Corporation X sold the land for $20,000 thereby realizing a gain of $15,000. Of this gain, $10,000 is due to realized appreciation in value which accrued before March 1, 1913 $15,000-$5,000). Of the gain of $15,000, $5,000 is taxable. Therefore, at December 31, 1955, Corporation X had a surplus from realized appreciation in the amount of $100,000. It had no accumulated earnings and profits and no deficit at January 1, 1955. The net earnings for 1955 (including the $5,000 gain on the sale of the land) were $20,000. During 1955, Corporation X distributed $75,000 to its stockholders. Of this amount, $20,000 will be treated as a dividend. The remaining $55,000, which is a distribution of realized appreciation, will be applied against and reduce the adjusted basis of the shareholders' stock. If any part of the $55,000 is in excess of the adjusted basis of a shareholder's stock, such part will be exempt from tax.

(g) Reduction for liabilities. For the purpose of section 301 (a), the amount of any distribution shall be reduced by

(1) The amount of any liability of the corporation assumed by the shareholder in connection with the distribution, and

(2) The amount of any liability to which the property received by the shareholder is subject immediately before and immediately after the distribution.

Such reduction, however, shall not cause the amount of the distribution to be reduced below zero.

(h) Basis. The basis of property received in the distribution to which section 301 applies shall be

(1) If the shareholder is not a corporation, the fair market value of such property;

(2) If the shareholder is a corporation

(i) In the case of a distribution of the obligations of the distributing corporation or of the stock of such corporation or rights to acquire such stock (if such stock or rights are treated as property under section 305 (b)), the fair market value of such obligations, stock, or rights;

(ii) In the case of the distribution of any other property, except as provided in subdivision (iii) of this subparagraph, whichever of the following is the lesser

(a) The fair market value of such property; or

(b) The adjusted basis (in the hands of the distributing corporation immediately before the distribution) of such property increased in the amount of gain to the distributing corporation which is

recognized under section 311(b) (relating to distributions of LIFO inventory), section 311 (c) (relating to distributions of property subject to liabilities in excess of basis) or section 1245(a) or 1250(a) (relating to gain from dispositions of certain depreciable property);

(iii) In the case of the distribution by a foreign corporation of any other property after December 31, 1962, the amount determined under paragraph (n) of this section.

(i) [Reserved]

(j) Transfers for less than fair market value. If property is transferred by a corporation to a shareholder which is not a corporation for an amount less than its fair market value in a sale or exchange, such shareholder shall be treated as having received a distribution to which section 301 applies. In such case, the amount of the distribution shall be the difference between the amount paid for the property and its fair market value. If property is transferred in a sale or exchange by a corporation to a shareholder which is a corporation, for an amount less than its fair market value and also less than its adjusted basis, such shareholder shall be treated as having received a distribution to which section 301 applies, and—

(1) Where the fair market value of the property equals or exceeds its adjusted basis in the hands of the distributing corporation the amount of the distribution shall be the excess of the adjusted basis (increased by the amount of gain recognized under section 311 (b) or (c) or section 1245 (a) or 1250(a) to the distributing corporation) over the amount paid for the property;

(2) Where the fair market value of the property is less than its adjusted basis in the hands of the distributing corporation, the amount of the distribution shall be the excess of such fair market value over the amount paid for the property. If property is transferred in a sale or exchange after December 31, 1962, by a foreign corporation to a shareholder which is a corporation for an amount less than the amount which would have been computed under paragraph (n) of this section if such property had beer received in a distribution to which section 301 applied, such shareholder shall be treated as having received a distribution to which section 301 applies, and the amount of the distribution shall be the excess of the amount which would

have been computed under paragraph (n) of this section with respect to such property over the amount paid for the property. In all cases, the earnings and profits of the distributing corporation shall be decreased by the excess of the basis of the property in the hands of the distributing corporation over the amount received therefor. In computing gain or loss from the subsequent sale of such property, its basis shall be the amount paid for the property increased by the amount of the distribution.

