Changes in corporate organizations and reorganizations under TRA '97.

Gain Recognition on Corporate Stock Distributions

The Taxpayer Relief Act of 1997 (TRA '97) restricts the availability of tax-free spin-offs. A gain will be recognized if the shareholders of the distributing companies lose control during the four-year period beginning two years before the distribution. If a company can demonstrate that the acquisition or disposition of stock was unrelated to the distribution of the spun-off corporation, gain recognition can be avoided.

If the shareholders lose control, the gain recognized is the amount of gain the distributing corporation would have recognized had stock of the controlled corporation been sold at fair market value (FMV) on the date of distribution. This gain is treated as a long-term capital gain.

Under the TRA '97, an acquisition of a controlled corporation under Sec. 355(e)(2)(A) occurs if one or more individuals acquire (directly or indirectly) 50% or more of the vote or value of the stock of the controlled or distributing corporation pursuant to a plan or arrangement.

Definition of "Control"

The act also modifies certain rules for determining "control" immediately after a distribution. In the case of certain transactions in which a controlled corporation is distributed and the transaction meets the requirements of Sec. 355, those shareholders receiving stock in the distributed corporation are treated as being in control of the distributed corporation immediately after the distribution if they hold stock representing a greater-than-50% interest in the vote and value of stock of the distributed corporation. The fact that a corporate transferor distributes part or all of the stock it receives to its shareholders in the exchange is disregarded.

The act does not change the current Sec. 355 requirement that the distributing corporation distribute 80% of the voting power and 80% of each other class of stock of the controlled corporation. It is expected that the IRS will apply this requirement to plans that permit certain types of planned restructuring of the distributing corporation following the distribution, and will treat similar restructurings of the controlled corporation in a similar manner. Thus, the 80% control requirement is expected to be administered in a manner that would prevent the tax-free spin-off of a less-than-80% controlled subsidiary, but generally would not impose additional restrictions on post-distribution restructurings of the controlled corporation if such restrictions would not apply to the distributing corporation.

Nonqualified Preferred Stock Treated as "Boot"

The TRA '97 treats certain preferred stock as other property or "boot." Thus, when a taxpayer exchanges property for this nonqualified preferred stock in a transaction under Sec. 351, 354, 355, 356 or 368, a gain (but not a loss) would be recognized.

Under the Sec. 351 nonrecognition rules, property must be transferred solely in exchange for stock by one or more persons who are in "control." If an individual transfers appreciated property to a corporation in exchange for common and preferred stock, the individual will recognize gain only to the extent of the FMV of the nonqualified preferred stock received in the transaction. The nonrecognition rules are applicable only to the property transferred for stock other than nonqualified preferred stock.

Example: J contributes property with a basis of $50,000 and an FMV of $150,000 to a controlled corporation under Sec. 351. In exchange, J receives common stock worth $80,000, preferred stock worth $60,000 and $10,000 cash. J realizes a gain of $100,000 ($150,000 - $50,000 basis). However, under Sec. 351(b), a gain of only $70,000 is recognized ($10,000 cash + $60,000 nonqualified preferred stock).

Nonqualified preferred stock is defined in new Sec. 351(g)(2) as preferred stock for which one of the following criteria applies:

1. The holder has the right to require the issuer or a related person to redeem or purchase the stock.

2. The issuer or a related person is required to redeem or purchase the stock.

3. The issuer or a related person has the right to redeem or purchase the stock and, as of the issue date, it is more likely than not that such right will be exercised.

4. The dividend rate on the stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices or other similar indices.

Investment Company Definition

New Sec. 351(e) states that a gain or loss is recognized on a contribution by a shareholder to a corporation considered to be an investment company. The definition of an investment company includes any corporation or partnership if more than 80% of the value of: its assets consists of any of the following:

* Money.

* Stocks and other equity interests in a corporation.

* Evidence of indebtedness, options, forward or futures contracts, notional principal contracts and derivatives.

* Foreign currency.

* Interests in precious metals.

* Interests in a real estate investment trust or a regulated investment company.

* Common trust funds.

* Publicly traded partnerships. Other assets that count toward the 80% test include interests in an entity if substantially all assets are listed assets. The Service has the authority to add other assets or to remove items from this list.