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Corporate separations under sec. 355.

Corporate separations are used by many corporations to accomplish various business objectives. Many distributions made as part of Sec. 368(a)(1)(D) (type "D") reorganizations remain tax-free despite new income recognition requirements for Sec. 355 distributions made after Oct. 9, 1990. (See Sec. 355(c), as amended by the Revenue Reconciliation Act of 1990 (RRA), and Sec. 355(d), as added by the RRA.) In addition to the income recognition pitfalls, a well thought-out approach is needed to avoid an unexpected allocation of earnings and profits (E&P). Regs. Sec. 1.312-10 prescribes rules for the allocation of E&P in Sec. 355 distributions (1) preceded by a D reorganization involving a newly created corporation and (2) involving a preexisting controlled corporation.

Sec. 355/D reorganization

Regs. Sec. 1.312-10(a) provides that, for a newly created controlled corporation, the allocation of E&P generally should be made in proportion to the fair market value (FMV) of the business (and interests in any other property) retained by the distributing corporation and the business (and interests in any other property) held by the controlled corporation immediately after the transaction. For this purpose, net FMV is used. In "a proper case," the allocation of E&P between the distributing corporation and the controlled corporation should be in proportion to "net basis" (basis of assets less liabilities assumed or taken subject to) or by another appropriate method (under the facts and circumstances). However, no part of the distributing corporation's deficit can be allocated to a controlled corporation (Regs. Sec. 1.312-10(c)).

Only one significant court decision has dealt with the allocation of E&P under Regs. Sec. 1.312-10(a). In Bennett, 427 F2d 1202 (Ct. Cl. 1970), the distributing corporation (D) contributed property, including real estate subject to a mortgage of $2 million taken out immediately before the transfer, to the controlled corporation (C) and distributed the C stock to the D shareholders. C had a net basis in property of 5% of the combined net basis in the total property of C and D. When measured by FMV, however, C's share of the combined property of both corporations was 20%.

Although the taxpayer advocated a net-basis allocation of E&P, the court adopted the IRS's position, allocating E&P based on relative FMV. The court reasoned that, absent "a proper case" being made by the taxpayer for the use of a different method, the relative FMV approach must prevail. Without elaboration, however, the court suggested that such an allocation could be made based on documentable evidence tracing the portion of D's E&P attributable to the assets transferred to C.

Allocation of E&P in a Sec. 355/D reorganization transaction based on the relative FMVs of the distributing and controlled corporations is a standard representation that the Service requires in private ruling requests. While this representation is not contained in the checklist of information that must be submitted with private ruling requests (Rev. Proc. 86-41, as amplified by Rev. Proc. 89-28), the FMV language is contained in Regs. Sec. 1.312-10, and the IRS will not issue a ruling for a Sec. 355/D transaction unless that representation is made. If a Sec. 355 ruling is not sought, taxpayers should consider whether they can establish "a proper case" for making E&P allocations on a net basis or a tracing approach (if that would enhance the economic value of the transaction).

Spinoff of existing controlled corporation

Regs. Sec. 1.312-10(b) provides for the allocation of E&P between the distributing corporation and the controlled corporation in Sec. 355 transactions not involving D reorganizations (e.g., the spinoff of an existing corporation). In these cases, the distributing corporation's E&P must be decreased by the lesser of

--the amount by which the distributing corporation's E&P would (in effect) have been decreased in a Sec. 355 distribution preceded by a D reorganization (i.e., relative FMVs), or --the "net worth" of the controlled corporation (cash plus tax basis of all other property, minus all liabilities). (Note: In this context, "all liabilities" can be interpreted to include economic liabilities that have not yet ripened for tax purposes (i.e., contingencies, reserves, etc.).)

If the controlled corporation's E&P immediately before the distribution is greater than the decrease in E&P made by the distributing corporation, the controlled corporation's E&P remains unchanged. If the controlled corporation's E&P immediately before the distribution is less than the decrease in E&P made by the distributing corporation (including the situation in which the controlled corporation has a deficit), the controlled corporation's E&P immediately after the transaction is equal to that decrease (i.e., it is increased as necessary). As noted, no part of a deficit of the distributing corporation is allocated to the controlled corporation. See the example on page 728.

Planning potential

In some situations the allocation of E&P in a Sec. 355 distribution can be planned through predistribution dividends or transfers of property that affect the determination of FMV, net tax basis and net worth, and thus the E&P of the distributing and the controlled corporation. Allocations of E&P can also have a significant impact in many other situations (e.g., consolidated groups that deconsolidate, subsidiaries with special issues of preferred stock, and recordkeeping and computation for state income tax purposes).
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Article Details
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Author:Haecker, Carol A.
Publication:The Tax Adviser
Date:Nov 1, 1991
Previous Article:Alternative disposition technique using sec. 338(h)(10).
Next Article:Qualified residence interest.

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