(k) Application of rule respecting transfers for less than fair market value. The application of paragraph (j) of this section may be illustrated by the following examples:

X,

Example (1). On January 1, 1955, A, an individual shareholder of corporation purchased property from that corporation for $20. The fair market value of such property was $100, and its basis in the hands of corporation X was $25. The amount of the distribution determined under section 301 (b) is $80. If A were a corporation, the amount of the distribution would be $5 (assuming that sections 311 (b) and (c), 1245 (a), and 1250 (a) do not apply), the excess of the basis of the property in the hands of corporation X over the amount received therefor. The basis of such property to corporation A would be $25. If the basis of the property in the hands of corporation X were $10, the corporate shareholder, A, would not receive a distribution. The basis of such property to corporation A would be $20. Whether or not A is a corporation, the excess of the amount paid over the basis of the property in the hands of corporation X ($20 over $10) would be a taxable gain to corporation X.

Example (2). On January 1, 1963, corporation A, which is a shareholder of corporation B (a foreign corporation engaged in business within the United States), purchased one share of corporation X stock from B for $20. The fair market value of the share was $100, and its adjusted basis in the hands of B was $25. Assume that if the share of corporation X stock had been received by A in a distribution to which section 301 applied, the amount of the distribution under paragraph (n) of this section would have been $55. The amount of the distribution under section 301 is $35, 1.e., $55 (amount computed under paragraph (n) of this section) minus $20 (amount paid for the property). The basis of such property to A is $55.

(1) Transactions treated as distributions. A distribution to shareholders with respect to their stock is within the terms of section 301 although it takes place at the same time as another transaction if the distribution is in substance a separate transaction whether or not

connected in a formal sense. This is most likely to occur in the case of a recapitalization, a reincorporation, or a merger of a corporation with a newly organized corporation having substantially no property. For example, if a corporation having only common stock outstanding, exchanges one share of newly issued common stock and one bond in the principal amount of $10 for each share of outstanding common stock, the distribution of the bonds will be a distribution of property (to the extent of their fair market value) to which section 301 applies, even though the exchange of common stock for common stock may be pursuant to a plan of reorganization under the terms of section 368 (a) (1) (E) (recapitalization) and even though the exchange of common stock for common stock may be tax free by virtue of section 354.

(m) Cancellation of indebtedness. The cancellation of indebtedness of a shareholder by a corporation shall be treated as a distribution of property.

(n) Distributions of certain property by foreign corporations to corporate shareholders. (1) If a foreign corporation distributes property (other than money, the obligations of the distributing corporation, stock of the distributing corporation treated as property under section 305(b), or rights to acquire such stock treated as property under section 305(b)) after December 31, 1962, to a shareholder which is a corporation, then, except as provided in subparagraph (2) of this paragraph, the fair market value of the property shall be taken into account under section 301(c).

(2) If any deduction is allowable to the recipient under section 245 with respect to a distribution of property described in subparagraph (1) of this paragraph and if the fair market value of the property exceeds its adjusted basis in the hands of the distributing corporation (increased by any gain to the distributing corporation recognized under section 311 (b) or (c), or under section 1245 (a) or 1250 (a)), then the amount taken into account under section 301(c) shall be determined under subparagraph (3) of this paragraph. In order to determine such amount

(i) First, compute the portion, if any, of the adjusted basis of the property (increased by any gain to the distributing corporation recognized under section 311 (b) or (c), or under section 1245 (a) or 1250 (a)) which is out of earnings and

profits of the taxable year (within the meaning of section 316(a)(2)).

(ii) Second, compute the portion, if any, of the adjusted basis of the property (increased by any gain to the distributing corporation recognized under section 311 (b) or (c), or under section 1245 (a) or 1250 (a)) which is out of earnings and profits accumulated during the portion of the uninterrupted period described in section 245 (a) which ends at the beginning of the taxable year.

(iii) Third, compute the portion, if any, of the adjusted basis of the property (increased by any gain to the distributing corporation recognized under section 311 (b) or (c), or under section 1245(a) or 1250(a)) which is out of sources other than earnings and profits of the taxable year and earnings and profits accumulated during the uninterrupted period described in section 245 (a).

