Recent statutes, regulations, cases, revenue rulings, notices, letter rulings and FSAs in the C corporation area.
Section 309 of the Community Tax Relief Act of 2000 enacted Sec. 358(h), effective for transactions after Oct. 18, 1999. Apparently designed to deny certain losses, Sec. 358(h) provides that if the basis of stock received in an exchange to which Sec. 358(a)(1) applies exceeds the fair market value (FMV) of such stock after the application of Sec. 358(d) (e.g., a Sec. 351 transfer of property to a corporation in exchange for its stock), the stock's basis in the transferor's hands is reduced (but not below FMV) by the liabilities assumed by the transferee corporation in the transaction. Sec. 358 (h) defines "liability" broadly to include not only fixed liabilities (already addressed by Sec. 358(d)), but also contingent obligations. (1)
Prior to Sec. 358(h)'s enactment, the Service had published guidance holding that contingent liabilities generally were not taken into account under Sec. 358(d). Rev. Rul. 95-74 (2) held that contingent liabilities (such as certain environmental remediation liabilities) were not liabilities for Sec. 358(d) purposes and, thus, did not reduce the basis of transferee stock received in a Sec. 351 transaction. In addition, the Service held that such liabilities generally could give rise to a deduction under either Sec. 162 or 263 on becoming fixed and determinable.
A transaction potentially affected by the new legislation involved a Sec. 351 transfer of a high-basis asset (i.e., a basis approximately equal to FMV) to a transferee corporation in exchange for its stock. The transferee corporation would assume a contingent liability (such as an environmental remediation liability that the transferor had not yet taken into account for Federal income tax purposes). The transferred asset's basis and FMV were generally only marginally greater than the assumed liability's present value; as a result, the transferee stock received had little value. However, under Rev. Rul. 95-74, the stock basis was not reduced by the contingent liability assumed by the transferee corporation under Sec. 358(d). Thus, the basis of the stock received in the transaction remained in excess of its FMV, generating a loss if the stock were sold.
Sec. 358(h), by contrast, would reduce the basis of the stock received by the transferor by the present value of the contingent liability assumed, effectively eliminating the loss on the subsequent stock sale. While Sec. 358(h) applies to transactions after Oct. 18, 1999, Notice 2001-17 (3) (discussed below) stated that the IRS may also attack transactions of this nature entered into before the Sec. 358(h) effective date on other grounds.
During the period covered by this article, noteworthy regulatory developments included the issuance of final regulations under Sec. 355(d) and a second set of proposed regulations under 355(e) that was ultimately made temporary (the first set of proposed regulations was withdrawn). In addition, final regulations were issued under Secs. 338 and 1060.
Sec. 355(d) Final Regs.
Sec. 355(d) final regulations were issued on distributions of controlled corporation stock or securities. (4) In general, Sec. 355(d) requires a distributing corporation to recognize gain on the distribution of a controlled corporation's stock or securities in a "disqualified distribution" (defined generally as any Sec. 355 distribution if, immediately after the distribution, any person holds a 50%-or-greater disqualified stock interest in the distributing or controlled corporation and such stock was acquired by purchase after Oct. 9, 1990 and during the five-year period ending on the distribution date).
Sec. 355(d)'s purpose is to prevent taxpayers from using Sec. 355's tax-free spinoff provisions either to dispose of subsidiaries in sale-like transactions or to obtain a FMV stepped-up basis in a subsidiary for future dispositions, without incurring a corporate-level tax. The final regulations carry out this objective, as follows:
* Regs. Sec. 1.355-6(b)(2)(iii) modifies the definition of "disqualified stock," providing that stock of a distributing or controlled corporation acquired by purchase within the five-year period ceases to be treated as acquired by purchase if the basis resulting from the purchase is eliminated.
* Regs. Sec. 1.355-6(b)(3)(i) provides that a distribution is not a disqualified distribution if it does not violate the "purposes" of Sec. 355(d). The purposes of Sec. 355(d) are not violated if the effect of the distribution does not (1) increase a disqualified person's ownership in the distributing or controlled corporation or (2) provide a disqualified person with a purchased basis in the stock of any controlled corporation.
