Research Problem 16:

Aqua Corporation wholly owns Egret Corporation.Aqua's basis in Egret stock is $5.5 million.Since it was formed, Egret has been a very profitable software company and currently has accumulated earnings and profits (E & P) of $4 million.The company's principal assets are software patents currently worth $5 million and cash and marketable securities of approximately $4.5 million (a total fair market value of $9.5 million).

Aqua and Egret are members of an affiliated group and have made the election under 243(b) so that Aqua is entitled to a 100% dividends received deduction. From a strategic perspective, Aqua is no longer interested in the software industry and so is considering a sale of Egret. In anticipation of a sale in the next year or two, the management of Aqua has contacted you for advice. If Egret is sold outright, then Aqua Corporation will have a capital gain of $4 million ($9.5 million fair market value less a basis of $5.5 million). As an alternative, it has been suggested that taxes on a future sale would be minimized if Egret pays Aqua a dividend (using existing cash and securities) equal to its E & P. With the 100% dividends received deduction, this payment would be a tax-free transfer from Egret to Aqua. Subsequent to the dividend payment, Egret could be sold for its remaining value of $5.5 million ($5 million in software patents plus $500,000 in cash), generating no addition gain or loss to Aqua.Prepare a letter a memo for the tax file documenting your conclusions.

Research aid:

Waterman Steamship Corp. v. Comm., 70-2 USTC 9514, 430 F.2d 1185(CA-5, 1970).

Litton Industries, Inc., 89 T.C. 1086 (1987).