(iv) Fourth, with respect to each of the portions computed under subdivisions (i), (ii), and (iii) of this subparagraph, determine the proportionate part of the fair market value of the property attributable to such portion. The proportionate part of the fair market value attributable to each portion shall be such fair market value multiplied by the ratio which such portion bears to the sum of all portions.

(3) The amount taken into account under section 301(c) shall be the sum of

(i) The portion computed under subparagraph (2) (i) of this paragraph, multiplied by the ratio which the gross income of the distributing corporation for the taxable year from sources within the United States bears to its gross income from all sources for such taxable year,

(ii) The portion computed under subparagraph (2) (ii) of this paragraph, multiplied by the ratio which the gross income of the distributing corporation from sources within the United States for the portion of the uninterrupted period described in section 245 (a) which ends at the beginning of the taxable year bears to its gross income from all sources for such portion of such uninterrupted period,

(iii) The porportionate part of the fair market value of the property attributable to the portion of the adjusted basis computed under subparagraph (2) (1) of this paragraph, multiplied by the ratio which the gross income of the distributing corporation for the taxable year from

sources without the United States bears to its gross income from all sources for such taxable year,

(iv) The proportionate part of the fair market value of the property attributable to the portion of the adjusted basis computed under subparagraph (2) (ii) of this paragraph, multiplied by the ratio which the gross income of the distributing corporation from sources without the United States for the portion of the uninterrupted period described in section 245 (a) which ends at the beginning of the taxable year bears to its gross income from all sources for such portion of such uninterrupted period, and

(v) The proportionate part of the fair market value of the property attributable to the portion of the adjusted basis computed under subparagraph (2) (iii) of this paragraph.

In determining the source of income for purposes of this subparagraph, see part I (section 861 and following), subchapter N, chapter 1 of the Code, and the regulations thereunder,

(4) See section 301(b) (2) and paragraph (g) of this section for reduction in the amount of a distribution on account of certain liabilities.

(5) The provisions of this paragraph may be illustrated by the following examples:

Example (1). Corporation A (a foreign corporation filing its income tax returns on a calendar year basis) whose stock is 100 percent owned by corporation B (a domestic corporation filing its income tax returns on a calendar year basis) for the first time engaged in trade or business within the United States on January 1, 1959, and qualifies under section 245 for the entire period beginning on that date and ending on December 31, 1963. During the period January 1, 1959, through December 31, 1962, corporation A derived 80 percent of its gross income from sources within the United States, and for 1963 corporation A derived 90 percent of its gross income from sources within the United States.

As of December 31, 1962, A had earnings and profits of $50,000 accumulated during the period January 1, 1959, through December 31, 1962, and for the year 1963 A had earnings and profits of $10,000. On December 31, 1963, corporation A distributes to corporation B 100 shares of stock in domestic corporation C which have an adjusted basis of $40,000 in A's hands and a fair market value of $100,000. Corporation A makes no other distributions during 1963. Since a deduction is allowable to B under section 245 with respect to the distribution, and since the fair market value of the property ($100,000) exceeds the adjusted basis of the property in A's hands ($40,000), the

amount of the distribution taken into account under section 301(c) is $50,500, which is the sum of

(1) 89,000, 1.e., $10,000 (the portion of the adjusted basis of the property which is out of earnings and profits for 1963), multiplied by 90 percent (the ratio which the gross income of A from sources within the United States for 1963 bears to its gross income from all sources for such year),

(ii) $24,000, i.e., $30,000 (the portion of the adjusted basis of the property which is out of earnings and profits accumulated during the period January 1, 1959 through December 31, 1962), multiplied by 80 percent (the ratio which the gross income of A from sources within the United States for such period bears to its gross income from all sources for such period),

(iii) $2,500, 1.e., $25,000 (the proportionate part of the fair market value of the property attributable to the portion of the adjusted basis which is out of earnings and profits for 1963 ($100,000 multiplied by $10,000/ $40,000)), multiplied by 10 percent (the ratio which the gross income of A for 1963 from sources without the United States bears to its gross income from all sources for such year), and

(iv) $15,000, i.e., $75,000 (the proportionate part of the fair market value of the property attributable to the portion of the adjusted basis which is out of earnings and profits accumulated during the period January 1, 1959 through December 31, 1962 ($100,000 multiplied by $30,000/$40,000)), multiplied by 20 percent (the ratio which gross income from sources without the United States for such period bears to gross income from all sources for such period).