* As to the definition of "purchase" Regs. Sec. 1.355-6(d)(2)(iv) provides that a qualified stock purchase (QSP) for which a Sec. 338 election is made is not treated as a stock purchase under Sec. 355(d)(5)(A). However, any stock held by the old target treated as purchased by the new target is deemed acquired by purchase under Sec. 355(d)(5)(A) (unless a Sec. 338 or 338(h)(10) election is made).
Sec. 355(e) Temp. Regs.
Preliminarily, if Sec. 355(d) applies to a transaction, Sec. 355(e) does not apply. If Sec. 355(d) does not apply, the focus quickly shifts to Sec. 355(e). Indeed, many a tax adviser has spent time fretting over the potential application of this fairly broad provision.
In general, Sec. 355(e) requires gain recognition on the distribution of stock of a controlled corporation if such distribution is part of a plan (or a series of related transactions) under which one or more persons acquire 50% or more of the stock of either the distributing or controlled corporation. On Aug. 24, 1999, the Service issued proposed regulations under Sec. 355(e), which, for the most part, provided exclusive rebuttals for establishing that transactions were not part of a prohibited plan. (5) Under those rules, taxpayers generally had to prove, through "clear and convincing evidence," that transactions were not part of a plan (or a series of related transactions). These proposed regulations were criticized and ultimately withdrawn.
New regulations were proposed on Jan. 2, 2001, and apply a facts-and-circumstances approach to determine whether a distribution is part of a plan. (6) These regulations were ultimately made temporary, effective for transactions after Aug. 2, 2001. (7) The temporary regulations set forth a nonexclusive list of factors indicative of the presence or absence of a plan and provide several safe harbors and examples.
Temp. Regs. Sec. 1.355-7T(b) provides that whether a distribution and a stock acquisition in the distributing or controlled corporation are part of a plan is a facts-and-circumstances inquiry; no one factor is determinative. In the case of a stock acquisition in the distributing or controlled corporation after a distribution, the temporary rules generally provide that the acquisition and distribution are deemed part of a Sec. 355(e) plan if the distributing or controlled corporation (or any of their respective controlling shareholders) intended, on the distribution date, that the acquisition (or a similar acquisition) occur in connection with the distribution.
In the reverse case (i.e., the stock acquisition precedes the distribution), the temporary regulations generally provide that the acquisition and distribution are deemed part of a plan if the distributing or controlled corporation (or any of their respective controlling shareholders) intended, on the acquisition date, that a distribution occur in connection with the acquisition.
A full analysis of the temporary regulations' plan and nonplan factors, and the safe harbors and examples, is beyond the scope of this article. However, the temporary regulations' operating rules shed some light on the Service's priorities. Temp. Regs. Sec. 1.355-7T(e)(1)(i) states that evidence of a business purpose to facilitate an acquisition of either the stock of the distributing or controlled corporation exists if there is a reasonable certainty that, within six months after the distribution, a stock acquisition would occur, an agreement, understanding or arrangement would exist or substantial negotiations would occur as to an acquisition. When an acquisition occurs before a distribution, Temp. Regs. Sec. 1355-7T(e)(1)(ii) asks whether, at the time of the acquisition, it was reasonably certain that within six months after the acquisition the distribution would occur, an agreement, understanding or arrangement would exist or substantial negotiations would occur as to the distribution.
While the temporary regulations draw no bright lines, their operating rules look to the period beginning six months before the distribution and ending six months after it. Of course, the Service could find that a distribution and acquisition occurring more than six months apart could be treated as occurring pursuant to a plan under Sec. 355(e). Still, in terms of the temporary regulations' apparent focus, six months would seem to be the targeted period. This is illustrated by the examples in Temp. Regs. Sec. 1.3557T(m)--all of which involve situations in which the acquisition and the distribution occur (or are substantially negotiated) within six months. Indeed, the examples generally link these acquisitions and the distributions, resulting in taxation under Sec. 355(e). (8)
On the other hand, Temp. Regs. Sec. 1.355-7T(m), Example 4, did not find a prohibited Sec. 355(e) plan in a distribution and acquisition occurring within six months. That example involves a 20% initial public offering (IPO) of a controlled corporation's stock in connection with a distribution; thus, the offering was clearly part of a Sec. 355(e) plan. Approximately five months after the distribution (in what was characterized as an unexpected opportunity), the controlled corporation acquired an unrelated company, X, in exchange for 40% of the controlled stock. The acquisition of X was found not to be related to the distribution because, as an "unexpected opportunity," it was not anticipated at the time of the distribution. Thus, the example demonstrates that a transaction may be unrelated to a distribution even if it occurs within six months of it, although establishing this lack of relationship would appear to be an uphill battle (based on the other examples). The authors understand that the Service is continuing to work on finalizing these regulations.
