Return-of-capital distributions in mutual thrift stock conversions.

In a series of letter rulings (Letter Rulings 9549021, 9627024, 9632010, 9632011, 9640029, 9736018 and 9821043), the IRS has affirmed a return-of-capital transaction that has become quite popular among mutual thrifts converting to the stock form of ownership. The transaction involves deliberately avoiding the consolidated earnings and profits (E&P) rules of Regs. Sec. 1.1502-33, so that a portion of the initial stock offering proceeds can be distributed back to shareholders with no current tax liability. By carefully planning these transactions, converting thrifts can avail themselves of a unique opportunity.

Background

The standard mutual-to-stock thrift conversion is accomplished as a tax-free reorganization under Sec. 368 (a) (1) (F) and often results in the formation of a new holding company. The mutual thrift is converted to a stock company while the newly formed holding company raises capital through a public stock offering. A portion of the proceeds from the public stock offering is generally retained by the holding company, while the remainder is used to purchase the newly issued thrift stock. Mutual depositors are given certain liquidation rights in the converted organization that represent a continuing proprietary interest.

Although it does not make sense that an institution would raise excess capital to begin with, this situation is actually created by Office of Thrift Supervision (OTS) regulatory requirements, rather than poor capital planning. As the regulatory agency with jurisdiction over the thrift industry, the OTS is heavily involved in all aspects of the conversion process. To meet market demand for the stock, the OTS often requires an institution to raise a level of capital significantly exceeding its operating needs. Many institutions find it difficult to employ this excess capital and decide to return it to shareholders.

Sec. 301(c) provides an ordering rule for any shareholder distribution made by a C corporation. All shareholder distributions must first be taxed as dividends to the extent of the corporation's current and accumulated E&P. Once E&P has been exhausted, further distributions are applied against, and reduce the basis of, the shareholders' stock. Distributions in excess of stock basis are treated as gain from the sale of property.

The second category of distributions, described in Sec. 301(c)(2), defines a return of capital as a distribution in excess of the distributing corporation's current and accumulated E&P. While shareholders are not taxed currently on such distributions, they must reduce the bases of their stock by the amount of these distributions.

Consolidated E&P Rules

The rules for determining E&P for a consolidated group are found in Regs. Sec. 1.1502-33. Specifically, Regs. Sec. 1.1502-33(b) requires that, in the case of a consolidated return, the E&P of a parent (P) is adjusted to reflect changes in the E&P of its subsidiary (S). Dividends paid by S to P do not increase P'S net E&P, provided the dividends are not sourced in E&P from S'S separate return years.

In addition, Regs. Sec. 1.1502-33(f) provides that in the &se of a "group structure change" S'S E&P will immediately tier up to and become part of P's E&P. For this purpose, a group structure change is defined as a change in the common parent under the principles of Regs. Sec. 1.1502-75(d)(2) or (3) (i.e., a mere change in the identity of the common parent or a reverse acquisition).

Example 1: S is a stand-alone mutual thrift association with $1,000 of accumulated E&P. At the beginning of the first year, S proceeds with a stock conversion plan that qualifies as an F reorganization. Under the conversion plan, S will convert from a mutual association to a stock company and all of its newly issued shares will be simultaneously purchased by P (a newly formed holding company) using a portion of the initial stock offering proceeds raised by P from its shareholders. S and P elect to file a consolidated return for the first year.

Based on the facts in Example 1, S's $1,000 accumulated E&P would immediately tier up to and become part of P's E&P under the group structure change rules. In addition, P's E&P would be adjusted for changes in S's E&P in the first year. Dividends paid by S to P would have no net effect on P'S E&P. Distributions by P to its shareholders in the first year would be taxed as ordinary dividends to the extent of P's current and accumulated E&P (i.e., $1,000 plus consolidated E&P generated in the first year).

