issuing corporation owned by the shareholder.
  • § 318(a) constructive ownership applies, so a shareholder who constructively owns stock through family members will not qualify unless the constructive ownership is also eliminated.
• The Zenz doctrine permits integrating related transactions to test for complete termination. Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954), held that when a redemption completely extinguishes a shareholder's interest as part of an integrated plan, the distribution is not essentially equivalent to a taxable dividend. The shareholder must retain no beneficial interest in the corporation.
  • Niedermeyer v. Commissioner, 62 T.C. 280 (1974), aff'd, 535 F.2d 500 (9th Cir. 1976), articulated the seminal "firm and fixed plan" test. The court stated that "the redemption must occur as part of a plan which is firm and fixed and in which the steps are clearly integrated."
  • Bleily & Collishaw, Inc. v. Commissioner, 72 T.C. 751 (1979), aff'd, 647 F.2d 169 (9th Cir. 1981), held that a plan need not be in writing, absolutely binding, or communicated to others to be fixed and firm, although these factors all tend to indicate that such is the case.
• Merrill Lynch demonstrates that the IRS can use integration to deny dividend treatment. Merrill Lynch & Co., Inc. v. Commissioner, 120 T.C. 12 (2003), aff'd, 386 F.3d 464 (2d Cir. 2004), involved cross-chain sales of subsidiary stock deemed § 304 redemptions followed by sales to unrelated third parties. The Tax Court and Second Circuit held the steps were integrated under a firm and fixed plan, making the redemption a complete termination under § 302(b)(3) with sale or exchange treatment.
  • The Second Circuit distinguished Paparo v. Commissioner, 71 T.C. 692 (1979), and held that a binding contract is not required for the firm-and-fixed-plan test.
  • The case demonstrates that the IRS can argue for integration to deny dividend treatment and basis increases, even when taxpayers structure transactions to achieve the opposite result.
• Benjamin v. Commissioner illustrates the burden of proof. Benjamin v. Commissioner, 66 T.C. 1084 (1976), aff'd, 592 F.2d 1259 (5th Cir. 1979), held that a redemption alleged to be part of a plan to terminate ownership was not properly integrated because there was minimal evidence supporting the existence of such a plan. The Fifth Circuit affirmed, reinforcing that objective verifiable evidence is required.
  • Monson v. Commissioner, 79 T.C. 827 (1982), held that board minutes documenting the redemption and subsequent sale as integrated steps can provide objective evidence of a firm and fixed plan.
  • Roebling v. Commissioner, 77 T.C. 30 (1981), held that gradual redemptions over multiple years can be integrated as a firm and fixed plan even without a binding agreement.

Step 5E. § 302(b)(4) Partial Liquidation

• § 302(b)(4) applies only to redemptions of stock held by a shareholder who is not a corporation. The redemption must be in partial liquidation of the distributing corporation.
  • § 302(b)(4) requires a genuine contraction of the corporation's business, not merely a distribution of accumulated earnings.
  • Because § 304(b)(1) applies § 302(b) by reference to the issuing corporation, the partial liquidation test is applied to the issuing corporation.
• The partial liquidation standard is stricter than it may initially appear. Courts examine whether the corporation has actually contracted its business operations.
  • A distribution funded by borrowing or by selling a passive asset does not typically qualify.
  • The test is rarely satisfied in closely held § 304 transactions.

Step 5F. § 303 Redemptions to Pay Death Taxes

• § 303 provides exchange treatment for redemptions to pay death taxes. § 304(a)(1) and § 304(a)(2) both expressly state that their rules apply "For purposes of sections 302 and 303."
  • § 1.304-1(a) confirms that sales to which § 304 applies shall be treated as redemptions subject to sections 302 and 303.
  • § 1.303-3(b) cross-references § 304 for redemptions through related corporations.
• § 303 applies only to stock included in a decedent's gross estate. The aggregate amount is limited to the sum of federal and state death taxes, funeral expenses, administration expenses, and claims against the estate. (§ 303(c))
  • § 303(b)(2) provides a special rule if the decedent owned directly or indirectly at least 50 percent of the voting power.
  • § 303(d) waives § 318(a) family attribution for § 303 purposes.
• TRAP. § 303 is available in § 304 transactions only if all § 303 conditions are met. The stock redeemed must have been included in the decedent's gross estate, the basis must be determined under § 1014, and the stock must not be publicly traded (for § 303(b)(1)).
  • § 1248(g)(1) excludes § 303 distributions from § 1248 treatment.
  • The practitioner must verify that the § 304 transaction structure does not inadvertently violate a § 303 requirement.

