Hippo Inc. a C corporation, has substantial (but reasonable) accumulated earnings and profits. Hippos assets are highly appreciated. Hippo has two classes of stock outstanding, voting common stock and nonvoting preferred stock. The preferred stock does not participate in corporate growth.

All of Hippos outstanding common stock, 100 shares, is owned by Hippos founder, Ziggy. Ziggys adjusted basis in the common stock is $1,000 per share. Ziggy is also a salaried executive officer of Hippo.

All of Hippos preferred stock is owned by Layla. Layla is Ziggys elderly mother. The preferred stock gives its holder the right to convert the stock into a short-term promissory note of Hippo, but Layla has never exercised this option, content to receive a sizable cash dividend each year.

Ziggy is approached by Whales & Sharks Corp., an "S corporation that wishes to purchase Hippo's business. Pursuant to a three-party agreement among Ziggy, Hippo, and Whales & Sharks, the following transactions take place:

1. On March 1, Hippo redeems 15 of Ziggys common shares in exchange for a five-year, promissory note in the principal amount of $150,000. Hippo immediately cancels the redeemed shares.

2. On August 15, Ziggy transfers his/her remaining 85 common shares of Hippo to Whales & Sharks in exchange for $450,000 cash and a two-year installment note from Whales & Sharks in the principal amount of $400,000. The note is secured by a pledge of the 85 shares of stock in Hippo.

The three-party agreement also requires that Ziggy refrain from competing with Hippo anywhere in its sales territory for two years commencing with the August 15 transfer. Under controlling state law, the agreement is enforceable. The agreement specifies that Ziggy will receive $100,000 cash at the end of each of the two years in consideration of the covenant not to compete. The cash payments are to be made by Whales & Sharks. Whales & Sharks also occasionally hires Ziggy as a consultant for a cash fee of $200 an hour.

Layla does not participate in the transactions among Ziggy, Hippo, and Whales & Sharks. Layla retains her Hippo convertible preferred stock.

You are the Tax Court judge trying to determine the federal income tax consequences to Ziggy, Layla, Hippo, and Whales & Sharks in the transactions described above. The IRS believes that the transaction is a sham or at the very least a step transaction as a method for Ziggy to bail out E&P. The taxpayers argue that the transaction has legitimate business purposes. In your decision, be sure to discuss the amount, timing, and character (capital or ordinary) of any income, gain, loss, or deduction realized or recognized by each party; each party's basis in the stock or assets that party holds at each stage of the transactions; and the effects of the transactions on Hippos earnings and profits.

Note: If you need to assume any additional facts you may do so but please make sure to include the assumed facts in your answer.