A step up from Sec. 355?
Example: Distributing corporation D has two equal shareholders, A and B. D has two active five-year business divisions, X and Y. B runs Y while A runs X. Because of disputes between A and B, it is decided to split off X to A. Accordingly, the following steps will be undertaken: 1. D will form a controlled corporation, C, as its wholly owned subsidiary, by transferring to it all of the assets of X in exchange for all of C's stock. 2. Simultaneously with step 1, A will enter into a binding legal commitment to sell 21% of C's stock to any unrelated individual or corporation (the "Buyer") for fair market value (FMV). 3. D distributes all of the stock of C to A in exchange for all of his D stock. 4. A sells the 21% of C to Buyer.
From a tax perspective, C's formation followed by the distribution of all of its stock looks like a tax-free formation under Sec. 368(a)(1)(D) or 351 and a tax-free distribution under Sec. 355. However, because A has a binding legal commitment to dispose of 21% of C, the control "immediately after" requirement is not satisfied. (See American Bantam Car Co., 11 TC 397 (1948), aff'd, 177 F2d 513 (3rd Cir. 1949), and Rev. Rul. 79-194.) Thus there is a "busted" transaction, resulting in C being treated as having purchased the assets of X for its FMV in a taxable transaction. C will have a cost basis in the X assets and D will have taxable gain on C's formation. For purposes of Sec. 355, the fact that C acquired its active business (X) within the past five years in a taxable transaction should not adversely affect the active trade or business test of Sec. 355(b). Taxable transactions occurring within the affiliated group should not result in a corporation failing the active trade or business test. See Baan, 45 TC 71 (1965), and Rev. Ruls. 69-461 and 78-442; but consider Regs. Sec. 1.355-3(b)(4)(iii) and (iv) and (b)(5).
It is unlikely that the IRS could successfully argue that D only distributed 79% of C to A. D played no part in the negotiation with or sale to Buyer. Consequently, for purposes of Sec. 355(a)(1)(d), D should be treated as distributing control of C.
D will also have cost basis in its C stock. Consequently, no gain will be recognized to D on its distribution of C stock to A in exchange for his D stock (Sec. 31 (1)(b)). A will have a basis in C equal to the basis of his D stock surrendered in exchange. Since A has a carry over basis, he will recognize gain and thus pay tax on the sale of the 21% to Buyer.
From a technical standpoint, this transaction under the current regulation and case law delivers the above tax results. Yet to be issued regulations under Sec. 337(d) may cover transactions such as this because they avoid the General Utilities repeal. Until that time, the "step-up" Sec. 355 can be undertaken and returns signed without disclosure.
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|Author:||Haran, Robert B.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1993|
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