Step 5G. § 302(c)(2)(A) Attribution Waiver

• A shareholder may waive family attribution under § 302(c)(2)(A) in a § 304 transaction. The waiver requires (i) that the shareholder have no interest in the corporation after the redemption (including as officer, director, or employee), (ii) that the shareholder not acquire any interest within 10 years, and (iii) that the shareholder file an agreement with the Secretary.
  • § 304(b)(1) applies § 318(a) without the 50-percent limitation for § 302(b) testing, but § 302(c)(2)(A) itself remains available.
  • Fehrs v. United States, No. 85-75 (Fed. Cir. 1986), held that a belated filing of the § 302(c)(2)(A) agreement did not qualify because the filing must be made at the time and in the manner prescribed by the Secretary.
• Rev. Rul. 77-293 illustrates a successful waiver in a redemption context. Rev. Rul. 77-293, 1977-2 C.B. 91, involved a father who gave 60 shares to his son and then had his remaining 40 shares redeemed. The IRS ruled that the redemption qualified as a complete termination and that the gift was not done with a principal purpose of avoiding federal income tax under § 302(c)(2)(B).
  • The fact pattern involved a father who owned all 100 shares of X corporation and gave 60 shares to his son as a gift not for services.
  • The conclusion was that the redemption qualified as a complete termination and the father was permitted to waive family attribution.
  • The rationale was that the gift was intended solely to enable the father to retire while leaving the business to his son, who was active in the business. The principal purpose was not tax avoidance.
• CAUTION. The § 302(c)(2)(A) waiver applies to the issuing corporation's stock. Because § 304(b)(1) references the issuing corporation, the waiver must be analyzed with respect to the issuing corporation. The shareholder must have no interest in the issuing corporation after the transaction.
  • The filing must be made with the timely filed return for the year of the redemption.
  • Post-litigation or belated filings do not constitute substantial compliance. (Fehrs Finance Co., 58 T.C. 174 (1972), aff'd, 487 F.2d 184 (8th Cir. 1973))

Step 6. E&P Sourcing and Dividend Treatment Under § 304(b)(2)

In the case of any acquisition of stock to which subsection (a) applies, the determination of the amount which is a dividend (and the source thereof) shall be made as if the property were distributed (A) by the acquiring corporation to the extent of its earnings and profits, and (B) then by the issuing corporation to the extent of its earnings and profits. (§ 304(b)(2))

• § 304(b)(2) creates a dual earnings and profits waterfall. The deemed distribution is treated first as coming from the acquiring corporation's earnings and profits, and then (to the extent the acquiring corporation lacks sufficient earnings and profits) from the issuing corporation's earnings and profits.
  • The 1982 amendment (Pub. L. 97-248, § 226(a)(3)) changed the rule from looking solely at the acquiring corporation's earnings and profits to the current cascading approach.
  • This is the opposite of what some practitioners intuitively expect. The acquiring corporation's earnings and profits are tapped first, not the issuing corporation's.
• The dividend amount is determined under § 301(c) and § 316. The portion constituting a dividend is included in gross income. The portion not constituting a dividend is applied against and reduces the adjusted basis of the stock. Any excess over basis is treated as gain from the sale or exchange of property. (§ 301(c)(1), (2), (3))
  • A "dividend" for this purpose means any distribution out of earnings and profits accumulated after February 28, 1913, or out of earnings and profits of the taxable year. (§ 316)
  • The amount distributed is measured under § 301(b)(1) as the amount of money received plus the fair market value of other property received, reduced by any liability assumed. (§ 301(b)(2))
• The § 304(b)(2) sourcing rule interacts with § 312. § 312(a) provides that distributions are treated as paid out of the current year's earnings and profits first, then from the most recently accumulated earnings and profits. § 312(n)(7) limits earnings and profits chargeable on a redemption to the ratable share attributable to the redeemed stock.
  • For § 304 transactions, the deemed distribution from the acquiring corporation reduces its earnings and profits.
  • To the extent the distribution exceeds the acquiring corporation's earnings and profits, the issuing corporation's earnings and profits are reduced.
• EXAMPLE. Acquiring Corporation A has $60 of earnings and profits. Issuing Corporation I has $100 of earnings and profits. Shareholder S sells I stock to A for $150. Under § 304(b)(2), the first $60 is treated as a dividend out of A's earnings and profits. The next $90 is treated as a dividend out of I's earnings and profits. The full $150 is dividend income. If the distribution exceeded both corporations' earnings and profits, the excess would reduce basis and then produce capital gain.
  • The acquiring corporation takes the same earnings and profits charge it would have taken on an actual distribution.
  • The issuing corporation's earnings and profits are charged only after the acquiring corporation's are exhausted.

Step 7. Basis Rules in § 304 Transactions

• Basis treatment depends on whether the deemed redemption qualifies for sale or exchange treatment or is treated as a § 301 distribution. The rules differ between § 304(a)(1) brother-sister transactions and § 304(a)(2) parent-subsidiary transactions.
  • For brother-sister transactions, Treas. Reg. § 1.304-2(a)(3) and (4) govern.
  • For parent-subsidiary transactions, Treas. Reg. § 1.304-3 governs.
• The § 304 deemed transaction can produce unusual basis results when the transferor has no direct stock ownership in the acquiring corporation. Rev. Rul. 70-496 and Rev. Rul. 71-563 address the basis disappearance and snap-back problems.
  • Rev. Rul. 70-496, 1970-2 C.B. 74, demonstrates basis disappearance when a transferor constructively controls but does not directly own stock in the acquiring corporation.
  • Rev. Rul. 71-563, 1971-2 C.B. 175, demonstrates basis snap-back to the transferor's remaining stock in the issuing corporation when no direct ownership in the acquiring corporation exists.

Step 7A. § 304(a)(1) Brother-Sister Basis Rules

• If § 301 applies to the deemed redemption, the transferor and acquiring corporation are treated as if a § 351(a) exchange occurred. Treas. Reg. § 1.304-2(a)(3) provides that the transferor and acquiring corporation are treated as if the transferor had transferred the issuing corporation stock to the acquiring corporation in exchange for acquiring corporation stock in a § 351(a) transaction, and then the acquiring corporation had redeemed the stock it was treated as issuing.
  • Under this deemed § 351 exchange, the transferor's basis in the acquiring corporation stock deemed issued equals the transferor's basis in the issuing corporation stock surrendered. (§ 358)
  • The acquiring corporation's basis in the issuing corporation stock equals the transferor's basis in the stock surrendered. (§ 362(a))
• If § 301 does not apply, the property received is treated as received in a distribution in full payment in exchange for stock. Treas. Reg. § 1.304-2(a)(4) states that the basis and holding period of the acquiring corporation stock treated as redeemed shall be the same as the basis and holding period of the issuing corporation stock actually surrendered. The acquiring corporation takes a cost basis in the stock of the issuing corporation.
  • This means if the transaction qualifies for § 302(a) treatment, the transferor's basis in the redeemed stock carries over from the surrendered stock.
  • The acquiring corporation's basis in the purchased stock is its cost (the amount paid to the transferor).

