                            117 T.C. No. 8



                     UNITED STATES TAX COURT



          GARY D. AND LINDY H. COMBRINK, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent*



     Docket No. 13580-99.                    Filed August 23, 2001.



     *
      On May 15, 2001, the Court filed its Opinion in this case
at 116 T.C. No. 24. On August 7, 2001, respondent filed a Notice
of Proceeding in Bankruptcy, in which respondent notified the
Court that this Court’s proceedings should have been stayed with
respect to petitioners Gary D. Combrink and Lindy H. Combrink,
who, on January 29, 2001, commenced a case in the United States
Bankruptcy Court for the Western District of Oklahoma, under 11
U.S.C. Chapter 7 of the Bankruptcy Code. Petitioners herein had
heretofore filed a timely petition with this Court on August 10,
1999.

     Pursuant to 11 U.S.C. sec. 362(a)(8)(1988), the proceedings
in this Court were automatically stayed on January 29, 2001, thus
nullifying our Opinion filed May 15, 2001.

     An Order was filed by the Bankruptcy Court on July 11, 2001,
discharging the debtors Gary Dean Combrink and Lindy Hayton
Combrink from all dischargeable debts. The automatic stay of
proceedings in this case was thereby lifted.

     By Order dated August 14, 2001, the Opinion in this case at
116 T.C. No. 24 was withdrawn. This Opinion is unchanged from
the previous Opinion.
                                - 2 -



          P owned 100 percent of the stock in two
     corporations, C and L. During 1995 and 1996, C made a
     series of remittances totaling $89,728.73 which were
     treated as loans from C to P, followed by subsequent
     loans from P to L. P also lent additional funds to L.
     Thereafter, in late 1996, promissory notes payable by L
     to P in the amount of $252,481.03 were converted into a
     single promissory note of $77,481.03 and additional
     paid-in capital of $175,000.00. Then, in December of
     1996, P transferred his shares in L to C in exchange
     for release from the $174,133.20 liability he had
     previously incurred to C.

          Held: To the extent of $12,247.70, the transfer
     of L stock to C in exchange for debt release is
     excepted from redemption characterization pursuant to
     sec. 304(b)(3)(B), I.R.C., and, under secs. 351 and
     357, I.R.C., generates no gain or loss.

          Held, further, to the extent of $161,885.50, the
     stock transfer is to be recast as a redemption, and
     taxed as a dividend distribution, in accordance with
     secs. 301, 302, and 304, I.R.C.


     Kerry R. Hawkins and Kenneth W. Klingenberg, for

petitioners.

     Brian A. Smith and C. Glenn McLoughlin, for respondent.



                               OPINION


     NIMS, Judge:    Respondent determined a Federal income tax

deficiency for petitioners’ 1996 taxable year in the amount of

$56,449.00.    The principal issue to be decided is the proper

application of section 304, which could in turn require

application of sections 301 and 302, to the facts of this case.
                               - 3 -

Additional adjustments made in the statutory notice of deficiency

are computational in nature and will be resolved by our holding

herein.

     Unless otherwise indicated, all section references are to

sections of the Internal Revenue Code in effect for the year at

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

                            Background

     This case was submitted fully stipulated pursuant to Rule

122, and the facts are so found.   The stipulations of the

parties, with accompanying exhibits, are incorporated herein by

this reference.   At the time the petition was filed in this case,

petitioners resided in Enid, Oklahoma.

     The primary dispute in this matter focuses on the proper

treatment for tax purposes of certain transactions involving

petitioner Gary D. Combrink and two related corporations, Cost

Oil Operating Company (COST) and Links Investment, Inc. (LINKS).

Mr. Combrink incorporated COST on January 7, 1983, and has at all

times owned 100 percent of the company’s stock.   COST, a

subchapter C corporation, is engaged in the operation of working

interests in oil and gas wells.    Mr. Combrink incorporated LINKS

on November 12, 1992, and has at all relevant times through
                                 - 4 -

November of 1996 owned all outstanding shares.        LINKS, also a

subchapter C corporation, was formed with the intention of

opening and operating a golf course.