Secs. 338 and 1060 Final Regs.
In February 2001, final regulations were issued on purchase-price allocations in deemed asset sales for QSPs under Sec. 338 and actual asset acquisitions under Sec. 1060. (9) The final rules apply to QSPs and asset acquisitions occurring after March 16, 2001. With a few exceptions (some of which are highlighted below), the final regulations are identical to the temporary regulations issued in January 2000. (10) Some of the key changes to the Sec. 338 temporary regulations are as follows:
Anti-abuse rule: Regs. Sec. 1.338-1(c) narrows the scope of the anti-abuse rule, as compared to the temporary regulations, by increasing the threshold for its application. Specifically, the Service may treat any property (including cash) transferred by an old target in connection with a transaction (e.g., to a target subsidiary) and not held by the target at the close of the acquisition date, as target property at that time in applying the residual method at the target corporate level (a result assumed unintended by the parties to the transaction). (11) The rule would apply if the property so transferred is (within 24 months after the deemed asset sale) owned by the new target or owned (directly or indirectly) by a member of the affiliated group of which the new target is a member and continues after the acquisition date to be held or used primarily in connection with one or more of the new target's activities. A key change is that "primarily" is used in the final regulations to replace "to more than an insignificant extent." This change was intended to permit some continuing use of the property by the transferring target without triggering the anti-abuse rule. The word "primarily" was used in the final regulations to replace the phrase "to more than an insignificant extent." This change was intended to clarify that some continuing use in its original location of an asset transferred to or from the target is permitted.
In addition, the Service may treat property transferred to the old target in connection with the transaction (and, thus, held by the target at the close of the acquisition date) as not being target property at the close of the acquisition date for residual-method purposes. This rule would apply if the property so transferred is (within 24 months after the deemed asset sale) not owned by the new target, but owned (directly or indirectly) by a member of the affiliated group of which the new target is a member (or owned by the new target, but held or used primarily in connection with an activity conducted (directly or indirectly) by another member of the affiliated group of which the new target is a member).
Next-day rule: Regs. Sec. 1.338-1(d) prevents buyers from structuring transactions outside the ordinary course of business after acquiring target stock that might have to be reported by an unsuspecting seller. Normally, gains and losses (other than those resulting from a deemed asset sale) on the Sec. 338 acquisition date must be reported by the selling group on its return, which normally covers the entire day on which the acquisition occurs (under Regs. Sec. 1.1502-76(b)(ii)(A)). Regs. Sec. 1.338-1(d) provides that if a target for which an election under Sec. 338 is made engages in a transaction outside the ordinary course of business on the acquisition date but after the actual QSP, the target (and all related persons) must treat the transaction as occurring at the beginning of the following day.
QSP (insolvent target): The definition of"purchase" in a Sec. 338 transaction now conforms to Sec. 338(h)(3); under Regs. Sec. 1.338-3(b)(2), there is no longer a requirement that a buyer pay more than a nominal amount for a share of target (or target affiliate) stock.
Reorganizations after QSPs: Regs. Sec. 1.338-3(d)(4) states that, by virtue of Sec. 338, a QSP for consideration other than voting stock will not prevent a subsequent transfer of target assets from meeting the "solely for voting stock" requirement in testing whether the transfer qualifies as a C reorganization.
S corporations: Regs. Sec. 1.1361-1(1)(2)(v) (which refers to Sec. 338(h)(10)) provides that the payment of different amounts to S shareholders in a Sec. 338(h)(10) election will not violate the single-class-of-stock requirement (thereby avoiding challenge to the validity of an S election).
Sec. 301 Final Regs.