Step 7B. § 304(a)(2) Parent-Subsidiary Basis Rules

• If the distribution is treated as a § 301 distribution, the transferor's basis in the remaining parent stock is adjusted. Treas. Reg. § 1.304-3(a) states that the transferor's basis for his remaining stock in the parent corporation will be determined by including the amount of the basis of the stock of the parent corporation sold to the subsidiary.
  • The basis of the redeemed parent stock attaches to the transferor's remaining parent stock.
  • If the transferor sells all of his parent stock to the subsidiary, there is no remaining stock to absorb the basis.
• The Webb rule limits collateral tax effects on the parent corporation. Webb v. Commissioner, 67 T.C. 293 (1976), aff'd per curiam, 572 F.2d 135 (5th Cir. 1978), held that when a subsidiary purchases its parent's stock from a shareholder under § 304(a)(2), the parent does not constructively receive a taxable dividend from its subsidiary.
  • Virginia Materials Corp. v. Commissioner, 67 T.C. 372 (1976), aff'd without opinion (4th Cir. June 20, 1978), reached the same conclusion.
  • Broadview Lumber Co., Inc. v. United States, 561 F.2d 698 (7th Cir. 1977), reversed a district court and held that § 304(b)(2)(B) does not cause the parent to receive a constructive distribution from the subsidiary.
  • Union Bankers Insurance Co. v. Commissioner, 64 T.C. 807 (1975), had held the opposite (that the parent receives a constructive dividend), but this position was rejected by the subsequent Webb, Virginia Materials, and Broadview Lumber decisions.

Step 7C. Basis Disappearance and Snap-Back (Rev. Rul. 70-496 and 71-563)

• Rev. Rul. 70-496 addresses basis disappearance when the transferor has no direct stock in the acquiring corporation. Rev. Rul. 70-496, 1970-2 C.B. 74, involved a situation where Corporation X owned 70 percent of Y and 100 percent of Z. Y owned 100 percent of S. Y sold all of its S stock to Z for cash. Through § 318 attribution, Y was in control of both S and Z.
  • The fact pattern involved a brother-sister § 304(a)(1) transaction where the transferor (Y) had no direct stock ownership in the acquiring corporation (Z) before or after the sale.
  • The conclusion was that Y's basis in the S stock surrendered disappeared and could not be used to increase the basis of any asset of Y.
  • The rationale was that the general basis rule under § 1.304-2(a) increases the transferor's basis in the acquiring corporation's stock, but since Y had no direct ownership in Z, there was no stock to which the basis could attach.
• Rev. Rul. 71-563 addresses the snap-back of basis to the target stock. Rev. Rul. 71-563, 1971-2 C.B. 175, involved an individual A who owned all the stock of Corporation X. C, A's son, owned all the stock of Corporation Y. A sold 25 percent of his X stock to Y for cash.
  • The fact pattern was a classic § 304(a)(1) brother-sister transaction where A had no direct stock ownership in Y after the transaction (only constructive ownership through C).
  • The conclusion was that the basis of the X stock sold should be added to the basis of the remaining X stock that A continued to own after the transaction.
  • The rationale was that the general basis adjustment rule in § 1.304-2(a) applies the basis of the surrendered stock to the transferor's remaining stock in the acquiring corporation. When the transferor has no direct stock in the acquiring corporation, the basis is added to the transferor's remaining stock in the target (issuing) corporation instead.
• CAUTION. The basis snap-back in Rev. Rul. 71-563 is controversial and may be challenged. Notice 2001-45, 2001-2 C.B. 129, addressed basis-shifting tax shelters and signaled IRS concern about transactions designed to shift basis from non-taxable parties to taxable parties. The IRS identified certain basis-shifting transactions as listed transactions.
  • Proposed regulations in REG-150313-01 (2002) and REG-143686-07 (2009) would have fundamentally changed basis recovery rules for redemptions, but both were withdrawn.
  • Practitioners should be cautious about relying on Rev. Rul. 71-563 in aggressive planning structures.

Step 8. Coordination with § 351 Under § 304(b)(3)

Except as otherwise provided in this paragraph, subsection (a) (and not section 351 and not so much of sections 357 and 358 as relates to section 351) shall apply to any property received in a distribution described in subsection (a). (§ 304(b)(3)(A))