     During the 1990’s, Mr. Combrink received various amounts

from COST which were treated as loans from the corporation to Mr.

Combrink.   In two instances, promissory notes payable to COST

were signed by Mr. Combrink.     A note in the amount of $56,404.47

was signed on December 31, 1992, and a note for $17,000.00 was

signed on December 31, 1993.     Additional loan amounts were

reflected on the corporate records as accounts receivable due

from Mr. Combrink.   As of May 25, 1995, the balance of COST’s

accounts receivable from shareholders was $11,000.00.

Thereafter, during 1995 and 1996, this balance was increased as a

result of transactions taking one of two forms.

     First, in 1995, COST repaid sums owed to third parties by

Mr. Combrink in his personal capacity, as follows:

                         Date             Amount
                  May 26, 1995           $16,362.98
                  August 31, 1995         15,729.17
                  December 20, 1995       11,228.64
                  December 29, 1995        1,102.37
                        Total            $44,423.16

The August 31, 1995, payment was made in satisfaction of amounts

owed by Mr. Combrink to a loan broker who had assisted in finding

a lender to finance LINK’s operations.     The December 20, 1995,
                                - 5 -

payment repaid sums owed by Mr. Combrink to a creditor for

equipment used exclusively by LINKS.     (The record does not

reflect the purpose or recipient of the remaining two payments.)

     The second type of transaction recorded on COST’s books as

accounts receivable from Mr. Combrink took the form of payments

made directly to LINKS in 1996.    These payments are set forth

below:

                        Date             Amount
                  April 29, 1996         $1,000.00
                  May 6, 1996             2,000.00
                  May 15, 1996            3,500.00
                  June 3, 1996          15,000.00
                  June 5, 1996          23,805.57
                       Total            $45,305.57

The foregoing nine accounts receivable transactions, totaling

$89,728.73, were consistently treated by Mr. Combrink and his

corporations as loans from COST to Mr. Combrink and as subsequent

loans from Mr. Combrink to LINKS.    LINKS recorded the amounts as

accounts payable to stockholders, and the debt resulting from

these and other funds advanced to LINKS by Mr. Combrink was

memorialized by two promissory notes payable by LINKS to Mr.

Combrink in the total amount of $252,481.03.
                              - 6 -

     Subsequently, on October 15, 1996, Mr. Combrink and LINKS

agreed to convert the above-referenced promissory notes payable

by LINKS to Mr. Combrink into one promissory note in the amount

of $77,481.03 and additional paid-in capital of $175,000.00.    No

further shares were issued at this time.    Then, on December 1,

1996, Mr. Combrink transferred all of his stock in LINKS to COST

in exchange for COST’s releasing Mr. Combrink from a liability to

COST in the amount of $174,133.20, apparently consisting of the

$56,404.47 promissory note, the $17,000.00 promissory note, the

$11,000 accounts receivable balance as of May 25, 1995, and the

$89,728.73 added to the accounts receivable balance in 1995 and

1996 as detailed above.

     On their timely filed joint 1996 U.S. Individual Income Tax

Return, Form 1040, petitioners did not report any income or loss

as a result of the release transaction.    Respondent determined

that $174,133.20 must be included in income as a dividend

pursuant to sections 301, 302, and 304.

                           Discussion

     Section 304 mandates that certain transactions involving

shares in related corporations be recast for tax purposes as

redemptions, the tax treatment of which is then governed by

section 302 and potentially section 301.    The parties here

disagree with respect to whether section 304 is applicable to the

December 1, 1996, transaction between Mr. Combrink and COST.
                               - 7 -

     Petitioners advance two alternative arguments as to why

section 304 should not be applied to the exchange of LINKS stock

for debt release, one of which rests on a general appeal to

policy and the other of which relies on a specific statutory

exception.   As a policy matter, petitioners emphasize that

Congress, in enacting section 304, sought to prevent the

“bailout” of corporate earnings as capital gain rather than

ordinary income.   Because it is petitioners’ position that the

transfer at issue does not manifest the characteristics of such a

bailout, petitioners aver that it should not be subjected to the

construct set up by section 304.

