Proposed regulations attack conversions of C corporations into exempt organizations.

The IRS recently issued proposed regulations under Sec. 337(d) to address the application of the Tax Reform Act of 1986's (TRA's) repeal of die so-called General Utilities doctrine to C corporations converting to exempt organizations. In essence, the regulations require a taxable corporation to recognize gain or loss on a transaction in which the corporation transfers its assets to a tax-exempt entity or converts from corporate to tax-exempt status.

Under the General Utilities doctrine, corporations under certain circumstances were not required to recognize gain or loss at the time they distributed appreciated or depreciated property to their shareholders. The general rule is that corporate income is taxed twice: to the corporation when the income is earned and to the shareholders when earnings are distributed. However, the General Utilities doctrine effectively eliminated corporate-level tax in the following situations: (1) distributions of property in complete liquidation, (2) sales of property conducted in connection with a complete liquidation and (3) nonliquidating property distributions. These principles were codified under Secs. 311, 336 and 337.

In 1969, Congress enacted a series of amendments, at first directed at nonliquidating distributions under Sec. 311 (which covers taxability of corporate distributions in general). Ultimately, the TRA eliminated the General Utilities doctrine altogether -- with narrow exceptions. Amendments to Secs. 336 and 337 dealt with distributions of appreciated or depreciated property in complete liquidation or sales in connection with a complete liquidation. The amendments required corporations to recognize gain or loss at the time the property in question is distributed. As a result of the repeal, recognition of gain is considered to be triggered when a corporation disposes of its assets in liquidation as if the assets had been sold.

Sec. 337(a) is one of the limited exceptions to the General Utilities doctrine repeal. It allows a subsidiary to liquidate into an 80% tax-exempt distributee that meets Sec. 332(b)'s stock ownership requirements in the liquidating corporation without recognizing gain or loss; the distributee is allowed a carryover basis in the distributed property. A significant "exception to the exception" is covered in Sec. 337(b)(2); the nonrecognition is void if the 80% distributee is an exempt organization unless this organization used the property in the production of "unrelated" taxable income. The theory is that, since the distributee exempt organization will be taxed on the business income deriving from the property, the forfeited corporate-level tax is, in effect, passed on to that entity.

The TRA, in adding Sec. 337(d), simply directed the Treasury to prescribe regulations to cover to-be-announced situations that would tend to circumvent the General Utilities repeal. Several notices in the Internal Revenue Bulletin throughout 1988 announced imminent regulations. These applied to certain corporate partner-partnership stock transfers (deemed redemptions) and built-in gains of regulated investment companies. Additionally, the Technical and Miscellaneous Revenue Act of 1988 amended Sec. 337(d) to ensure that future regulations would deal with potential circumvention. The regulations were to consider the transfer of appreciated property of a C corporation to a tax-exempt entity in a carryover basis transaction that would otherwise eliminate corporate-level tax on the built-in appreciation. This project was designed to broaden the Sec. 337(b)(2) qualification, which was limited to Sec. 332 liquidations.

Several letter rulings were issued by the IRS soon after the inauguration of the exempt organizations regulations project in 1989. The thrust of these rulings was to revoke any outstanding prior ruling letters that granted a nontaxable transfer of appreciated property from a taxable corporation to an exempt organization by way of a consolidation or organizational conversion. Typical was one in which shareholders of X, a for-profit organization, transferred all of their X stock to newly formed not-for-profit Y in exchange for membership rights in Y. In turn, X transferred all of its assets, subject to liabilities, to Y in exchange for the X stock held by Y. The Service ruled that the transaction had no tax consequences because Y was considered the alter ego of X. Additionally, X would not recognize any recapture of depreciation under Secs. 1245 and 1250. Recognizing the impending overturn to this position by the forthcoming Sec. 337(d) regulations, the IRS revoked this letter ruling along with several others -- involving transfers and mergers or conversions-because they were "not in accord with the Service's current views on the treatment of transactions in which a for-profit corporation converts to a non-profit corporation that is exempt from tax under section 501(c)(3) of the Code." Pending the publication of final regulations, the Service is refusing to rule on the gain (or loss) recognition aspects of such transactions.

The proposed regulations under Sec. 337(d) contain a couple of special exceptions to the "change in status application" noted above; newly formed corporations that qualify for exemption under Sec. 501 (a) within three years and those that regain lost exempt status within a three-year period may avoid application of the new proposed regulations. These exceptions are designed to provide relief both to corporations that need a brief start-up period to establish their exempt status and to those that lose exempt status.

The regulations include an anti-abuse rule and an anti-stuffing provision. The anti-abuse rule prevents a taxable corporation that acquires assets from another corporation and then changes its status -- for the purpose of avoiding recognition of gain or loss on the transfer of assets -- from using the exceptions. Further, losses are disallowed if the assets are acquired by a taxable corporation in a Sec. 351 transaction or a contribution to capital, or if the corporation distributes assets to a shareholder for the purpose of recognizing a corporate loss on the transfer of the assets to a tax-exempt entity (the loss limitation rule). For purposes of this rule, Sec. 336(d)(2) principles apply.

These new rules have an obvious impact on die series of ongoing hospital and health care system reorganizations, many of which entail exempt organization takeovers of liquidated C corporations. This was already apparent in the revocation of the letter rulings applying the old liberal rules to these transactions. Another area that could be affected is the area of investment property from C corporations into title-holding organizations (Sec. 501(c)(2) or (c)(25)) that manage property on behalf of related exempt entities.

The regulations would be applicable to transfers of assets occurring after a date that is 30 days after publication of final regulations; they would not apply to transfers subsequent to that date as long as they were done pursuant to a binding contract in effect before the noted effective date. The IRS has scheduled a hearing on the regulations for May 6, 1997. Written comments and outlines of oral comments are due by Apr. 15, 1997.