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Letter rulings flirt with limits of liquidation-reincorporation doctrine.

Several recent letter rulings raise questions on the application of the liquidation-reincorporation (LR) doctrine to an upstream combination when a corporation owns 80% or more of the liquidating corporation's vote and value. Although these rulings are taxpayer-favorable, the IRS's rationale is often obscured or ill-defined, much to practitioners' frustration.


The LR doctrine is a subset of the judicial tax law canons of substance-over-form and step-transaction. Typically, it applies to a transaction in which a corporation (T) liquidates and its shareholders reincorporate some or all of T'S assets in a new or existing corporation controlled by such shareholders (the LR transaction). The LR doctrine disregards the independent tax consequences of each step in the LR transaction and, instead, generally recasts the LR transaction as follows: (1) a Sec. 368(a) reorganization of T into new T (see Regs. Sec. 1.331-1(c); cf. Atlas Tool Co., 70 TC 86 (1978), aff'd, 614 F2d 860 (3d Cir. 1980)); or (2) a transaction in which T fails to completely liquidate and new T becomes T's alter ego; see Telephone Answering Service Co., Inc., (TASCO), 63 TC 423 (1974), aff'd, 546 F2d 423 (4th Cir. 1976), cert. den.

The LR doctrine was developed to deny taxpayers certain benefits (i.e., bailing out T's earnings and profits (E&P) at capital gain rates or obtaining a tax-free stepped-up basis in T's operating assets (before the Tax Reform Act of 1986)) that could arise if the separate steps were respected. The taxpayer-favorable effects of an LR transaction are significantly lessened if the shareholder is a corporation and the liquidation, if respected, qualifies under Sec. 332. Nevertheless, the LR doctrine may still apply in this context (see, e.g., American Mfg. Co., 55 TC 204 (1970)) and can impose a taxpayer-unfavorable result.

Example: Corporation P owns all the stock of corporation T. T has business assets with a $50 value and zero basis, an appreciated nonbusiness (NB) asset with a $50 value and $5 basis, and E&P. To restructure business operations, T distributes all its assets to P in complete liquidation; P retains the NB asset and contributes all T's business assets to newly created, new T.

The tax policy implications of applying the LR doctrine to a Sec. 332 liquidation are the location and timing of gain on the NB asset, the reformation of T's stock basis and the separation of E&P from the business that generated such earnings. If the transaction steps are respected, neither P nor T will recognize gain or loss under Secs. 332 and 337, respectively; P will hold the NB asset with a $5 basis under Sec. 334(b)(1); P's basis in newt will reflect the net basis of T's assets under Sec. 358; and T'S E&P (and other attributes) will have shifted from T to P under Sec. 381. However, if the LR doctrine imposes the Sec. 368(a) recast (i.e., a cross-chain D reorganization) or the TASCO recast (a distribution by T's alter ego), then T or the alter ego should recognize gain on the distribution of the NB asset. P'S basis in new T or the alter ego will remain unchanged (adjusted for certain distributions) and T's E&P (reduced by the distribution) will remain with the business assets in T or the alter ego.

Rev. Rul. 69-617 ameliorates this result by not applying the LR doctrine to a parent-subsidiary liquidation if the upstream transaction can also qualify as a reorganization. In that ruling, P owned more than 80% of the stock of T; the public owned the remainder. T merged into P under applicable state law; the public shareholders received P stock and contributed all the T assets to new T. The IRS did not apply the LR doctrine. Instead, it respected the mechanics of the upstream transaction as an A reorganization, followed by a contribution of the assets to new T under Sec. 368(a)(2)(C).

The Service did not address whether Rev. Rul. 69-617 would apply if P owned all of the T stock. Also, it is not entirely clear whether the analysis could encompass an upstream C reorganization, in light of the recent publication of the "anti-Bausch & Lomb" regulations at Regs. Sec. 1.368-2(d)(4) (providing that T stock owned by the acquirer (P in an upstream transaction) will not prevent satisfaction of the Sec. 368(a)(1)(C) solely-for-voting-stock requirement).

The application of the LR doctrine to an upstream C reorganization would be significant because, if an upstream combination of wholly owned T into P can constitute a C reorganization, many (if not most) liquidations of T into P would be excepted from the LR doctrine. This uncertainty is further complicated by the historical ambiguity as to whether Sec. 332 takes precedence over the Sec. 368 reorganization provisions, as to P, if the two overlap; see Regs. Sec. 1.332-2(d) (permitting Sec. 332 treatment to P and potential reorganization treatment to minority shareholders) and Kansas Sand & Concrete, Inc., 56 TC 522 (1971), aff'd, 462 F2d 805 (10th Cir. 1972) (interpreting Regs. Sec. 1.332-2(d) to mean that Sec. 332 takes precedence over Sec. 368); but see Rogan v. Starr Piano Co., Pacific Div., 139 F2d 671 (9th Cir. 1943) (state law merger of wholly owned T into P qualified as an A reorganization).