• § 304 generally trumps § 351. § 304(b)(3)(A) provides that except as otherwise provided, § 304(a) applies to any property received in a § 304 distribution, and § 351 (along with § 357 and § 358 as they relate to § 351) does not apply.
  • This means a shareholder cannot elect to treat a § 304 transaction as a § 351 exchange.
  • The deemed § 351 exchange in § 304(a)(1) applies only for basis and earnings and profits purposes when § 301 treatment governs. It does not provide a separate nonrecognition path.
• The liability assumption exception in § 304(b)(3)(B) provides limited relief. § 304(b)(3)(B)(i) provides that § 304(a) does not apply to any liability assumed by the acquiring corporation or to which the stock is subject, if such liability was incurred by the transferor to acquire the stock.
  • The term "stock" for this purpose means stock referred to in § 304(a)(1)(B) or § 304(a)(2)(A).
  • Extensions, renewals, or refinancings of a qualifying liability are treated as meeting the requirements. (§ 304(b)(3)(B)(ii))
  • The exception applies only to stock acquired from a person whose stock is not attributable to the transferor under § 318(a) (other than paragraph (4) thereof), or who satisfies rules similar to § 302(c)(2) with respect to both corporations. (§ 304(b)(3)(B)(iii))
• The bank holding company exception in § 304(b)(3)(C) applies to certain BHC formations. § 304(b)(3)(C) provides an exception for certain distributions incident to the formation of bank holding companies.
  • Subsection (a) does not apply to securities received by a "qualified minority shareholder" (owning less than 10 percent of BHC stock).
  • A "qualified minority shareholder" means any shareholder who owns less than 10 percent (in value) of the stock of the BHC, determined with the rules of § 304(c)(3). (§ 304(b)(3)(D)(i))
  • "BHC" means a bank holding company within the meaning of § 2(a) of the Bank Holding Company Act of 1956. (§ 304(b)(3)(D)(ii))
  • The most recent amendment to § 304 struck out a transition rule for pre-1985 BHCs in § 304(b)(3)(D)(iii) on December 19, 2014 (Pub. L. 113-295, div. A, title II, § 221(a)(48)).

Step 9. Intragroup Transactions Under § 304(b)(4)

(A) In general. In the case of any transfer described in subsection (a) of stock from 1 member of an affiliated group to another member of such group, proper adjustments shall be made to (i) the adjusted basis of any intragroup stock, and (ii) the earnings and profits of any member of such group, to the extent necessary to carry out the purposes of this section. (§ 304(b)(4)(A))

• § 304(b)(4) mandates basis and earnings and profits adjustments for affiliated-group § 304 transactions. When stock is transferred from one member of an affiliated group to another member in a § 304 transaction, proper adjustments must be made to prevent distortion.
  • The term "affiliated group" has the meaning given by § 1504(a). (§ 304(b)(4)(B)(i))
  • "Intragroup stock" means stock in a corporation that is a member of an affiliated group and is held by another member of such group. (§ 304(b)(4)(B)(ii))
• Notice 87-14 identified the "son-of-mirror" problem for consolidated groups. Notice 87-14, 1987-1 C.B. 445, addressed transactions where a parent owns a subsidiary (X), which owns another subsidiary (Y). If X sells Y stock to another subsidiary (Z) in a § 304 transaction, the parent's basis in X may be inappropriately affected.
  • Prior to the notice, the parent's basis in X would be reduced by the distribution amount and increased by X's gain on Y stock, which would increase X's earnings and profits. The net effect could inappropriately build a loss into the parent's basis.
  • The notice addressed the built-in gain problem by preventing positive basis adjustments to the extent the gain was economically accrued when the parent acquired X.
  • Treas. Reg. § 1.1502-20 (and subsequent regulations) addressed related problems by generally prohibiting loss recognition on the sale of a subsidiary from a consolidated group.
• Practitioners must apply both § 304(b)(4) and the consolidated return regulations. § 1.1502-32 (investment adjustments) and § 1.1502-33 (earnings and profits adjustments) may require additional modifications beyond § 304(b)(4).
  • The § 304 transaction may trigger § 1.1502-32 basis adjustments to the parent corporation's stock in the selling subsidiary.
  • Earnings and profits of the group members may need adjustment to reflect the deemed distribution.

Step 10. Foreign Acquiring Corporations Under § 304(b)(5) and § 304(b)(6)

• § 304(b)(5) and § 304(b)(6) were enacted to prevent inappropriate use of foreign corporation earnings and profits in § 304 transactions. These provisions apply when the acquiring corporation or the issuing corporation is a foreign corporation.
  • § 304(b)(5) was added by the Taxpayer Relief Act of 1997 (Pub. L. 105-34, § 1013(c)).
  • § 304(b)(5)(B) was added by Pub. L. 111-226, § 215(a), effective for acquisitions after August 10, 2010.
  • § 304(b)(6) was added by Pub. L. 105-206, § 6010(d)(2), on July 22, 1998.

Step 10A. Limited E&P Rule Under § 304(b)(5)(A)

In the case of any acquisition to which subsection (a) applies in which the acquiring corporation is a foreign corporation, the only earnings and profits taken into account under paragraph (2)(A) shall be those earnings and profits (i) which are attributable (under regulations prescribed by the Secretary) to stock of the acquiring corporation owned (within the meaning of section 958(a)) by a corporation or individual which is (I) a United States shareholder (within the meaning of section 951(b)) of the acquiring corporation, and (II) the transferor or a person who bears a relationship to the transferor described in section 267(b) or 707(b), and (ii) which were accumulated during the period or periods such stock was owned by such person while the acquiring corporation was a controlled foreign corporation. (§ 304(b)(5)(A))

• When the acquiring corporation is foreign, only limited earnings and profits are taken into account. § 304(b)(5)(A) restricts the acquiring corporation's earnings and profits that can be used for dividend treatment.
  • The earnings and profits must be attributable to stock owned by a U.S. shareholder (as defined in § 951(b)) of the acquiring corporation.
  • The U.S. shareholder must be the transferor or a person related to the transferor under § 267(b) or § 707(b).
  • The earnings and profits must have been accumulated during the period the stock was owned by such person while the acquiring corporation was a controlled foreign corporation.
• Practitioners must trace the ownership history of the acquiring corporation stock. Only earnings and profits accumulated while the relevant U.S. shareholder held the stock and the corporation was a CFC count toward the § 304(b)(2)(A) amount.
  • Treas. Reg. § 1.304-7 provides detailed rules for applying these provisions.
  • The attribution rules use § 958(a) direct ownership, not § 958(b) constructive ownership.