     In the alternative, petitioners contend that the transaction

here is specifically exempted from the redemption treatment

otherwise required under section 304(a) by the exception

established in section 304(b)(3)(B).   According to petitioners,

the disputed transfer involved COST’s assumption of liability

incurred by Mr. Combrink to acquire the LINKS stock.   As such,

petitioners claim that the transaction falls within the section

304(b)(3)(B) exception applicable in certain cases where there is

an assumption of acquisition indebtedness.

     Conversely, respondent asserts that to characterize the

December 1996 transaction as a redemption pursuant to the rules

of section 304(a) is consistent with both the language and the

policy of the statute.   Respondent further maintains that Mr.
                               - 8 -

Combrink’s transfer of the LINKS stock to COST is not covered by

the section 304(b)(3)(B) exception.     In respondent’s view, the

evidence fails to establish that the liability released by COST

was incurred to acquire the transferred LINKS stock.     Respondent

therefore alleges that the transaction must be taxed as a

dividend in accordance with sections 302(d) and 301.

     Thus, as framed by the parties’ contentions, resolution of

this matter requires determining the applicability of section 304

to the December 1996 transfer of LINKS stock.     In considering

this broad question, we address in turn, to the extent relevant,

each of three subissues.   The first is whether the subject

transaction is, absent any exception, of a type intended to be

covered by section 304(a).   If yes, the second question is

whether section 304(b)(3)(B) exempts the transfer from the

redemption characterization that subsection (a) would otherwise

require.   Third, it will be necessary to analyze the appropriate

tax treatment in light of the answers given to the foregoing

inquiries.

I.   The General Rule--Section 304(a)

     As previously indicated, section 304 mandates that certain

transactions involving shares in related corporations be recast

for tax purposes as redemptions.   The general rule is set forth

in section 304(a) and provides in relevant part as follows:
                               - 9 -

          SEC. 304(a).   Treatment of Certain Stock
     Purchases.--

               (1) Acquisition by related corporation (other
          than subsidiary).--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. To the extent that such distribution is
          treated as a distribution to which section 301
          applies, the stock so acquired shall be treated as
          having been transferred by the person from whom
          acquired, and as having been received by the
          corporation acquiring it, as a contribution to the
          capital of such corporation.

     Accordingly, there are two elements required for a

transaction to fall within the purview of section 304(a)(1).

First, the transferor(s) of the issuing corporation’s stock must

be in control of both the issuing and the acquiring corporations.

Second, the issuing corporation’s stock must be transferred to

the acquiring corporation in exchange for property.   Transfers so

described in section 304(a)(1) are often referred to as “brother-

sister” stock sales; section 304(a)(2) offers analogous rules for

“parent-subsidiary” sales.

     To guide in evaluating the above two requisites, section 304

and related sections set forth several pertinent definitions.
                                - 10 -

Regarding the control element, section 304(c)(1) specifies that

“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.”      Section 304(c)(3)(A) further

clarifies that “Section 318(a) (relating to constructive

ownership of stock) shall apply for purposes of determining

control under this section”.    As a result, indirect ownership

through family members and related entities is taken into account

in ascertaining control.   See sec. 318(a).    A person who owns at

least 5 percent of a corporation’s stock, for example, is

considered as owning a proportionate amount of any shares held by

that corporation.   See sec. 304(c)(3)(B)(i); sec. 318(a)(2)(C).

     Property is defined for purposes of sections 301 through 318

as “money, securities, and any other property; except that such

term does not include stock in the corporation making the

distribution (or rights to acquire such stock).”     Sec. 317(a);

cf. Bhada v. Commissioner, 89 T.C. 959, 963-964 (1987), affd. 892

F.2d 39 (6th Cir. 1989), affd. sub nom. Caamano v. Commissioner,

879 F.2d 156 (5th Cir. 1989).

     Given the foregoing requirements and definitions, we are

satisfied that Mr. Combrink’s exchange of LINKS stock for debt

release is a transaction of the type described in section

304(a)(1).   With respect to control, Mr. Combrink directly owned
                              - 11 -

100 percent of the stock of both LINKS (the issuing corporation)

and COST (the acquiring corporation) immediately prior to the

transfer.   Furthermore, after the transfer he continued to own

100 percent of COST directly and thereby owned 100 percent of

LINKS constructively through application of section 318(a)(2)(C).

