C and S Corporations for Estate Planners: Related Corporations and IRC Section 304

An intro to control, and related issues

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This is the eleventh installment of C and S corporations for estate planners. For the first article in this series and a series index, click here.

Table of Contents

1. Intro and Control

2. Related Corporation Examples

   1. Example 1

   2. Example 2

3. IRC Section 304

   1. Priority Rules

   2. Definition of Control

4. Non-Control Attribution Factors

   1. Special Dividend Rules, and 351

   2. Which Corporation’s Stock Counts?

   3. Attribution for Dividend or Redemption, but not Control

5. Control-Related Attribution Factors

   1. Express Implication of Attribution Rules, and Modifications

   2. Special Rules – Attribution Between Corporations and Selling Shareholders

   3. Vote or Value, Versus Just Value

   4. Pre- and Post-Transfer Control, and Which Corporation Counts?

6. Conclusion

Intro and Control

So far, we have explored some common issues that arise when assets flow out of a corporation to a shareholder.  To recap:

• Distributions of cash to a shareholder will often be treated as dividends;

• Distributions of property (other than stock in the corporation) to a shareholder will often be treated as dividends to the extent of the fair market value of the property, with an added twist that the corporation is treated as selling appreciated property for fair market value; and

• Distributions to a shareholder from a corporation in exchange for such shareholder’s stock in the corporation may be respected as sales or exchanges if they meet certain requirements, otherwise they will be treated as dividends. 

The taxation of these outcomes can vary between C corporations and S corporations, as we have explored.  And, a step-up in basis at the death of a shareholder may not benefit the heirs receiving that stock (or the corporation in which the stock is held) unless there is a sale of stock to an outside third party.

In estate planning, it is common for family members to own corporate shares.  So far we have explored some of the attribution rules under which family members might be treated as one aggregate shareholder for purposes of redemptions. 

But, there is a broader picture to consider.  Much of Subchapter C of the Internal Revenue Code (the rules applying to “C” corporations – hence the name), and by reference Subchapter S (applying to – you guessed it – “S” corporations), deals with the issue of “control.”  Control often examines stock ownership by a shareholder, group of shareholders, or even another corporation.  If control is present, there can be certain benefits or detriments. 

Lest we leave an open thread, the starting definition of “control” for purposes of Subchapter C is found in IRC Section 1504(a)(2) (which, as we will later discuss, usually considers whether co-owned corporations can file one consolidated return and how inter-corporation transactions are thus treated).  Generally, this Code Section defines control based on an 80% threshold in two categories:

• Voting power (across all voting classes of stock), and

• Value of the stock (across all classes of stock, voting and nonvoting). 

However, 80% is not universally applied across the board.  In some cases, specific Code provisions change this threshold as we will see below.  Also, as we will see below, sometimes instead of a conjunctive requirement (vote and value), we see a disjunctive qualifier (vote or value).  Where there is one class of stock, this ownership threshold (however defined under the context) is an easy determination.  But, where there are multiple classes of stock – especially perhaps voting shares and nonvoting shares – this becomes more complicated.

Control and attribution are not always expressly linked under Subchapter C.  Indeed, as seen in IRC Section 318(a), attribution relationships in that Code section only apply to “those provisions of this subchapter [C] to which [such relationships]… are expressly made applicable… .”  Yet, they can create opportunities for abuse where two corporations are subject to common ownership. 

Related Corporation Examples

Example 1

Let’s take a situation where a shareholder owns 100% of the stock in Corporation I.  In turn, Corporation I owns 100% of the stock in Corporation A. 

If Corporation A were to distribute some of its earnings and profits (E&P) to Corporation I, there would be a taxable dividend to Corporation I (subject to a dividends received deduction of 65% or 100% under IRC Section 243).  Then, if Corporation I were to in turn distribute these funds out to the shareholder, there would be another taxable dividend. 

Being creative, the shareholder decides to sell 30% of their shares in Corporation I to Corporation A.  In doing so, the shareholder reasons that there should be sale or exchange treatment, since the stock is being sold to a party other than the “issuing” corporation itself (a hint at why it is labeled “Corporation I” under this example).  And, in the process, the shareholder has gotten some cash out of Corporation A (the “acquiring corporation,” hence the Corporation “A” label) without a possible double dividend tax. 

Example 2

Alternatively, let’s assume shareholder and the shareholder’s spouse each own 50% of Corporation I and Corporation A, respectively.

Again, shareholder wants some cash out of Corporation A.  Since shareholder A is a direct shareholder of Corporation A, there would only be one layer of dividend tax.  Due to ownership by shareholder A’s spouse, shareholder also reasons that a redemption of his shares might be subject to dividend treatment under IRC Section 302 due to the attribution rules. 

So, again being crafty, shareholder has Corporation A purchase some of shareholder’s stock in Corporation I – again thinking that this creates guaranteed sale or exchange treatment.  But does it?

IRC Section 304