Step 10B. The More Than 50% Exclusion Under § 304(b)(5)(B)

In the case of any acquisition to which subsection (a) applies in which the acquiring corporation is a foreign corporation, no earnings and profits shall be taken into account under paragraph (2)(A) (and subparagraph (A) shall not apply) if more than 50 percent of the dividends arising from such acquisition (determined without regard to this subparagraph) would neither (i) be subject to tax under this chapter for the taxable year in which the dividends arise, nor (ii) be includible in the earnings and profits of a controlled foreign corporation (as defined in section 957 and without regard to section 953(c)). (§ 304(b)(5)(B))

• If more than 50 percent of the deemed dividends would escape U.S. taxation, no foreign acquiring corporation earnings and profits are taken into account. This is the most powerful limitation in the foreign acquiring corporation rules.
  • Treas. Reg. § 1.304-7(b) provides that only the earnings and profits of the foreign acquiring corporation are considered in the 50-percent test.
  • A controlled foreign corporation for this purpose is defined by § 957 without regard to § 953(c), determined without applying § 318(a)(3)(A), (B), and (C) to consider a U.S. person as owning stock owned by a non-U.S. person.
• Treas. Reg. § 1.304-7(d), Example 1, illustrates the rule. In the example, FA (foreign, not a CFC) wholly owns DT (domestic), which wholly owns FS1 (CFC). DT has $51 of earnings and profits. FS1 has $49 of earnings and profits. FA transfers DT stock with a fair market value of $100 to FS1 for $100 cash. Under § 304(a)(2), the $100 is treated as a distribution in redemption of DT stock.
  • Ordinarily the $100 would be sourced first from FS1's earnings and profits.
  • Under § 304(b)(5)(B), taking into account only FS1's earnings and profits, more than 50 percent of the dividend would neither be subject to tax nor includible by a CFC.
  • Therefore, no portion is treated as a dividend out of FS1's earnings and profits. The $100 is treated as a dividend to the extent of DT's earnings and profits ($51).
• Treas. Reg. § 1.304-7(c) contains an anti-avoidance rule. If a partnership, option, or similar interest, or other arrangement is used with a principal purpose of avoiding the application of § 1.304-7, it will be disregarded.
  • The regulation applies to acquisitions completed on or after September 22, 2014.
  • T.D. 9834, 83 FR 32544 (July 12, 2018), finalized these rules.

Step 10C. § 304(b)(6) Multiple Inclusion Prevention

In the case of any acquisition to which subsection (a) applies in which the acquiring corporation or the issuing corporation is a foreign corporation, the Secretary shall prescribe such regulations as are appropriate in order to eliminate a multiple inclusion of any item in income by reason of this subpart and to provide appropriate basis adjustments (including modifications to the application of sections 959 and 961). (§ 304(b)(6))

• § 304(b)(6) grants the Treasury regulatory authority to prevent double taxation in foreign § 304 transactions. When either the acquiring or issuing corporation is foreign, regulations may be issued to eliminate multiple inclusions of income and provide basis adjustments.
  • The statutory reference to §§ 959 and 961 indicates Congress was concerned about previously taxed income and basis adjustments in the CFC context.
  • As of the current date, comprehensive regulations under § 304(b)(6) have not been issued, but Treasury retains the authority.
• Practitioners must monitor developments in this area. The IRS could issue regulations addressing basis recovery, gain recognition, or earnings and profits adjustments in outbound § 304 transactions.
  • Notice 2012-15, 2012-9 I.R.B. 424, addressed gain recognition agreements for transfers to foreign corporations, including in § 304 contexts involving CFCs.
  • PLR 201330004 (released July 26, 2013) applied § 304 to a Granite Trust-type transaction involving cross-border related-party stock sales and confirmed dividend treatment.

Step 10D. § 367(b)(2)(F) E&P Swap for Foreign-to-Foreign Transactions

(i) In general. In the case of any acquisition by a foreign corporation of stock of another foreign corporation in an exchange to which section 304(a)(1) applies (I) the exchanging shareholder shall be treated as having sold or exchanged the stock of the acquiring corporation for an amount equal to its fair market value, (II) the transfer of the stock of the acquiring corporation to the issuing corporation shall be treated as a distribution in redemption of the stock of the issuing corporation, and (III) the foreign acquiring corporation shall be treated as having purchased the stock of the issuing corporation. (§ 367(b)(2)(F)(i))

(ii) Treatment of earnings and profits. For purposes of this paragraph, in any exchange described in clause (i) (I) the earnings and profits of the issuing corporation shall include the earnings and profits of the acquiring corporation, and (II) the earnings and profits of the acquiring corporation shall include the earnings and profits of the issuing corporation which are attributable (under regulations prescribed by the Secretary) to the stock of the issuing corporation transferred to the acquiring corporation in such exchange. (§ 367(b)(2)(F)(ii))

• § 367(b)(2)(F) provides special rules for foreign-to-foreign § 304(a)(1) transactions. When a foreign corporation acquires stock of another foreign corporation in a § 304(a)(1) transaction, the exchanging shareholder treats the acquiring corporation stock as sold at fair market value.
  • The transfer is treated as a distribution in redemption of the issuing corporation stock.
  • The foreign acquiring corporation is treated as having purchased the issuing corporation stock.
• The E&P swap rule is critical for foreign-to-foreign transactions. The issuing corporation's earnings and profits include the acquiring corporation's earnings and profits. The acquiring corporation's earnings and profits include the issuing corporation's earnings and profits attributable to the transferred stock.
  • This swap prevents taxpayers from manipulating which corporation's earnings and profits are accessed in the transaction.
  • The rule ensures that the economic substance of the transaction is reflected in the earnings and profits account.