In general under Sec. 301(b)(2), a distribution is reduced by any liability assumed by the shareholder or any liability to which the distributed property is subject (regardless of whether the shareholder actually satisfied the liability). On Jan. 4, 2001, temporary regulations were issued under Sec. 301, providing that a distribution will be reduced by any liability treated as assumed by the shareholder under Sec. 357(d). Under Temp. Regs. Sec. 1.301-1T, only those liabilities for which a shareholder is actually liable are taken into account. These regulations were finalized in September 2001. (12)
During the period covered by this article, several important tax cases were decided, including one by the Supreme Court.
Rite Aid Corp.
In July 2001, the Federal Circuit invalidated a provision in Regs. Sec. 1.1502-20 that disallows loss recognition on subsidiary stock to the extent of the subsidiary's "duplicated losses" under Regs. Sec. 1.1502-20(c)(3). (13) The court's rationale was that the rule is not within the authority delegated by Congress under Sec. 1502, because duplicated losses do not arise from filing consolidated returns. The Court of Federal Claims had granted the government summary judgment, concluding that Regs. Sec. 1.1502-20 is not arbitrary, capricious or manifestly contrary to law. The government appealed; a rehearing was denied.
Rite Aid sought to take a loss on the sale of stock of a member of its consolidated group; the member also had a built-in loss in its assets. Generally under Regs. Sec. 1.1502-20, a loss on the sale or other disposition of stock of a consolidated-group member is disallowed to the extent of the sum of (1) extraordinary gains, (2) positive investment adjustments in excess of extraordinary gains and (3) duplicated losses. Duplicated losses generally equal the sum of the subsidiary's net operating losses (NOLs) and built-in losses in assets.
The Federal Circuit held that Sec. 1502 grants Treasury "the power to conform the applicable income tax law of the Code to the special, myriad problems resulting from the filing of consolidated income tax returns." (14) The opinion states that, in the absence of a problem created by the filing of a consolidated return, Treasury is not authorized to change the application of other Code provisions for corporations filing consolidated returns. The court found no such problem here. It reasoned that in a separate-return-filing situation, Sec. 165 would have allowed the deduction of a loss on the sale of subsidiary stock even when there is a duplicated loss factor in the subsidiary's assets. Therefore, by disallowing use of the loss on the stock sale, Regs. Sec. 1.1502-20 loss disallowance results in the imposition of income tax on a consolidated group that would not otherwise exist in a separate-company context. Thus, the court concluded that Regs. Sec. 1.1502-20 is contrary to statute and granted Rite Aid summary judgment.
United Dominion Industries, Inc.
United Dominion Industries, Inc. (15) dealt with product liability losses (PLLs) in a consolidated-return context; the Supreme Court held that the amount of a consolidated group's PLLs potentially available for 10-year carry-back is calculated on a consolidated (single-entity) basis, rather than a member-by-member (separate-company) basis. In so holding, the Court stated that there is no concept of a separate-company NOL in the consolidated-return context.
Frontier Chevrolet Co.
Frontier Chevrolet Co. (16) held that payments made under a covenant not-to-compete entered into with a stock redemption had to be amortized under Sec. 197. Although the statute is quite clear that noncompete covenants are covered by Sec. 197, the case is significant because it stands for the proposition that a stock redemption is an acquisition of a trade or business interest for Sec. 197 purposes. (17) An open question is the level of redemption sufficient to be treated as a trade or business acquisition.
A number of significant revenue rulings were issued.
Rev. Rul. 2001-24
In Rev. Rul. 2001-24, (18) the Service did not apply step-transaction principles to disqualify a transaction otherwise qualifying as a Sec. 368(a)(2)(D) forward subsidiary merger, simply because the parent, as part of the overall transactions, transferred the acquiring subsidiary's stock to another parent subsidiary. In the ruling, corporation X merged with and into S, a newly formed wholly owned subsidiary of P (unrelated to X) in a transaction intended to qualify as a Sec. 368(a)(2)(D) reorganization. Following the merger (and as part of an overall plan), P transferred all of the S stock to S1 (a pre-existing, wholly owned P subsidiary).