Consequently, Mr. Combrink at all times held and never

relinquished control of both LINKS and COST.

     As regards the second element, the exchange of stock for

property, Mr. Combrink transferred the LINKS stock to COST and

received in return a release from liability.   In this connection,

regulatory law indicates that a corporation’s cancellation of

shareholder indebtedness owed to the corporation constitutes

property within the meaning of the section 317(a) definition.

See sec. 1.301-1(m), Income Tax Regs.   Regulations under section

301, which statute relies on the same section 317(a) definition

of property, expressly provide that “cancellation of indebtedness

of a shareholder by a corporation shall be treated as a

distribution of property.”   Id.

     Accordingly, we conclude that release by COST of Mr.

Combrink’s liability was a distribution of property within the

meaning of sections 317(a) and 304.    We further observe that our

result is the same regardless of whether we characterize the

instant transaction as involving assumption, cancellation, or

forgiveness of debt.   Although petitioners repeatedly emphasize
                               - 12 -

that the LINKS stock was exchanged for debt assumption rather

than forgiveness of Mr. Combrink’s liability, the section 304

calculus does not turn on the basis of such labels, at least not

in the circumstances of this case.      As a practical matter, there

exists no substantive difference between a corporation’s

canceling versus assuming a debt owed to itself.     We thus treat

the terms as synonymous on these facts and equally applicable to

the release of Mr. Combrink’s liability.

      Lastly, we note that whatever particular abuses may have led

to the enactment of section 304, we may not judicially create a

supposed policy-based exception where a transaction falls within

the plain language of the statute as written.     We therefore need

not parse whether the December 1996 transfer did or did not

effect something akin to a bailout of earnings.     The transaction

meets the only two elements set forth in section 304(a) and

hence, absent a specific statutory exception, must be recast as a

redemption.

II.   The Exception--Section 304(b)(3)(B)

      Section 304(b) provides an exception to the statute’s

operation.    Although section 304(a) is expressly stated to

override section 351 in most cases where both are potentially

applicable, see sec. 304(b)(3)(A), section 304(b)(3)(B)

authorizes the following limited exception:
                              - 13 -

          (B) Certain assumptions of liability, etc.--

               (i) In general.--In the case of an
          acquisition described in section 351, subsection
          (a) shall not apply to any liability--

                     (I) assumed by the acquiring
                corporation, or

                     (II) to which the stock is subject,

          if such liability was incurred by the transferor
          to acquire the stock. For purposes of the
          preceding sentence, the term “stock” means stock
          referred to in paragraph (1)(B) or (2)(A) of
          subsection (a).

               (ii) Extension of obligations, etc.--For
          purposes of clause (i), an extension, renewal, or
          refinancing of a liability which meets the
          requirements of clause (i) shall be treated as
          meeting such requirements.

               (iii) Clause (i) does not apply to stock
     acquired from related person except where complete
     termination.--Clause (i) shall apply only to stock
     acquired by the transferor from a person--

                     (I) none of whose stock is attributable
                to the transferor under section 318(a) (other
                than paragraph (4) thereof), or

                      (II) who satisfies rules similar to the
                rules of section 302(c)(2) with respect to
                both the acquiring and the issuing
                corporations (determined as if such person
                were a distributee of each such corporation).
                * * *

     This exception can be restated in terms of four general

requirements:   (1) The acquiring corporation must have obtained

the transferred stock in a section 351 transaction; (2) the

acquiring corporation must have assumed a liability or taken the

transferred stock subject to a liability; (3) the transferor
                              - 14 -

shareholder must have incurred the assumed liability to acquire

the transferred stock; and (4) the transferred stock must not

have been acquired from a person whose stock was attributable to

the shareholder under the section 318 attribution rules.