Step 11. Anti-Avoidance Rules Under § 1.304-4

(1) Deemed acquiring corporation. A corporation (deemed acquiring corporation) shall be treated as acquiring for property the stock of an issuing corporation acquired for property by another corporation (acquiring corporation) that is controlled by the deemed acquiring corporation, if a principal purpose for creating, organizing, or funding the acquiring corporation by any means is to avoid the application of section 304 to the deemed acquiring corporation. (§ 1.304-4(b)(1))

(2) Deemed issuing corporation. The acquiring corporation shall be treated as acquiring for property the stock of a corporation (deemed issuing corporation) controlled by the issuing corporation if, in connection with the acquisition of stock of the issuing corporation, the issuing corporation acquired stock of the deemed issuing corporation with a principal purpose of avoiding the application of section 304 to the deemed issuing corporation. (§ 1.304-4(b)(2))

• § 1.304-4 contains two anti-avoidance rules that apply automatically if a principal purpose exists. The regulations do not require IRS discretion. If a transaction was undertaken with a principal purpose of avoiding § 304, the rules apply by operation of law.
  • The original temporary regulations were issued as T.D. 8209 on June 14, 1988.
  • The current final regulations were issued as T.D. 9606 on December 26, 2012, and apply to acquisitions on or after December 29, 2009.
  • T.D. 9477 (2009) added the deemed issuing corporation rule, which closed a perceived gap in the 1988 regulations.
• The deemed acquiring corporation rule prevents the use of a funded intermediary. If a principal purpose for creating, organizing, or funding the acquiring corporation is to avoid § 304, the corporation that controls the acquiring corporation is treated as the acquiring corporation.
  • Example from § 1.304-4(c). P wholly owns CFC1 (high-tax country) and CFC2 (low-tax country, $200 of earnings and profits). To repatriate cash without triggering a CFC2-to-P dividend, P causes CFC2 to form CFC3 and contribute $100. CFC3 acquires all CFC1 stock from P for $100. Because a principal purpose for creating and funding CFC3 is to avoid § 304 to CFC2, CFC2 is treated as the deemed acquiring corporation. P receives a $100 dividend out of CFC2's earnings and profits.
  • The deemed acquiring corporation must control the actual acquiring corporation for the rule to apply.
  • The rule applies automatically if a principal purpose exists. The regulations do not require IRS exercise of discretion.
• The deemed issuing corporation rule prevents circular acquisitions. If the issuing corporation acquires stock of another corporation with a principal purpose of avoiding § 304, that other corporation is treated as the issuing corporation.
  • This prevents a corporation from acquiring stock of a lower-tier entity to change the issuing corporation identity and thereby access different earnings and profits.
  • The rule was added by T.D. 9477 in 2009 to close a perceived gap in the original 1988 temporary regulations.
  • The deemed issuing corporation must be controlled by the actual issuing corporation for the rule to apply.
• CAUTION. The "principal purpose" standard is lower than the sole-purpose standard. A transaction can trigger § 1.304-4 even if tax avoidance is one of several purposes, provided it is the principal purpose.
  • The regulations apply only to controlled corporations. The deemed acquiring corporation must control the actual acquiring corporation.
  • Documenting a genuine business purpose is essential for transactions that could be viewed as structured to access or avoid specific earnings and profits.

Step 12. Step-Transaction and Economic Substance Doctrines

• The step-transaction doctrine can integrate a § 304 deemed redemption with related transactions. Courts apply three principal variants in the § 304 context. (1) The binding commitment test. (2) The end-result test. (3) The interdependence test. The leading application involves integrating a cross-chain stock sale with subsequent dispositions.
  • Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954), is the foundational case for integrating a sale and redemption as a single complete termination transaction.
  • Niedermeyer v. Commissioner, 62 T.C. 280 (1974), aff'd, 535 F.2d 500 (9th Cir. 1976), articulated the "firm and fixed plan" test that courts apply in § 304 contexts.
  • Merrill Lynch & Co., Inc. v. Commissioner, 120 T.C. 12 (2003), aff'd, 386 F.3d 464 (2d Cir. 2004), is the leading modern case on step-transaction integration in § 304 contexts.
• Merrill Lynch demonstrates the power of the step-transaction doctrine against taxpayers. In 1986 and 1987, Merrill Lynch undertook cross-chain sales in which targets sold 100 percent stakes in lower-tier subsidiaries to cross-chain affiliates before third-party sales. Merrill treated the deemed § 304 redemptions as dividends to increase basis in the targets.
  • The Tax Court held that the cross-chain sales were steps in a firm and fixed plan to terminate the targets' ownership of the lower-tier subsidiaries. The § 304 redemptions therefore qualified for § 302(b)(3) sale or exchange treatment rather than dividend treatment.
  • The Second Circuit affirmed that Merrill had a firm and fixed plan at the time the cross-chain sales were executed.
  • The case shows that the IRS can successfully argue for integration to deny dividend treatment and basis increases.
• The economic substance doctrine applies to § 304 transactions lacking business purpose. H.J. Heinz Co. & Subsidiaries v. United States, 76 Fed. Cl. 570 (2007), is the leading case applying economic substance to a § 304 transaction.
  • Heinz Credit Company, a subsidiary, purchased 3.5 million shares of Heinz common stock in the public market for $130 million, financed by borrowing. It transferred 3.325 million shares to Heinz for a zero-coupon convertible note, then sold the remaining shares at a loss.
  • The Court of Federal Claims held that the transaction lacked economic substance. The court stated that the acquisition "had one purpose, and one purpose alone -- producing capital losses that could be carried back to wipe out prior capital gains. There was no other genuine business purpose."
  • The court applied both the sham transaction doctrine and the step-transaction doctrine, following Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006).
• The codified economic substance doctrine in § 7701(o) creates additional risk for § 304 planning. A transaction has economic substance only if (A) the transaction changes in a meaningful way the taxpayer's economic position apart from federal income tax effects, and (B) the taxpayer has a substantial purpose apart from federal income tax effects for entering into the transaction. (§ 7701(o)(1))
  • The taxpayer bears the burden of proof. (§ 7701(o)(2))
  • The doctrine does not apply to personal transactions of individuals or to certain specific statutory provisions. (§ 7701(o)(5)(A))
  • § 304 transactions structured solely to extract earnings at capital gains rates or to shift basis without economic change are vulnerable.
• TRAP. The Granite Trust planning structure is under active IRS scrutiny. Modern commentary discusses whether the IRS can use the step-transaction doctrine, economic substance doctrine, or regulatory authority to challenge Granite Trust transactions that use § 304 to shift basis.
  • If a pre-liquidation related-party stock sale is integrated with a subsequent liquidation under a firm and fixed plan, the § 302(b)(3) complete termination test applies to the integrated transaction.
  • Because the group retains no ownership post-liquidation, the redemption would be treated as a sale or exchange rather than a dividend, foreclosing the basis-shifting benefit.
  • PLR 201330004 (released July 26, 2013) applied § 304 to a Granite Trust-type transaction and confirmed dividend treatment.