Under Sec. 368(a)(2)(C), a corporation can drop its acquired assets or acquired stock into a controlled corporation while still qualifying the transaction as an A, B or C reorganization. (19) However, because the S stock in the ruling was not "acquired" in the transaction, there was an issue as to whether specific authority existed for the drop of the S stock to S1. If the acquisition and the stock drop were stepped together, the transaction would fail to qualify as a Sec. 368(a)(2)(D) reorganization, because P would not control S immediately after the transaction. In light of the Sec. 368(a)(2)(E) legislative history, however (which suggests that Sec. 368 reorganizations generally should be treated similarly), the IRS concluded that the transaction would not be recast. Significantly, the Service stated that, by its terms, Sec. 368(a)(2)(C) is a permissive (rather than an exclusive or restrictive) section.
Rev. Rul. 2001-25
In Rev. Rul. 2001-25, (20) corporation P formed S (a wholly owned subsidiary); S merged with and into T (an unrelated corporation). In the merger, T shareholders holding 90% of the T stock exchanged their T stock for P voting stock; the remaining T shareholders received cash in exchange for their T stock. Immediately after the merger (and as part of the overall plan), T sold 50% of its operating assets to X (an unrelated corporation) for cash. T retained the sales proceeds following the sale. The ruling held that the merger qualified as a Sec. 368(a) (2) (E) reorganization, notwithstanding the asset sale.
The ruling held that the Sec. 368(a)(2)(E) "hold" requirement (i.e., that the corporation surviving the merger (T) hold substantially all of its properties and the properties of the merged corporation) did not impose any additional requirements on T (such as a C reorganization). That type of reorganization also has a "substantially all" requirement. Thus, Rev. Rul. 2001-25 relied on Rev. Rul. 88-48, (21) which held that in a C reorganization, under a "substitution-of-assets theory," a target could dispose of 50% of its assets, provided that the target (or its successor in the reorganization) retained the proceeds.
Rev. Rul. 2001-26
Rev. Rul. 2001-26 (22) presented two situations in which a portion of a target's stock was acquired in a tender offer; the remainder was acquired in a reverse subsidiary merger (using a mix of stock and cash). The ruling concludes in each case that the tender offer and the merger qualify as a Sec. 368(a)(2)(E) reorganization. The T stock acquired in the tender offer (in addition to that acquired in the merger) was treated as acquired in the transaction, meeting the statute's definitional requirements.
In Situation 1, P intended to acquire all of T's stock. P initially acquired 51% from T shareholders solely for P voting stock through a tender offer. P then formed S, a wholly owned subsidiary; S merged into T. In the merger, P's S stock was converted into T stock; the T shareholders holding the remaining 49% of the T stock exchanged their T stock for two-thirds P voting stock and one-third cash. The issue was whether the two steps of the transaction could be integrated to satisfy the Sec. 368(a)(2)(E) requirement that the T shareholders relinquish control (as defined in Sec. 368(c)) of T "in the transaction" in exchange for P voting stock. The issue arose because a portion of the T stock was received in the tender offer (as opposed to the merger).
Situation 2 was the same as Situation 1, except that S initiated the tender offer and acquired 51% of the T stock for P stock provided by P. Rev. Rul. 2001-26 concluded in both situations that the tender offer and merger were an integrated acquisition; further, the ruling held that the transactions satisfied Sec. 368(a)(2)(E), because P acquired a controlling interest in T (as defined under Sec. 368(c)) "in the transaction" for P voting stock.
Rev. Rul. 2001-29
A final noteworthy ruling was Rev. Rul. 2001-29, (23) which held that a real estate investment trust can be engaged in the active conduct of a trade or business for Sec. 355(b) purposes, solely by virtue of rental activity functions that produce income qualifying as real property rents for Sec. 856(d) purposes.
In the time period covered by this article, the Service issued two important notices, both designed to attack certain types of transactions that result in losses.
The substance of Notice 2001-17 (and the transaction it targets) is addressed earlier in this article under "Certain Stock" The key point is that the Service is putting taxpayers on notice that it intends to marshal its best arguments to attack transactions not subject to new Sec. 358(h).