     In the present controversy, respondent challenges only the

third of the elements enumerated above.    Accordingly, we focus

our analysis on whether the $174,133.20 liability released by

COST was incurred by Mr. Combrink to acquire the LINKS stock.

Petitioners bear the burden of proving that this question should

be answered in the affirmative.    See Rule 142(a).

     Of the $174,133.20 assumed by COST, the stipulated evidence

explicitly establishes only that $72,263.38 was transferred to or

used for the benefit of LINKS.    Remittances on August 31 and

December 20, 1995, of $15,729.17 and $11,228.64, respectively,

were applied to repay creditors for services and property related

to the LINKS business.   Then, in 1996, payments totaling

$45,305.57 were made directly to LINKS.    However, the parties

also agreed that all nine accounts receivable transactions,

including those on May 26 and December 29, 1995, were

consistently treated as loans from COST to Mr. Combrink, followed

by loans from him to LINKS.   On the basis of such consistency, we
                              - 15 -

are willing to assume that $89,728.73 was applied for the benefit

of LINKS.   Conversely, the record fails to trace the remaining

$84,404.47 canceled to any use benefiting LINKS.

     Furthermore, the evidence shows that the amounts supplied by

Mr. Combrink to LINKS, both through COST and from personal

sources, were initially characterized as debt, not equity.    Mr.

Combrink owned 100 percent of the outstanding LINKS stock prior

to any such remittances and did not at the time of these loans to

LINKS receive any additional shares or equity.    Only subsequently

was $175,000.00 of the $252,481.03 once represented by promissory

notes from LINKS to Mr. Combrink redesignated as additional paid-

in capital.   Although we are willing in these circumstances to

accept this recapitalization as establishing that $175,000.00 was

used to acquire LINKS stock within the meaning of section

304(b)(3)(B)(i), $77,481.03 still remained outstanding in the

form of debt.   Since the $89,728.73 portion of the assumed

liability that can be traced to LINKS exceeds this $77,481.03

that clearly was intended to represent debt rather than equity in

LINKS by only $12,247.70, we are able to determine from the

record only that $12,247.70 of the $174,133.20 assumed by COST

was used to acquire stock or equity in LINKS.

     As to this $12,247.70 amount, we hold that petitioners are

entitled to the section 304(b)(3)(B) exception.    With respect to

the remaining $161,885.50, petitioners have failed to carry their
                                - 16 -

burden of proof on a required element of the section 304(b)(3)(B)

exception.    We therefore hold that, to the extent of $161,885.50,

the disputed December 1996 transaction is not removed from the

purview of section 304(a) by reason of section 304(b)(3)(B).

III.    The Tax Treatment--Sections 301 and 302

       The $12,247.70 exempted from section 304(a) results in no

gain or loss under sections 351 and 357, and we need not address

it further.     However, because we have decided that $161,885.50 of

the transaction must be recast as a redemption in accordance with

section 304(a), we turn now to the tax consequences of that

characterization.     Section 302 provides the framework governing

tax treatment of redemptions and reads in pertinent part as

follows:

       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.--
                   - 17 -

          (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 immediately after the
     redemption the shareholder owns less 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.
          * * *

     (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) Redemption from noncorporate shareholder
in partial liquidation.--Subsection (a) shall
apply to a distribution if such distribution is--

          (A) in redemption of stock held by a
     shareholder who is not a corporation, and
     (B) in partial liquidation of the distributing
corporation.

          *    *    *    *    *     *    *

(c) Constructive Ownership of Stock.--
                             - 18 -

               (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.

                    *    *    *      *    *    *    *

          (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.

Thus, under the schematic created in section 302, unless a

redemption transaction falls into one of four enumerated

categories qualifying for treatment as a sale or exchange, it is

taxed in accordance with section 301.    When evaluating whether a

transfer takes one of the four listed forms in the context of a

section 304 proceeding, section 304(b)(1) directs that such

determination be made by reference to the stock of the issuing

corporation.