The IRS will not ordinarily issue advance rulings on transactions that involve the LR issue; see Rev. Proc. 2003-3, Section 4.01(23). Nevertheless, in the three recent rulings discussed below, the Service concluded that the LR doctrine will not apply to a wholly owned T. Unfortunately, in two of the rulings, it did not enunciate a clear principle for this conclusion.

Letter Ruling 200028027. P acquired "a percent" (that under the facts of the ruling appears to be 100%) of T stock for cash. T liquidated into P and P reincorporated a "not insignificant amount" of the T assets into one or more of P's subsidiaries. The IRS ruled--without any analysis or citations--that T's transfer of the assets to P was nontaxable.

Significantly, the Service did not apply the LR doctrine, but did not explain its rationale. Did the upstream transaction constitute a C reorganization to which Rev. Rul. 69-617 applied? Did the IRS not apply the LR doctrine became the upstream transaction constituted a liquidation? Or because tax-free recharacterizations (i.e., a cross-chain D reorganization or alter ego) were not applicable, because P may have sprinkled T's assets among several subsidiaries? (This rationale is debatable, became the facts would permit a transaction in which all the T assets are reincorporated into a single new T. (T assets will be reincorporated in "one or more" subsidiaries.)) (Emphasis added.) Perhaps the ambiguity is a matter of timing: the letter ruling was issued when a proposed regulation would have prevented the anti-Bausch & Lomb rule from applying to wholly owned subsidiaries. The final regulations later deleted this provision.

Letter Ruling 200250024. P owned all of the stock of three subsidiaries, S1, S2 and S3 (collectively, S1-S3). S1-S3 together owned all of the stock of S4. To facilitate a new business model and realign the management structure, (1) S1, S2 and S3 each merged into P; (2) P transferred "almost all" of the former S1-S3 operating assets (contributions) to three newly formed corporations, new S1, new S2 and new S3 (transferees); and (3) S4 merged upstream into P in a statutory merger.

The ruling does not indicate the specific transferee to which the former S1, S2 and S3 assets were contributed. Thus, it is not known whether S1's operating assets transferred in the contribution were transferred solely to new S1 or sprinkled among the transferees. Letter Ruling 200250024 concludes that the upstream mergers of S1, S2 and S3 into P, respectively, each qualified as an A reorganization; P's reincorporation of the former S1-S3 operating assets in the contributions was nontaxable under Sec. 351(a); and the S4 merger into P was a nontaxable, Sec. 332 complete liquidation. Although Letter Ruling 200250024 does not cite Rev. Rul. 69-617, by characterizing the upstream transaction as a reorganization, it clearly is extending that ruling's principles to the situation in which P owns all the T stock.

Letter Ruling 200310005. A domestic corporation (Distributing) engaged in a complex restructuring. A subsidiary of distributing (Sub 7) owned trademarks; more than 80% of their value was used in a to-be-retained business (wanted trademarks); the remaining trademarks were used in an unwanted business (unwanted trademarks). In relevant part: (1) Sub 7 merged into Distributing under applicable state law; (2) Distributing contributed the wanted trademarks to Sub 8, a newly created subsidiary; (3) Distributing contributed the unwanted trademarks (as well as other significant business assets) to Controlled, a newly created subsidiary; and (4) Distributing distributed Controlled stock to its shareholders.

In Letter Ruling 200310005, the Service did not apply the LR doctrine to recharacterize the Sub 7's LR as a reorganization into Sub 8 or treat Sub 8 as Sub 7's alter ego. Instead, it concluded that the merger of Sub 7 into Distributing would be a tax-free transaction. Unfortunately, the IRS eschewed the certainty of Letter Ruling 200250024 and backslid into the ambiguity of Letter Ruling 200028027, by failing to indicate whether the merger would be respected as a liquidation or viewed as an upstream reorganization via Rev. Rul. 69-617. Further adding to the confusion, Letter Ruling 200310005 included Secs. 368 and 332 representations.


Under Sec. 6110(k) (3), letter rulings are not precedential authority; however, they sometimes provide useful insight into the IRS's analysis of, and approach to, Federal tax issues. In this regard, Letter Rulings 200028027, 200250024 and 200310005 show that the Service appears to be flirting with the concept that the LR doctrine will not apply to an upstream combination of a wholly owned T into P.

Unfortunately, these rulings also indicate that the IRS has not developed a consistent approach. Rather than tease taxpayers with ambiguously reasoned rulings, the Service should issue guidance that decisively addresses applying the LR doctrine to upstream combinations that also qualify as A or C reorganizations.



David Madden, J.D., LL.M.


Washington National Tax Service


Washington, DC
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Author:Madden, David
Publication:The Tax Adviser
Date:Jun 1, 2003
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