Step 13. Interactions with § 306, § 1059, and § 1248

• § 306 can trigger ordinary income treatment for § 306 stock disposed of in a § 304 transaction. § 306(a) provides that if a shareholder sells or otherwise disposes of § 306 stock, the amount realized is treated as ordinary income to the extent the fair market value of the preferred stock would have constituted a dividend at the time of distribution.
  • § 306(c)(1)(A) defines § 306 stock as stock distributed to a shareholder if any part of the distribution was not includible in gross income by reason of § 305(a).
  • If § 306 stock is transferred in a § 304 deemed redemption, the § 306 taint may trigger ordinary income treatment to the extent of the earnings and profits that would have been a dividend at issuance.
  • § 306(b)(1)(A) provides an exception for redemptions, but the § 304 characterization must be navigated carefully.
• § 1059 requires corporate shareholders to reduce basis for extraordinary dividends from redemptions. § 1059(a) provides that if a corporation receives an extraordinary dividend with respect to any share of stock and has not held the stock for more than 2 years before the dividend announcement date, the basis is reduced by the nontaxed portion of the dividend.
  • § 1059(c)(5) specifically provides that a redemption shall be treated as an extraordinary dividend if the amount distributed exceeds the threshold percentage of the adjusted basis.
  • § 304(b)(4) contains an explicit cross-reference to § 1059.
  • Corporate shareholders receiving § 304 distributions treated as dividends must reduce their stock basis by the nontaxed portion.
• § 1248 may recharacterize gain on CFC stock as dividend income. § 1248(a) provides that if a U.S. person sells or exchanges stock in a foreign corporation and meets the 10-percent ownership test, the gain recognized shall be included in gross income as a dividend to the extent of the earnings and profits attributable to the stock.
  • Treas. Reg. § 1.1248-1(b) states that for purposes of § 1248(a), the term "sale or exchange" includes the receipt of a distribution treated as in exchange for stock under § 302(a).
  • Because § 304 creates a deemed redemption under § 302, § 1248 may apply to recharacterize gain as a dividend to the extent of CFC earnings and profits.
  • § 1248(c)(2) can attribute lower-tier CFC earnings and profits to the stock sold or exchanged.
  • § 1248(g)(1) excludes § 303 distributions from § 1248 treatment.
• § 367(b)(2)(F) provides special rules for foreign-to-foreign § 304 transactions. See Step 10D for the detailed analysis of the earnings and profits swap rule.
  • The interaction between § 304, § 367, and § 1248 creates a complex web for outbound transactions.
  • Notice 2012-15, 2012-9 I.R.B. 424, addressed gain recognition agreements for transfers subject to § 367(a)(1) in § 304 contexts.

