Changing the tax consequences of Morris Trust transactions.

A spate of high-profile corporate spin-offs coupled with acquisitive reorganizations prompted the Clinton Administration to propose a change in the requirements for certain tax-free spin-offs under Sec. 355. The "Morris Trust" proposal, as it is known, first appeared in the Administration's budget proposal submitted in March 1996, and reappeared in the President's fiscal-year 1998 budget proposal submitted to Congress on Feb. 6, 1997. The proposal, which resurfaced after several transactions were labeled "abusive" by the press, would require gain recognition at the corporate level for certain distributions of controlled corporation stock. There would be no change to the shareholder's consequences. If enacted, the proposal would have far-reaching effects on many common corporate transactions.

Morris Trust transactions date back to Morris Trust, 367 F2d 794 (4th Cir. 1966), in which the IRS challenged the tax-free status of a reorganization of a distributing company following a spinoff by that company. The Service lost the case, and the Morris Trust transaction was born. Since that time, Morris Trust transactions have been accepted by the IRS (see Rev. Rul. 68-603); today, many such transactions are carried out with the Service's blessing (in the form of letter rulings).

Morris Trust transactions typically arise when an acquirer wants only part of another company. A direct purchase of only that part would trigger gain recognition for the selling company. In the most basic Morris Trust transaction, a corporation (P) operates two businesses. Another corporation (A) wants to acquire one (but not both) of the businesses in an otherwise tax-free transaction. P transfers the business that A does not want to a newly formed subsidiary (C), and P then distributes the stock of C to P's shareholders. A is then free to acquire the business it does want by acquiring P in a tax-free reorganization.

In some recently publicized cases, in anticipation of such a transaction, P has borrowed and transferred both the business that A does not want and the cash proceeds of the borrowing to C. P then distributes the stock of C to P's shareholders. In the subsequent tax-free reorganization of P and A, A assumes the debt incurred by P, while the cash proceeds remain with C. Such transactions have been called abusive and equated with a tax-free sale of assets.

The President's Morris Trust proposal would require the distributing corporation to recognize gain on the distribution of the stock, unless the direct and indirect shareholders of the distributing corporation retain control of both the distributing and controlled corporations (P and C in the examples) for a four-year period beginning two years before the distribution. "Control" for this purpose would be retention of 50% of the stock of such corporation (by both vote and value).

The basic function of Sec. 355 is to permit existing shareholders to rearrange their ownership interests, either by separating an existing business into more than one corporation or separating ownership of different businesses with a non-pro rata distribution. The Treasury's stated reason for its proposal is that "[c]orporate nonrecognition under Sec. 355 should not apply to distributions that are effectively dispositions of a business." Many argue that the President's proposal goes too far because it would interfere with transactions that are not akin to sales.

On Apr. 17, 1997, Senate Finance Committee Chair William Roth, Senate Finance Committee ranking Democrat Daniel Patrick Moynihan and House Ways and Means Committee Chair Bill Archer introduced legislation that tracks the President's proposal. In addition, the proposed legislation includes a provision that would substantially curtail all Sec. 355 distributions within consolidated groups, including those not part of a Morris Trust transaction. For example, assume P owns S and S1. P can spin S1 off to P's shareholders tax-free; this result would not change under the proposed legislation. If, however, S1 is a second-tier subsidiary (i.e., P owns S and S owns S1), to position S1 for a spin-off to P's shareholders, S would first have to spin S1 off to P. Under current law, that spin-off is tax-free. Under the proposed legislation, the spin-off of S1 to P would not be subject to Sec. 355, but instead would result in an intercompany gain that would have to be taken into account by S if and when P spins S1 off to P's shareholders.

Now that the President's Morris Trust proposal has been introduced in Congress and has been supplemented with the new consolidated group proposals, it is likely that practitioners will redouble their efforts to persuade legislators to consider the benefits of a more targeted approach to curtail perceived abuses.

From Ted Godbout and Donnell Rini, J.D., LL.M., Washington, D.C.