Example (2). Assume the same facts as in example (1) except that as of December 31, 1962, A had earnings and profits of $20,000 accumulated during the period January 1, 1959 through December 31, 1962. Since a deduction is allowable to B under section 245 with respect to the distribution and since the fair market value of the property ($100,000) exceeds the adjusted basis of the property in A's hands ($40,000), the amount of the distribution taken into account under section 301 (c) is $62,500, which is the sum of

(1) $9,000, 1.e., $10,000 (the portion of the adjusted basis of the property which is out of earnings and profits for 1963), mulitplied by 90 percent (the ratio which the gross income of A for 1963 from sources within the United States bears to its gross income from all sources for such year),

(11) $16,000, i.e., $20,000 (the portion of the adjusted basis of the property which is out of earnings and profits accumulated during the period January 1, 1959 through December 31, 1962), multiplied by 80 percent (the ratio which the gross income of A from sources within the United States for such period bears to its gross income from all sources for such period),

(iii) $2,500, i.e., $25,000 (the proportionate

part of the fair market value of the property attributable to the portion of the adjusted basis which is out of earnings and profits for 1963 ($100,000 multiplied by $10,000/ $40,000)), multiplied by 10 percent (the ratio which the gross income of A for 1963 from sources without the United States bears to Its gross income from all sources for such year),

(iv) $10,000, i.e., $50,000 (the proportionate part of the fair market value of the property attributable to the portion of the adjusted basis which is out of earnings and profits accumulated during the period January 1, 1959 through December 31, 1962 ($100,000 multiplied by $20,000/$40,000)), multiplied by 20 percent (the ratio which the gross income of A from sources without the United States for such period bears to its gross income from all sources for such period), and

(v) $25,000, the proportionate part of the fair market value of the property attributable to the portion of the adjusted basis which is out of sources other than earnings and profits for 1963 and earnings and profits accumulated during the uninterrupted period described in section 245(a) ($100,000 multiplied by $10,000/$40,000).

For certain

(o) Cross references. rules relating to adjustments to earnings and profits and for determining the extent to which a distribution is a dividend, see sections 312 and 316 and regulations thereunder.

[T.D. 6500, 25 F.R. 11607, Nov. 26, 1960, as amended by T.D. 6752, 29 F.R. 12701, Sept. 9, 1964; T.D. 7084, 36 F.R. 267, Jan. 8, 1971]

§ 1.302 Statutory provisions; distributions in redemption of stock.

SEC. 302. Distributions in redemption of stock-(a) General rule. If a corporation redeems its stock (within the meaning of section 317 (b)), and if paragraph (1), (2), (3), or (4) of subsection (b) applies, such redemption shall be treated as a distribution in part or full payment in exchange for the stock.

(b) Redemptions treated as exchanges(1) Redemptions not equivalent to dividends. Subsection (a) shall apply if the redemption is not essentially equivalent to a dividend.

(2) Substantially disproportionate redemption of stock—(A) In general. Subsection (a) shall apply if the distribution is substantially disproportionate with respect to the shareholder.

(B) Limitation. This paragraph shall not apply unless immedir.tely after the redemption the shareholder owns iess than 50 percent of the total combined voting power of all classes of stock entitled to vote.

(C) Definitions. For purposes of this paragraph, the distribution is substantially disproportionate if—

(i) The ratio which the voting stock of the corporation owned by the shareholder

immediately after the redemption bears to all of the voting stock of the corporation at such time,

is less than 80 percent of

(ii) The ratio which the voting stock of the corporation owned by the shareholder immediately before the redemption bears to all of the voting stock of the corporation at such time.