Notice 2001-16 (24) targeted so-called "intermediary transactions" stating that they are tax shelters that must be registered. Such transactions generally involve a shareholder who desires to sell stock of a target that holds appreciated assets, an intermediary corporation (normally, either a tax-exempt entity or one with NOLs) and a buyer who desires to purchase the target's assets (but not its stock). The shareholder sells the target's stock to the intermediary; the target then sells some or all of its assets to the buyer. Thus, the seller receives capital gain on the stock sale and the buyer receives a basis step-up in the corporate assets without the imposition of a double tax. In addition, transactions that are the same as or similar to the one described in the notice are "listed transactions" under Temp. Regs. Secs. 1.6011-4T(b)(2) and 301.6111-2T(b)(2). Persons who have failed to register these shelters may be subject to Secs. 6707 and 6708 penalties.
Several important letter rulings were published in the Sec. 355 spinoff area.
Delay in IPO After a Spinoff
Letter Ruling 200103054, (25) a supplemental ruling, allowed a controlled corporation (Controlled) to delay its IPO following a spinoff. In prior rulings, a distributing corporation (Distributing) had represented that the principal business purpose for the spinoff was to facilitate Controlled's IPO (no other business purpose was identified) within a year. The spinoff was consummated, but the IPO was not. In Letter Ruling 200103054, Distributing stated that because of "unanticipated business difficulties and unexpected market adversity" and advice from investment bankers, the IPO likely would not be completed within the year. Distributing proposed a new deadline for IPO completion; the Service ruled that the delay would not adversely affect the prior rulings. (26) These types of letter rulings may become more important given the uncertainty in today's IPO marketplace.
Sec. 355 "Five Percent" Active Business Test
Letter Ruling 200121069 (27) allowed the gross value of Controlled's active business assets to fall below the five-percent threshold. (28) In a prior ruling, the Service ruled that Distributing could separate its two businesses in a tax-free reorganization under Secs. 355(a)(1) and 368(a)(1)(D). Distributing had previously represented that five percent of the gross value of Controlled's assets would be active-trade-or-business assets. However, after that ruling was issued, Controlled completed its IPO at a price substantially higher than the projected price and the FMV of its assets had fluctuated significantly. Given this volatility, Distributing stated that, even if the relative value of Controlled's active business assets fell below five percent, these assets would not be de minimis compared with Controlled's other assets and activities. The Service held that this would have no adverse effect on the prior ruling. Hopefully, given current unpredictable economic conditions, the Service will continue to be flexible in this and related areas.
Control Requirement in Sec. 368(a)(2)(H)(ii)
Letter Ruling 200113019 (29) illustrated the eased control requirement in Sec. 368(a)(2)(H)(ii). That provision states that, in the case of a transaction that meets Sec. 355, the fact that the distributing corporation's shareholders dispose of part or all of the distributed stock shall be disregarded. (30) In the ruling, to separate a nonregulated business from a regulated one and comply with a government mandate, Distributing contributed the nonregulated business to newly formed Controlled, then distributed all of the Controlled stock to its parent. Following the spinoff and as part of an overall plan, Controlled was merged into an existing subsidiary of the parent.
This section highlights recent FSAs.
In FSA 200120011, (31) the Service found that certain lease-in, lease-out (LILO) transactions lacked business purpose, economic substance and profit potential; thus, they were shams. In one transaction, a U.S. taxpayer had purchased property from a foreign government, then leased it back, depreciating the property and deducting interest on the financing. Alternatively, the Service argued that the transaction could be recharacterized as a financing transaction, so that the foreign entity would be treated as retaining true economic ownership of the property, preventing the taxpayer from claiming depreciation deductions. The FSA summarily rejected the taxpayer's appraisals.
Similarly, in FSA 200113016, (32) a taxpayer borrowed funds to lease property located in a foreign country. The property was then leased to a party that subleased it back to the original lessee. The Service concluded that, because the transaction lacked the "potential for any significant economic consequences, the LILO transaction lacked economic substance." The taxpayer's depreciation deductions were disallowed. Additionally, because the loans were such an integral part of the LILO transaction, the Service disallowed the interest deductions.
Basis Recovery Not Limited to Basis of Actual Shares Redeemed
An important FSA in the Sec. 304 redemption area related to the proper distribution rules applicable to a Sec. 304 transaction on an S corporation's acquisition of stock in a related C corporation. In FSA 200041009, (33) the Service held that while an S corporation's acquisition of stock in a related C corporation qualifies as a Sec. 304 redemption, the redemption is not a distribution under Sec. 301, but rather a distribution under Sec. 1368, because the redeeming corporation is an S corporation under Sec. 304. The Service did not determine whether the shareholders had to include any amount in income, as it planned to issued further guidance on the application of Sec. 1368(b)(2) (S corporation distribution in excess of basis) in a transaction to which Sec. 304(a) applies.