If a consolidated return is not filed, Regs. Sec. 1.1502-33 would not apply and each corporation's E&P would be calculated on a separate basis. Consequently, S's E&P would not tier up to P as a result of the reorganization; P's E&P would not be adjusted to reflect changes in S'S E&P and dividends paid by S to P would increase P'S net E&P.

The Strategy

Opting not to file a consolidated return is the strategy for a return-of capital distribution in a mutual thrift stock conversion. By avoiding the consolidated E&P rules, the holding company will have no accumulated E&P and will calculate its E&P on a standalone basis going forward. Many holding companies will not generate an extensive amount of E&P on their own. Further, the holding company can minimize its E&P by having the thrift subsidiary refrain from paying dividends until after the close of the year in which the return-of-capital distribution is made.

Example 2: The facts are the same as in Example 1, except that P and S do not file a consolidated return until the second year. The absence of a consolidated return election dramatically changes the E&P calculations. Under these circumstances, the $1,000 of S's accumulated E&P would not tier up to P in the first year and P's E&P would not be adjusted for changes in S's E&P in the first year. Instead, P's E&P would be calculated on as fund-alone basis. As a new corporation, P has no accumulated E&P at the beginning of the first year. Any dividends paid by S to P during the first year would increase P's E&P for that year.

Shareholder distributions made by P during the first year would be taxed as dividends only to the extent of P's separate E&P for that year. However, if P generates very little E&P in the first year and receives no dividends from S, it will be well situated to make a return-of-capital distribution to shareholders (given that it holds a portion of the proceeds which it retained from the initial stock offering).

In the second year, when P and S proceed with a consolidated return election, E&P will be calculated on a consolidated basis. Thus, S's accumulated E&P will immediately tier up to, and become part of, P's E&P as of the beginning of the second year; P's E&P will be adjusted for changes in S's E&P during the second year. However, this will not affect the return-of-capital distribution return in the prior tax year.

To take advantage of this strategy, the converted organization must not be otherwise required to file a consolidated return. If practicable, the thrift should consider liquidating any subsidiaries prior to the beginning of the tax year in which the stock conversion takes place. This will terminate the consolidated group under Regs. Sec. 1.1502-75(d)(1), and eliminate any commitment on the part of the new common parent (i.e., the holding company) to file a consolidated return with the thrift restitution.

As previously noted, it is common for a holding company to retain a portion of the initial stock offering proceeds for its own use. While this is generally the source of the funds used to make the distribution, Letter Ruling 9821043 indicates that the funds can also be borrowed from an independent third party. Apparently, this is acceptable even though the funds to repay the borrowing will likely come from a distribution of the thrift's E&P in a year subsequent to the year of the return of capital. This treatment follows Milton Falkoff, 7th Cir., 8/30/79, rev'g TC Memo 1977-93, in which a corporation with no E&P was permitted to borrow against its assets to make a return-of-capital distribution, even though the borrowing was repaid with a large dividend from a subsidiary in the following year.

ESOP Issues

In conjunction with the mutual-to-stock conversion, many institutions establish an employee stock ownership plan (ESOP) for employees' benefit. The return-of-capital distribution can result in a significant payment to the ESOP if it owns a large number of the newly issued shares of holding company stock. However, this payment will not result in a tax deduction, because it is not a qualified employer contribution under Sec. 404.

Sec. 404(k) does allow a tax deduction for dividends on employer securities held by an ESOP if certain conditions are met. However, because a return-of-capital distribution does not meet the definition of a dividend under Sec. 316, it falls outside the scope of Sec. 404(k) and cannot be deducted. This conclusion is specifically stated in Letter Ruling 9736018, which indicates that the return-of-capital distribution will not be considered an annual addition for Sec. 415 purposes.

Conclusion

Over the past few years, the return-of-capital distribution has become a common component of mutual thrift stock conversions. Many of these converted institutions use these transactions as a means of reducing the newly raised capital to a manageable level without adversely affecting shareholders. By carefully planning a transaction before the conversion process begins, converting thrifts can preserve the opportunity to make a return-of-capital distribution if it becomes necessary to do so for capital management purposes.