For purposes of this paragraph no distribution shall be treated as substantially disproportionate unless the shareholder's ownership of the common stock of the corporation (whether voting or nonvoting) after and before redemption also meets the 80 percent requirement of the preceding sentence. For purposes of the preceding sentence, if there is more than one class of common stock, the determinations shall be made by reference to fair market value.

(D) Series of redemptions. This paragraph shall not apply to any redemption made pursuant to a plan the purpose or effect of which is a series of redemptions resulting in a distribution which (in the aggregate) is not substantially disproportionate with respect to the shareholder.

(3) Termination of shareholder's interest. Subsection (a) shall apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder. (4) Stock issued by railroad corporations in certain reorganizations. Subsection (a) shall apply if the redemption is of stock issued by a railroad corporation (as defined in section 77 (m) of the Bankruptcy Act, as amended) pursuant to a plan of reorganization under section 77 of the Bankruptcy Act.

(5) Application of paragraphs. In determining whether a redemption meets the requirements of paragraph (1), the fact that such redemption fails to meet the requirements of paragraph (2), (3), or (4) shall not be taken into account. If a redemption meets the requirements of paragraph (3) and also the requirements of paragraph (1), (2), or (4), then so much of subsection (c) (2) as would (but for this sentence) apply in respect of the acquisition of an interest in the corporation within the 10-year period beginning on the date of the distribution shall not apply.

(c) Constructive ownership of stock-(1) In general. Except as provided in paragraph (2) of this subsection, section 318 (a) shall apply in determining the ownership of stock for purposes of this section.

(2) For determining termination of interest. (A) In the case of a distribution described in subsection (b) (3), section 318 (a) (1) shall not apply if

(1) Immediately after the distribution the distributee has no interest in the corporation (including an interest as officer, director, or employee), other than an interest as a creditor,

(11) The distributee does not acquire any such interest (other than stock acquired

by bequest or inheritance) within 10 years from the date of such distribution, and

(iii) The distributee, at such time and in such manner as the Secretary or his delegate by regulations prescribes, files an agreement to notify the Secretary or his delegate of any acquisition described in clause (11) and to retain such records as may be necessary for the application of this paragraph.

If the distributee acquires such an interest in the corporation (other than by bequest or inheritance) within 10 years from the date of the distribution, then the periods of limitation provided in sections 6501 and 6502 on the making of an assessment and the collection by levy or a proceeding in court shall, with respect to any deficiency (including interest and additions to the tax) resulting from such acquisition, include one year immediately following the date on which the distributee (in accordance with regulations prescribed by the Secretary or his delegate) notifies the Secretary or his delegate of such acquisition; and such assessment and collection may be made notwithstanding any provision of law or rule of law which otherwise would prevent such assessment and collection.

(B) Subparagraph (A) of this paragraph shall not apply if

(i) Any portion of the stock redeemed was acquired, directly or indirectly, within the 10-year period ending on the date of the distribution by the distributee from a person the ownership of whose stock would (at the time of distribution) be attributable to the distributee under section 318 (a), or

(ii) Any person owns (at the time of the distribution) stock the ownership of which is attributable to the distributee under section 318 (a) and such person acquired any stock in the corporation, directly or indirectly, from the distributee within the 10year period ending on the date of the distribution, unless such stock so acquired from the distributee is redeemed in the same

transaction.

The preceding sentence shall not apply if the acquisition (or, in the case of clause (ii), the disposition) by the distributee did not have as one of its principal purposes the avoidance of Federal income tax.

(d) Redemptions treated as distributions of property. Except as otherwise provided in this subchapter, if a corporation redeems its stock (within the meaning of section 317 (b)), and if subsection (a) of this section does not apply, such redemption shall be treated as a distribution of property to which section 301 applies.

(e) Cross references. For special rules relating to redemption—

(1) Death taxes. Of stock to pay death taxes, see section 303.

(2) Section 306 stock. Of section 306 stock, see section 306.

(3) Liquidations. Of stock in partial or complete liquidation, see section 331.