Demise of Morris Trust transactions yields new planning opportunities.
Even though businesses split up all of the time, they have spawned some extraordinarily complex regulations. On many occasions, the owners of a company that operates more than one business decide to split their operations and have the business operate as two separate entities. This is often done to defuse internal business conflicts, allowing feuding owners to split and take with them the assets necessary to run their respective portions of the company.
Normally, the disposition of assets to another company is a recognition event for the disposing company. However, Sec. 355 allows the historical owners of a company to divide the company's assets (via a divisive reorganization) without recognizing gain when the owners intend to continue using the assets in the conduct of separate businesses. The nonrecognition of gain represents an understanding by Congress that a divisive reorganization is similar to its Sec. 368 cousins, in which owners merely shift ownership of (but do not dispose of) assets. In a typical Sec. 355 transaction, some of the assets and liabilities of a corporation (Distributing) are transferred to a newly formed subsidiary (Controlled) in exchange for stock in a transaction that qualifies under Sec. 351 or 368(a)(1)(D). All of the stock in Controlled is then distributed to one or more of Distributing's shareholders. This distribution of stock can also occur tax-free with a pre-existing subsidiary, as long as there is no disqualifying distribution (as defined by Sec. 355(d)(2)).
Sec. 355 will apply as long as at least 80% of the voting power and at least 80% of the total number of all other shares in Controlled are transferred upward. There are certain other requirements for nonrecognition, including an active business requirement, a business purpose requirement and a prohibition against devices that disguise the transaction as a distribution of earnings and profits to shareholders. Until now, the most important implication of this last requirement was a removal of nonrecognition treatment if the distribution of assets was done as part of a taxable plan of reorganization. If there' was a reorganization involving either Distributing or Controlled within two years of a Sec. 355 distribution, this distribution of assets upward was viewed as an attempt to pay out a dividend (in the form of assets) to the parent's shareholders before the sale of Distributing was consummated. If there was a plan to sell either Distributing or Controlled in a taxable transaction, Sec. 355 did not apply and gain would be recognized.
However, in what came to be known as a "Morris Trust transaction," the Service did not require gain recognition if either Distributing or Controlled were subsequently acquired in a tax-free transaction. If Controlled was created merely to effect a tax-free disposition and was acquired pursuant to a prearranged plan, Sec. 355 would not apply to the distribution and gain would be recognized. For the most part, however, if there was no plan for a subsequent nonrecognition transaction at the time of the distribution, and Controlled was not created merely to accomplish the distribution, Sec. 355 would apply to the distribution even if Controlled was merged out of existence. If Controlled was created for purposes of the transaction, the distribution of its stock was tax-free when Distributing was instead acquired in a tax-free reorganization. If these requirements were met, the assets could be passed to the shareholders prior to a nontaxable acquisition of the parent, with a significant deferral of gain by those shareholders.
New Sec. 355(e)
Congress originally intended Sec. 355 to permit the tax-free separation of existing businesses by the historical owners, not to provide the means for assets to be divided and transferred to new owners. There was also a disparity in treatment depending on whether Distributing or Controlled was acquired.
For these reasons, Sec. 355(e) was added as part of the Taxpayer Relief Act of 1997. If either Distributing or Controlled is acquired in a plan that existed at the time of a Sec. 355 distribution, Distributing recognizes gain on the distribution of Controlled shares, regardless of which entity is acquired. The gain to be recognized, which is treated as long-term capital gain, equals the fair market value (FMV) of the Controlled stock immediately before the transfer, less Distributing's basis in the stock. No adjustment to the basis of the stock or assets by either company is allowed, nor will Sec. 355(e) affect the tax treatment of shareholders who receive a distribution in a divisive reorganization.
Sec. 355(e) win apply if more than 50% of the voting Power or value of either Distributing or Controlled is acquired by one or more persons as the result of a plan or series of related transactions. There is a rebuttable presumption that acquisitions occurring during the four-year window that starts two years prior to the distribution are part of a plan in place at the time of the distribution. However, if Distributing and Controlled are both members of the same affiliated group after the transaction, Sec. 355(e) will not apply. Additionally, if the same person owns more than 50% of both Distributing and Controlled after the disposition, Distributing is not required to recognize gain.
Because the recognition of gain is related to the assets transferred to Controlled, significant tax savings can be achieved if the correct assets are distributed. If a corporation distributes nonappreciated assets and keeps its appreciated assets, either Distributing or Controlled can be acquired without gain recognition. For example, if Distributing maintains two businesses, one of which owns appreciated assets and one of which does not, and Distributing has been approached by a third party that wishes to acquire only the business with the appreciated assets, Sec. 355(e) can be used to limit gain recognition.
The nonappreciated assets should first be transferred to a subsidiary (Controlled) in a Sec. 351 transaction, and shares in Controlled should then be distributed to Distributing's shareholders in a Sec. 355 transaction. When Distributing is then acquired by the third Party in a tax-free reorganization, it will not be required to recognize gain; there would be no difference between the FMV of the assets Distributing transferred to Controlled and Distributing's basis in those assets. If Controlled is acquired in a tax-free reorganization, Distributing will still not be required to recognize gain, as the FMV of the Controlled stock will equal Distributing's basis in the stock.
Caution should be taken by those contemplating a divisive acquisition in two specific instances. The first is a tax-free acquisition that occurs outside the four-year window specified in Sec. 355(e); this is not a four-year safe harbor, and should not be treated as such. If a plan exists at the time of the distribution in which a distribution is to be followed by the acquisition of Distributing or Controlled, it is irrelevant when the acquisition takes place. The second situation is a distribution followed by an initial public offering (IPO). Because Sec. 355 is phrased in such a way that the parties acquiring the stock in Distributing or Controlled are aggregated together to determine if more than 50% of the value or voting power of either company has been acquired, if there is an IPO contemplated after a distribution covered by Sec. 355 and more than 50% of value or voting power will be sold, Sec. 355(e) will be triggered and the distribution will become taxable.
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|Author:||Guida, Thomas A.|
|Publication:||The Tax Adviser|
|Date:||May 1, 1998|
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