IRS Issues Guidance on Disguised Corporate Sales

I n Chief Counsel Notice CC-2002-003, the Service advised Chief Counsel attorneys that when a parent disposes of a subsidiary in a merger and receives control of cash or liquid assets equal to the subsidiary's value, the transaction is a sale.

The typical transaction involves a parent that wants to dispose of a target subsidiary. The acquiring corporation forms a new subsidiary by contributing cash or liquid assets. The acquiring subsidiary forms a single-member limited liability company (SMLLC) by contributing cash or liquid assets equal to the target's value. The acquiring subsidiary uses a merger subsidiary to acquire the target's stock in a triangular merger. Following the merger, the acquiring subsidiary receives high-vote/low-value preferred stock in the target, giving it voting control over the target (but little of its value). The actual acquirer receives high-value/low-vote common stock in the target, and receives high-vote/low-value preferred stock in the acquiring subsidiary, giving it indirect voting control over the target. The parent ends up with managerial control of the SMLLC through an operating agreement and a nominal interest in the acquiring subsidiary in the form of high-value/low-vote common stock. The parent reports the transaction as either a tax-free reorganization or a Sec. 351 exchange.

According to the IRS, the transaction was a sale disguised as a reorganization or Sec. 351 exchange. The Service noted that, after the transaction, only a small portion of the acquiring subsidiary's assets consisted of its stock interests in the target, compared to the cash held by the SMLLC. In contrast, the actual acquirer held common equity interests in the target that approximated all of its value. Thus, in economic substance, the parent exchanged its interest in the target for an equivalent interest in the acquiring subsidiary, which held, through the SMLLC, mostly cash or liquid assets. Further, the parent, through the SMLLC's operating agreement, had complete autonomy to determine how to invest the SMLLC's cash. In the IRS's view, the parent effectively exchanged the target for cash, liquid assets or both (i.e., sold the target).

The Service also noted that the acquiring subsidiary's preferred stock in the target had such little value that value shifts in the target were unlikely to affect the value of the acquiring subsidiary's assets (and, thus, the parent's value). Under these circumstances, according to the IRS, the parent had an insufficient continuing interest in the target.

Further, the transaction did not qualify as a Sec. 351 exchange, because the acquiring subsidiary was an investment company under Sec. 351(e)(1). In reaching that conclusion, the IRS noted that more than 80% of the assets' value held by the acquiring subsidiary derived from cash, which, for Sec. 351(e) purposes, was treated as marketable stock and securities. Even if the SMLLC were not a disregarded entity for Federal income tax purposes, the acquiring subsidiary would still be an investment company, because its interest in the SMLLC would be treated as stock and securities of an entity substantially all of whose assets consisted of cash. Moreover, the IRS added, the transaction was not the type intended to be covered by Sec. 351, as it was a substantive sale.

Finally, the Service noted that the transaction implicated Sec. 269(a), because it was a carryover-basis transaction and the parent (who had no direct or indirect interest in the acquiring subsidiary before the transaction) acquired control of at least 50% of the acquiring subsidiary's stock. The IRS also stated that the term "allowance," which Regs. Sec. 1.269-1(a) defines as referring "to anything in the internal revenue laws which has the effect of diminishing tax liability," can apply to deny the nonrecognition treatment under Secs. 368 and 351.

In the Service's view, the principal, if not the sole, purpose for the parent's acquisition of the acquiring subsidiary was to evade or avoid Federal income tax, as evidenced by the complex and unnecessary transactions undertaken to effectuate the "sale." Accordingly, the IRS might impose penalties on participants in these transactions, or, as applicable, on persons who participate in their promotion or reporting.

From Nelson Crouch, Washington, DC