Control requirement in divisive "D" reorganizations.

In two related (but easily overlooked) 1998 legislative changes, Congress again amended the definition of "control" for Sec. 368(a)(1)(D) purposes in connection with a divisive reorganization to which Sec. 355 applies. (Conforming amendments were also made to Sec. 351(c)(2)). The effect of these amendments on the "control" requirement is to prevent a postdistribution change in the ownership of either the distributing or controlled corporation from adversely affecting gain nonrecognition on the transfer of assets from the distributing to the controlled corporation. Consequently, corporations now have greater flexibility in restructuring their businesses.

The "Control" Requirement

To qualify as a divisive D reorganization, the transferor corporation's (Distributing's) shareholders must be in control of the transferee corporation (Controlled) immediately after the property transfer. Control was long defined for this purpose as ownership of 80% or more of a company's voting power, and at least 80% of the total number of shares of all other classes of stock. Any change in stock ownership that occurred soon after the distribution of Controlled was taken into account and could prevent the control requirement from being satisfied; see Rev. Rul. 70-225. Congress changed the definition of control in a divisive D reorganization in 1997, and again in 1998.

Background

In recent years, Congress has tightened the Secs. 355 and 368(a)(1)(D) requirements to prevent potential abuses, including the avoidance of repeal of the General Utilities doctrine. In 1990, Congress added Sec. 355(d) to require Distributing to recognize gain on a "disqualified" distribution (one in which any person owns 50% or more of Distributing or Controlled) if the interest was acquired in a taxable transaction within five years of the distribution.

TRA '97

In the Taxpayer Relief Act of 1997 (TRA '97), Congress added Sec. 355(e), the so-called "anti-Morris Trust" rule. This provision requires Distributing, in an otherwise qualifying tax-free separation, to recognize gain as if it had sold the stock of Controlled if 50% or more of the stock of either corporation was acquired as part of a plan that existed at the time of the distribution. Because Congress was clearly allowing a less-than-50% postdistribution change in ownership of either Distributing or Controlled (in a disposition that does not constitute a prohibited device) without adversely affecting the tax-free qualification of the distribution, the TRA '97 made a conforming change to the definition of control in a divisive reorganization. Congress added Sec. 368(a)(2)(H)(ii) to define "control" in the case of a divisive D reorganization as the ownership of more than 50% of the voting power of the stock of the distributed corporation and more than 50% of all other classes of stock. (Congress did not change the requirement of Sec. 355(a) that Distributing distribute at least 80% of the voting stock and 80% of the total number of shares of all other classes of stock of Controlled.) Rev. Rul. 98-27 modified Rev. Rul.70-225.

IRSRRA '98

In the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98), Congress again amended the definition of control. Congress repealed Sec. 368(a)(2)(H)(ii) and instead provided that, in determining whether a transaction qualified as a divisive D reorganization, the fact that the shareholders of Distributing dispose of all or part of the Controlled stock is not taken into account.

This amendment has two significant consequences. First, it reinstated the old definition of control; thus, the shareholders of Distributing must own stock with 80% or more of the voting power and at least 80% of the total number of shares of all other classes of Controlled stock. Second, there is no statutory limit on the amount of shares that a shareholder can dispose of following a distribution. If 50% or more of the stock is disposed of, Sec. 355(e) may apply and Distributing will recognize gain.

While this amendment to Sec. 368(a)(2)(H) allowed shareholders to lose control after the distribution by disposing of their stock, it did not address the situation in which the shareholders lose control because Controlled issues shares of stock to new investors, as in an initial public offering (IPO). However, in the Tax and Trade Relief Extension Act of 1998, Congress added a technical amendment to Sec. 368(a)(2)(H)(ii), to provide that the issuance of stock by Controlled is also not taken into account. Following this amendment, it is clear that Controlled can engage in an IPO alter the distribution without causing the property transfer to be taxable. Controlled is still subject to Sec. 355(e), which will limit the amount of stock that can be issued or disposed of to less than 50%. Both of the 1998 amendments are effective for transactions occurring after Aug. 5, 1997 (the effective date of the TRA '97).

FROM LAWRENCE H. COHEN, J.D., LL.M., NEW YORK, NY, AND LORIN D. LUCHS, CPA, J.D., LL.M., WASHINGTON, DC