Step 14. E&P Effects on the Acquiring and Issuing Corporations

• The acquiring corporation's earnings and profits are reduced by the deemed distribution. Under § 304(b)(2)(A), the property is treated as distributed by the acquiring corporation to the extent of its earnings and profits. This deemed distribution reduces the acquiring corporation's earnings and profits under § 312(a).
  • § 312(a) treats distributions as paid out of the current year's earnings and profits first, then from the most recently accumulated earnings and profits.
  • § 312(n)(7) limits the earnings and profits chargeable on a redemption to the ratable share attributable to the redeemed stock.
• The issuing corporation's earnings and profits are reduced only to the extent the distribution exceeds the acquiring corporation's earnings and profits. Under § 304(b)(2)(B), the property is treated as distributed by the issuing corporation to the extent of its earnings and profits after the acquiring corporation's are exhausted.
  • This means the issuing corporation does not necessarily suffer an earnings and profits reduction in every § 304 transaction.
  • If the acquiring corporation has sufficient earnings and profits to cover the full distribution, the issuing corporation's earnings and profits are unaffected.
• Notice 87-14 addressed the "son-of-mirror" earnings and profits problem. When a parent owns a subsidiary (X) which owns another subsidiary (Y), and X sells Y stock to another subsidiary (Z) in a § 304 transaction, the parent's basis in X may be inappropriately affected by the interaction of distribution rules and gain recognition.
  • The parent's basis in X is reduced by the amount of the distribution (the value of Y stock) and increased by X's gain on Y stock, which increases X's earnings and profits.
  • The net effect could inappropriately build a loss into the parent's basis if X was recently purchased.
  • The notice prevented positive basis adjustments to the extent the gain was built-in at the time of acquisition.
• For affiliated groups, § 304(b)(4) requires proper adjustments to earnings and profits. See Step 9 for the detailed discussion of intragroup adjustments.
  • Both the acquiring and issuing corporations may need earnings and profits adjustments to carry out the purposes of § 304.
  • The consolidated return regulations under § 1.1502-33 may impose additional earnings and profits adjustments.

Step 15. Documentation and Reporting Obligations

• Form 8806 must be filed for acquisitions of control. A reporting corporation whose stock was acquired in an acquisition of control, or that had a substantial change in capital structure, must file Form 8806 within 45 days after the transaction.
  • The acquiring corporation must file if the reporting corporation does not file.
  • Late filing penalties are $500 per day (maximum $100,000).
  • The form must generally be faxed to the IRS.
• Form 1099-CAP provides information to shareholders. A domestic corporation required to file Form 8806 must file Form 1099-CAP for shareholders receiving cash, stock, or other property.
  • The form must be furnished to shareholders by January 31.
  • Exceptions apply for transactions within an affiliated group, stock valued under $100 million, and transactions reported on other forms.
• Form 926 is required for outbound transfers to foreign corporations. U.S. citizens, residents, domestic corporations, estates, or trusts that transfer property (including stock) to a foreign corporation must file Form 926 with their income tax return.
  • No filing is required if transferred property has an adjusted basis of $100,000 or less during the tax year.
  • Cash transfers require reporting if the transferor holds 10 percent or more of the foreign corporation after transfer, or if cash transferred in a 12-month period exceeds $100,000.
  • Penalties are 10 percent of the fair market value of property transferred (capped at $100,000 unless intentional disregard).
• Form 5471 may be required for CFC transactions. If a § 304 transaction involves one or more foreign corporations, Form 5471 filing obligations may be triggered for U.S. shareholders under §§ 6038 and 6046.
  • Category 4 and Category 5 filings are most commonly implicated for U.S. shareholders of CFCs.
  • Schedule J (accumulated earnings and profits), Schedule M (related party transactions), and Schedule P (previously taxed earnings and profits) may be relevant.
  • Penalties are $10,000 per form for failure to file.
• Form 8886 may be required for reportable transactions. Taxpayers participating in reportable transactions must disclose each transaction on Form 8886.
  • If a § 304 transaction is identified as a listed transaction or transaction of interest, disclosure must be made within 90 days of identification or with the next filed return.
  • Notice 2001-45, 2001-2 C.B. 129, identified certain basis-shifting transactions involving redemptions as listed transactions.
• Corporate returns must accurately characterize the transaction. The applicable corporate income tax return must report the deemed redemption as either dividend income or sale or exchange, with appropriate basis and earnings and profits adjustments.
  • Treas. Reg. § 1.6011-4 governs reportable transaction disclosures.
  • Supporting documentation should include board minutes, stock purchase agreements, valuation reports, and earnings and profits calculations.

Step 16. State Tax Conformity

• State conformity to § 304 treatment depends on each state's method of adopting federal law. Rolling conformity states automatically adopt current federal law. Fixed-date conformity states adopt the IRC as of a specific date. Selective conformity states adopt some provisions but not others.
  • Massachusetts, Maryland, Virginia, North Carolina, and Georgia generally use rolling or broad conformity.
  • California generally conforms on a fixed-date basis. Practitioners must verify the operative conformity date for any specific § 304 transaction.
  • New York State corporate tax uses federal taxable income as a starting point, so § 304 recharacterization generally flows through.
• Dividend characterization at the state level depends on conformity. If federal § 304 recharacterizes a stock sale as a dividend, state tax treatment of that dividend depends on whether the state conforms to federal characterization and to the dividends received deduction.
  • States may have different dividends received deduction percentages or eligibility rules.
  • Most states do not allow foreign tax credits, creating potential mismatches for § 304 transactions involving foreign corporations.
• Basis adjustments are generally respected in conforming states. States that follow federal basis rules will generally respect § 304 basis adjustments, including the deemed § 351 exchange basis under § 358 and § 362.
  • States that decouple from federal basis rules may require separate basis computations.
  • State treatment of GILTI and Subpart F inclusions varies widely, creating additional complexity for foreign § 304 transactions.
• Outbound transactions may face state-specific limitations. States may have specific rules for income from foreign corporations that differ from federal Subpart F and GILTI treatment.
  • State withholding obligations on deemed dividends to non-U.S. holders may differ from federal 30-percent withholding or treaty-reduced rates.
  • Practitioners should analyze state tax effects separately from federal effects for every cross-border § 304 transaction.
• TRAP. State nonconformity can produce unexpected results. A transaction treated as a dividend for federal purposes may be treated as a sale for state purposes (or vice versa) depending on the state's conformity date and selective adoption provisions.
  • Always verify the operative IRC conformity date and any state-specific modifications before filing.
  • Consider whether state estimated payment requirements apply to deemed dividends recognized under § 304.