Later that year, in FSA 200110004, (34) the Service concluded that Sec. 304, as amended by the TRA '97, does not limit a shareholder's basis recovery to the basis of the shares actually redeemed. At issue was the effect of amended language in Sec. 304(a)(1) and whether it evidenced congressional intent to limit a shareholder's basis recovery (specifically, whether the language intended to substitute a segregated-basis rule in place of the "spillover rule" in Regs. Sec. 1.1367-1(c)(3)). The Service concluded that the spillover rule (as described below) applies; the basis to be reduced under Sec. 1368 is the shareholder's entire basis in the S stock.
The FSA outlined the appropriate ordering to be applied to a Sec. 304 transaction involving an acquiring S corporation. The Service stated that, under Sec. 1368(c), the selling shareholders in the Sec. 304 transaction first apply the distribution against their basis in the hypothetical S stock and then against their remaining basis in all other S shares they own. Any excess, to the extent of remaining accumulated adjustments account (AAA), is treated as gain. Any distribution exceeding the AAA is treated as a dividend to the extent of the acquiring S corporation's and the target C corporation's earnings and profits. Any remaining distribution qualifies' for Sec. 1368(b) treatment (i.e., return of capital to the extent of any remaining S stock basis, then gain).
The FSA did not directly address the Sec. 304 flush language, which provides, "[t]o the extent that such distribution is treated as a distribution to which Sec. 301 applies ..." (Emphasis added.) It appears that the Service believes Sec. 1368 steps in at this point and partially overrides the Sec. 304 language as to Sec. 301. Nevertheless, the FSA did incorporate Sec. 304(b)(2)(A) and (B) into the Sec. 1368 ordering rules.
* In the tax-free spinoff area, final regulations were issued under Sec. 355(d) and temporary regulations were issued under Sec. 355(e).
* Final regulations were issued under Secs. 338 (deemed asset sales) and 1060 (actual asset sales).
* Several important tax cases were decided, including one by the Supreme Court.
Editor's note: Mr. Schneider chairs the AICPA Tax Division's Corporations & Shareholders Taxation Technical Resource Panel.
Authors' note: The authors would like to thank their colleague, Stephen R. Wegener, for his very helpful comments and insight.
(1) An exception applies if the transfer involves either (1) the trade or business with which the liability is associated or (2) substantially all the assets with which the liability is associated.
(2) Rev. Rul. 95-74, 1995-2 CB 36.
(3) Notice 2001-17, IRB 2001-9, 730.
(4) Regs. Sec. 1.355-6 (TD 8913, 12/19/00); see Ann. 2001-26, IRB 2001-11, 896 (correcting TD 8913).
(5) REG-116733-98 (8/24/99).
(6) REG-107566-00 (1/2/01).
(7) TD 8960 (7/26/01); Prop. Regs. Sec. 1.355-7 was adopted as Temp. Regs. Sec. 1.355-7T.
(8) The temporary regulations delete and reserve a seventh example contained in the second set of proposed regulations. That example, which was not well received in comment letters, had treated as part of one plan under Sec. 355(e) a distribution and an acquisition that occurred approximately 18 months apart.
(9) TD 8940 (2/13/01).
(10) TD 8858 (1/5/00).
(11) The precise mechanics of the residual method are beyond the scope of this article; see Regs. Sec. 1.338-6. Under that provision, amounts generally are allocated among seven classes; the full FMV of assets in a particular class is allocated to that class before any allocation is made to the next asset class. If the amount allocable to a class is less than the FMV of all assets in the class, the amount allocable to the class is to be allocated among the various assets in the class in proportion to their relative FMVs.
(12) TD 8964 (9/26/01).
(13) Rite Aid Corp., 255 F3d 1357 (2001), rev'g 46 Fed. Cl. 500 (2000).
(14) Citing Am. Standard, Inc., 602 F2d 256, 261 (Ct. Cl. 1979).
(15) United Dominion Industries, Inc., 121 S.Ct. 1934 (2001), rev'g and remd'g 259 F3d 193 (4th Cir. 2000).
