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Significant Recent Developments This article examines significant recent C corporation and consolidated return developments, including the Sarbanes-Oxley Act of 2002, temporary regulations on loss disallowance, Sec. 355(e) and conversions to regulated investment companies or real estate investment trusts. It also examines significant rulings on divisive and acquisitive reorganizations.
Mark A. Schneider, J.D., LL.M.
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, Diane Clifton, CPA, for her very helpful comments and insight. For more information about this article, contact Mr. Schneider at MSchneider@bdo.com.
Executive Summary
This article summarizes significant recent developments in the C corporation and consolidated return area. Specifically, it addresses (1) the Sarbanes-Oxley Act of 2002 (SOA), (2) temporary regulations on loss disallowance, Sec. 355(e) and conversions of C corporations into regulated investment companies (RICs) or real estate investment trusts (REITs), (3) revenue rulings covering divisive and acquisitive reorganizations and (4) a letter ruling applying the principles of the proposed regulations on statutory mergers into disregarded entities.
Legislation SOA The SOA,1 signed into law by President Bush on July 30, 2002, focuses primarily on auditors and corporate officers responsible for financial reporting. It also contains certain tax provisions. Notably, Section 201 requires that a CPA firm that is auditing a public corporation to secure permission from the corporation’s audit committee (or board of directors, if the company is not required to have an audit committee) as a condition of engaging in any non-audit tax work. In addition, Section 1001 provides that in “the sense” of the Senate, corporate Federal income tax returns (not just those of public corporations) “should” be signed by the corporation’s chief executive officer. This somewhat curious provision has been interpreted as a nonbinding suggestion.
Temp. Regs. Loss Disallowance Temp. Regs. Secs. 1.337(d)-2T and 1.1502-20T(i) were added2 to amend the loss disallowance rule (applicable to the sale of subsidiary stock by consolidated groups) in response to the Rite Aid Corp.3 decision, which invalidated the "duplicated loss" rule in Regs. Sec. 1.1502-20.4 In general, Temp. Regs. Sec. 1.337(d)-2T uses a "tracing" approach in determining whether a stock loss is disallowed. A stock loss is allowed to the extent the taxpayer establishes that the loss is not attributable to the recognition of built-in gain (BIG) on an asset’s disposition. Thus, the rule looks to whether the loss is attributable to a positive basis adjustment caused by the disposition of a BIG asset. Temp. Regs. Sec. 1.1502-20T(i) provides transition rules and an election to apply Temp. Regs. Sec. 1.337(d)-2T retroactively.
Sec. 355(e) Sec. 355(e) generally requires a distributing corporation (Distributing) to recognize gain (if any) on a distribution of a controlled corporation’s (Controlled’s) stock that would otherwise meet Sec. 355 tax-free requirements if the distribution were part of a plan (or series of related transactions) under which one or more persons acquire at least 50% of either Distributing’s or Controlled’s stock (a Sec. 355(e) plan). It contains a rebuttable presumption that any acquisition beginning two years before the distribution and ending two years thereafter is part of a Sec. 355(e) plan. On April 23, 2002, Treasury significantly revised temporary regulations in this area.5 These regulations use a facts-and-circumstances approach in determining whether there is a Sec. 355(e) plan. In general, they categorize factors as either Plan or Nonplan factors; a practitioner must weigh the relative importance of such factors in determining whether there is a Sec. 355(e) plan. Inevitably, this analysis is subjective. In contrast, the temporary regulations also provide objective safe harbors; if a transaction falls within a safe harbor, it is not subject to Sec. 355(e). Plan factors: Temp. Regs. Sec. 1.355-7T(b)(3) sets forth Plan factors that suggest the existence of a Sec. 355(e) plan. The first set of Plan factors involves an acquisition of the stock of Distributing or Controlled (other than in a public offering) before or after a Sec. 355 distribution. For an acquisition before, Temp. Regs. Sec. 1.355-7T(b)(3)(iii) looks to whether Distributing or Controlled discussed the distribution with the acquirer at some time during the two-year period ending on the stock acquisition date. For an acquisition after a Sec. 355 distribution, Temp. Regs. Sec. 1.355-7T(b)(3)(i) focuses on whether, during the two-year period ending on the distribution date, there was an agreement, understanding, arrangement or substantial negotiations about the acquisition. The next set of Plan factors involves public offerings of Distributing or Controlled’s stock. For a public offering before the Sec. 355 distribution, Temp. Regs. Sec. 1.355-7T(b)(3)(iv) focuses on whether, at some time during the two-year period ending on the acquisition date, Distributing or Controlled discussed the distribution with an investment banker. For a public offering after a distribution, Temp. Regs. Sec. 1.355-7T(b)(3)(ii) looks to whether, at some time during the two-year period ending on the distribution date, Distributing or Controlled discussed the offering with an investment banker. The final Plan factor, in Temp. Regs. Sec. 1.355-7T(b)(3)(v), concerns the acquisition of Distributing