Final regs. issued for transfers from taxable corporations to exempt entities.

In recent years, there has been a surge in the number of conversions of entities, either from for-profit to not-for-profit status, or from not-for-profit to for-profit status. The IRS has issued final regulations on the repeal of the General Utilities doctrine, involving asset transfers from taxable corporations to exempt entities. The final regulations adopt, in most part, the rules in the proposed regulations. The final regulations apply to transfers of assets occurring after Jan. 28, 1999, unless the transfer is pursuant to a written agreement binding on or before that date. The purpose of the regulations is to prevent taxable corporations with appreciated assets from using exempt entities to escape taxation on the appreciation.

Background

Under the General Utilities doctrine, corporations were not required to recognize gain or loss when distributing appreciated or depreciated property to their shareholders. The General Utilities doctrine was an exception to the general rule that income earned by a corporation is taxed twice, once to the corporation when the income is earned and again to the corporation's shareholders when the earnings are distributed. The General Utilities doctrine generally permitted the permanent elimination of corporate-level tax on the disposition of appreciated assets, because the transferee received a fair market value (FMV) basis in the assets and the corporation generally did not recognize any gain. Beginning in 1969, the scope of the General Utilities doctrine was restricted, until ultimately it was repealed, with limited exceptions, in the Tax Reform Act of 1986 (TRA '86). The TRA '86 added Sec. 337(d), directing the Secretary to prescribe regulations necessary to carry out the purposes of the repeal of the General Utilities doctrine. The TRA '86 legislative history indicated that the General Utilities doctrine was repealed because it tended to undermine the corporate income tax, by allowing appreciated property to leave the corporation without imposition of a corporate-level tax. The Technical and Miscellaneous Revenue Act of 1988 amended Sec. 337(d) to specify that the section authorizes regulations to "ensure that such purposes may not be circumvented ... through the use of a ... tax-exempt entity."

On Jan. 15, 1997, the Service published proposed regulations under Sec. 337(d) to apply to a corporation that transferred all (or substantially all) of its assets to a tax-exempt entity or that converted from a taxable corporation to a tax-exempt entity. These transactions could eliminate the corporate-level tax on the appreciation in the taxable corporation's assets. Accordingly, the proposed regulations generally required the corporation to recognize gain or loss on such a transaction.

The proposed regulations applied rules similar to Sec. 337(b)(2) to these transactions. Sec. 337(a) provides the general rule that "[n]o gain or loss shall be recognized to the liquidating corporation on the distribution to the 80-percent distributee of any property in a complete liquidation." Sec. 337(b)(2) provides that the general rule shall not apply when the 80% distributee is an organization exempt from income tax. Liquidation of a taxable subsidiary into an exempt parent is a taxable event.

The proposed regulations provide that a taxable corporation that transfers all (or substantially all) of its assets to one or more tax-exempt entities is required to recognize gain or loss as if the assets transferred were sold at their FMVs. Like Sec. 337(b)(2), the proposed regulations provide that no gain or loss will be recognized on any of the assets transferred that are used by the tax-exempt entity in an activity the income from which is subject to the unrelated business tax under Sec. 511 (a). However, gain on such assets will later be recognized as unrelated business taxable income if the tax-exempt entity disposes of the assets or ceases to use them in an unrelated trade or business activity.

The proposed regulations generally treat a taxable corporation that changes its status to a tax-exempt entity as having transferred all of its assets to a tax-exempt entity immediately before the change in status becomes effective, regardless of whether an actual transfer of the assets has occurred. For this purpose, if a state, a political subdivision thereof, or an entity any portion of whose income is excluded from gross income under Sec. 115, acquires the stock of a taxable corporation and thereafter any of the taxable corporation's income is excluded from gross income under Sec. 115, the taxable corporation will be treated as if it transferred all of its assets to a tax-exempt entity immediately before the stock acquisition.

The proposed regulations generally do not affect the tax treatment of the taxable corporation's shareholders or the availability of any charitable deduction.

The Final Regulations

The final regulations generally conform with the proposed regulations. Under Regs. Sec. 1.337(d)-4(a)(1), a taxable corporation that transfers all (or substantially all) of its assets to one or more tax-exempt entities is required to recognize gain or loss as if the assets transferred were sold for their FMVs (the asset sale rule). Under Regs. Sec. 1.337(d)-4(c) (3), the term "substantially all" has the same meaning as under Sec. 368(a)(1)(C). Under Regs. Sec. 1.337(d)-4(a)(2), if a taxable corporation changes its status to a tax-exempt entity, it generally is treated as having transferred all its assets to a tax-exempt entity immediately before the change in status becomes effective in a transaction governed by the asset sale rule.

The final regulations modified the proposed regulations to exclude transactions from the asset sale rule to the extent they qualify for nonrecognition of gain or loss under Sec. 1031 or 1033 (Regs. Sec. 1.337(d)-4(b)(3)). In addition, the final regulations modified the rules in the proposed regulations in response to comments about the application of the regulations to specific types of tax-exempt entities (e.g., under the final regulations, taxable corporations may convert to Sec. 528 homeowners' associations without triggering gain or loss).

Effective Date

Under Regs. Sec. 1.337(d)-4(e), the final regulations apply to transfers of assets and conversions occurring after Jan. 28,1999, unless the transfer is pursuant to a written agreement binding on or before that date.

FROM GENNARO MUSI, CPA, NEW YORK, NY