(16) Frontier Chevrolet Co., 116 TC No. 23 (2001).
(17) Compare Burien Nissan, Inc., TC Memo 2001-116, in which the Tax Court concluded that amounts paid under a noncompete covenant in a stock sale had to be amortized under Sec. 197.
(18) Rev. Rul. 2001-24, IRB 2001-22, 1290.
(19) See Regs. Sec. 1.368-2(k) (drops of target stock following a Sec. 368(a)(2)(E) reorganization).
(20) Rev. Rul. 2001-25, IRB 2001-22, 1291.
(21) Rev. Rul. 88-48, 1988-1 CB 117, concluded that the "substantially all" requirement was met in a C reorganization when the target sold 50% of its historic assets and transferred the sales proceeds and its other properties to the acquiring corporation.
(22) Rev. Rul. 2001-26, IRB 2001-23, 1297.
(23) Rev. Rul. 2001-29, IRB 2001-26, 1348, obsolet'g Rev. Rul. 73-236, 1973-1 CB 183 (holding that a real estate investment trust could not be engaged in an active business).
(24) Notice 2001-16, IRB 2001-9, 730.
(25) IRS Letter Ruling 200103054 (10/23/00), supplementing IRS Letter Rulings 9950032 (9/13/99) and 200030007 (4/24/00).
(26) See also IRS Letter Ruling 200119048 (2/12/01) (the Service ruled that a delay in both the distribution and the public offering would not affect its earlier rulings that a spinoff would be tax-free under Secs. 355 and 368(a)(1)(D)).
(27) IRS Letter Ruling 200121069 (2/28/01), supplementing IRS Letter Ruling 200043044 (8/1/00).
(28) Under Rev. Proc. 96-43, 1996-2 CB 330, the Service generally will decline to rule that a taxpayer has satisfied the Sec. 355(b) active-trade-or-business requirement unless the gross assets of the distributing and controlled corporations, respectively, relied on to meet such requirement have an FMV at least five percent of the total FMV of the respective corporation's gross assets.
(29) IRS Letter Ruling 200113019 (12/27/00).
(30) The changes to the statute were made by the Taxpayer Relief Act of 1997 (TRA '97) and the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRKA '98). Prior to that time, the step-transaction doctrine applied to transactions in which assets were contributed to Controlled, and Controlled was spun off, then acquired. For example, Rev. Rul. 70-225, 1970-1 CB 80, provided that the contribution of assets by a distributing corporation to a newly formed corporation (Newco), a spinoff of Newco to the distributing corporation shareholders, and a third party's acquisition of Newco in a purported B reorganization would not be respected. Instead, the transaction would be recharacterized as a transfer of the assets by the distributing corporation directly to the unrelated corporation in exchange for its stock, followed by a distribution of the unrelated corporation's stock to the distributing corporation's shareholders in a transaction that did not qualify for tax-free treatment under Sec. 355. Thus, Newco was disregarded. Reflecting the changes made by the TRA '97 and the IRSR-RA '98, Rev. Rul. 98-44, 1998-2 CB 315, obsoleted Rev. Rul. 70-225, thereby permitting a newly formed controlled corporation to engage in the types of transactions described in Rev. Rul. 70-225.
(31) FSA 200120011 (2/7/01).
(32) FSA 200113016 (3/30/01).
(33) FSA 200041009 (6/30/00). In the ruling, two shareholders directly or indirectly owned more than 50% of the S stock and directly owned all of the C stock. They sold their C stock to the S corporation. The Service concluded that, because the shareholders controlled both corporations, their sale of the C stock should be treated as a Sec. 304 redemption of the S stock. Additionally, because the shareholders continued to control the S corporation after the transaction, the redemption did not qualify as a Sec. 302 sale or exchange.
(34) FSA 200110004 (11/14/00).
Mark A. Schneider, J.D., LL.M. Partner Office of Federal Tax Services Arthur Andersen LLP Washington, DC
Indu Magoon, J.D., CPA Manager Office of Federal Tax Services Arthur Andersen LLP Washington, DC
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|Title Annotation:||IRS Field Service Advice|
|Publication:||The Tax Adviser|
|Date:||Jan 1, 2002|
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