     Here, we conclude that the December 1996 transaction is not

among the four types afforded exchange treatment.   First,

pursuant to United States v. Davis, 397 U.S. 301, 313 (1970), the

transfer cannot qualify as “not essentially equivalent to a

dividend” under section 302(b)(1).    The U.S. Supreme Court ruled

in United States v. Davis, supra at 307, 313, that redemption of

the shares of a corporation’s sole stockholder is “always”

essentially equivalent to a dividend and, consequently, that a

taxpayer “who (after application of the attribution rules) was
                               - 19 -

the sole shareholder of the corporation both before and after the

redemption” could not meet the section 302(b)(1) test.    Since

section 318(a) deems Mr. Combrink the sole stockholder of LINKS,

the issuing corporation, both prior to and following the

transfer, he likewise is entitled to no relief under paragraph

(1).

       Second, the attribution rules similarly prevent the subject

transaction for qualifying for sale treatment under section

302(b)(2).    As a result of constructive ownership, the transfer

failed to effect the requisite change in Mr. Combrink’s voting

control which would signal a substantially disproportionate

redemption.

       Third, an identical rationale, namely, no reduction in

deemed ownership, precludes the redemption from constituting a

complete termination of Mr. Combrink’s interest under section

302(b)(3).

       Lastly, with respect to section 302(b)(4), the facts contain

no indication that LINKS or COST was involved in a plan of

partial termination.    We therefore conclude that the December

1996 transaction is governed by section 302(d) and, accordingly,

that the tax effects thereof must be determined under section

301.
                          - 20 -

Section 301 provides in relevant part:

SEC. 301.   DISTRIBUTIONS OF PROPERTY.

     (a) In General.--Except as otherwise provided in
this chapter, a distribution of property (as defined in
section 317(a)) made by a corporation to a shareholder
with respect to its stock shall be treated in the
manner provided in subsection (c).

     (b) Amount Distributed.--

          (1) General rule.--For purposes of this
     section, the amount of any distribution shall be
     the amount of money received, plus the fair market
     value of the other property received.

                 *    *    *     *   *    *    *

     (c) Amount Taxable.--In the case of a distribution
to which subsection (a) applies--

          (1) Amount constituting dividend.--That
     portion of the distribution which is a dividend
     (as defined in section 316) shall be included in
     gross income.

          (2) Amount applied against basis.--That
     portion of the distribution which is not a
     dividend shall be applied against and reduce the
     adjusted basis of the stock.

            (3) Amount in excess of basis.--

                 (A) In general.--Except as provided in
            subparagraph (B), that portion of the
            distribution which is not a dividend, to the
            extent that it exceeds the adjusted basis of
            the stock, shall be treated as gain from the
            sale or exchange of property. * * *
                              - 21 -

     Section 316(a), in turn, defines “dividend” as “any

distribution of property made by a corporation to its

shareholders--(1) out of its earning and profits accumulated

after February 28, 1913, or (2) out of its earnings and profits

of the taxable year”.   In other words, a section 301 distribution

is taxed as a dividend, and therefore as ordinary income, to the

extent of the distributing corporation’s earnings and profits.

Only after such earnings and profits are exhausted may the

distribution be treated as a return of basis or capital gain.

     Additionally, for purposes of applying the above test to a

section 304 redemption, section 304(b)(2) specifies that the

amount of the dividend shall be determined as if the property

were distributed first by the acquiring corporation to the extent

of its earnings and profits and then by the issuing corporation

to the extent of its earnings and profits.

     As previously indicated, the cancellation of a liability is

considered the equivalent of a distribution of money in the face

amount of the obligation.   See sec. 1.301-1(m), Income Tax Regs.

Yet on the record before us, petitioners, who bear the burden of

proof, have introduced no evidence to show that COST lacked

earnings and profits in at least the amount of the debt release
                              - 22 -

afforded to Mr. Combrink.   We thus are constrained to hold that

petitioners received dividend income in the amount of $161,885.50

in 1996, pursuant to sections 301, 302, and 304.

     To reflect the foregoing,



                                         Decision will be entered

                                    under Rule 155.