or Controlled stock, either before or after the Sec. 355 distribution, when the distribution itself was motivated by the stock acquisition. For example, a distribution is motivated by the acquisition if Distributing, on the advice of its investment adviser, distributes Controlled’s stock to its shareholders to facilitate a public offering of Controlled stock. In contrast, a Sec. 355 distribution undertaken solely to save insurance costs of Distributing or Controlled would be motivated by a nonacquisition business purpose. Nonplan factors: Temp. Regs. Sec. 1.355-7T(b)(4) sets forth Nonplan factors (i.e., favorable factors) that suggest the absence of a Sec. 355(e) plan. For an acquisition of Distributing or Controlled’s stock (other than in a public offering) before a Sec. 355 distribution, a favorable factor would be that neither Distributing nor Controlled had discussions with the stock acquirer as to the distribution during the two-year period ending on the stock acquisition date. For an acquisition either before or after a distribution, it would be favorable if the distribution were motivated (in whole or substantial part) by a corporate business purpose other than facilitation of the stock acquisition; it would also be favorable if the distribution would have occurred at approximately the same time and in a similar form, regardless of the acquisition. For a public offering after a Sec. 355 distribution, a favorable factor would exist if neither Distributing nor Controlled discussed the offering with an investment banker during the two-year period ending on the distribution date. For an acquisition after a distribution, it would be favorable if there were an identifiable but unexpected change in market or business conditions after the distribution that resulted in an otherwise unexpected stock acquisition. Similarly, for a stock acquisition before the distribution, it is favorable if an identifiable but unexpected change in market conditions after the acquisition led to an otherwise unexpected distribution. Safe harbors: Temp. Regs. Sec. 1.355-7T(d) contains several safe harbors, four of which are addressed below. Under Safe Harbor I, the distribution cannot be motivated by a business purpose to facilitate an acquisition of Distributing or Controlled stock. In addition, the acquisition must occur more than six months after the distribution with no agreement, understanding, arrangement or substantial negotiations about the acquisition during the period beginning one year before the distribution and ending six months thereafter. Safe Harbor II is virtually identical to Safe Harbor I, except that it permits an acquisition of Distributing or Controlled stock, provided that no more than 25% of such stock is acquired or was the subject of an agreement, understanding, etc., during the same period. Safe Harbor III applies when there is a postdistribution acquisition of Distributing or Controlled stock, but there is no agreement, understanding, etc., concerning the post-distribution acquisition either at the time of the distribution or within one year thereafter. Finally, under Safe Harbor IV, a stock acquisition that occurs more than two years before a Sec. 355 distribution will not be treated as part of a plan, if no agreement, understanding, etc., about the distribution existed at the time of the acquisition or within six months thereafter.
Transfers to RICs or REITs Temp. Regs. Secs. 1.337(d)-6T and 7T6 provide new transitional rules taxing BIGs when a C corporation converts or transfers assets to a RIC or REIT. Temp. Regs. Sec. 1.337(d)-6T applies to transfers between June 10, 1987 and Jan. 2, 2002.7 Temp. Regs. Sec. 1.337(d)-7T applies to transfers after Jan. 2, 2002. In general, Temp. Regs. Sec. 1.337(d)-6T(a) provides that the transfer or conversion is deemed a current sale, unless the taxpayer elects Sec. 1374 treatment for BIGs. In contrast to prior Temp. Regs. Sec. 1.337(d)-5T, a corporation is treated under Temp. Regs. Sec. 1.337(d)-6T(b) as having sold only the property actually transferred to the RIC or REIT (relevant in transactions other than full conversions). In addition, the deemed-liquidation construct has been eliminated (the temporary regulations are intended to carry out the repeal of the General Utilities8 doctrine by imposing only a corporate-level tax on the disposition of appreciated property, not a shareholder-level tax). Also, Temp. Regs. Sec. 1.337(d)-6T(c) generally allows RICs and REITs to use loss carryforwards, credits and credit carryforwards arising in C corporation tax years to reduce net recognized BIG, subject to the limits imposed by Sec. 1374 and underlying regulations. Temp. Regs. Sec. 1.337(d)-7T generally follows Temp. Regs. Sec. 1.337-6T, with some differences. For example, Temp. Regs. Sec. 1.337(d)-7T(b) adopts Sec. 1374 treatment as a default rule (i.e., no taxpayer action is needed to fall within its provisions). The rationale for this rule is that it will reduce the incidence of inadvertent failures to elect Sec. 1374 treatment. In addition, Temp. Regs. Sec. 1.337-7T(c)(4) provides an "antistuffing rule" intended to prevent taxpayers from transferring loss property to a corporation to reduce or eliminate overall gain. It also addresses corporate transfers of BIG assets to partnerships. Under an "aggregate" approach, a partnership generally will recognize gain if it then transfers the asset to a RIC or REIT, with the gain allocated to the contributing corporate partner.
Revenue Rulings Step Transactions Rev. Rul. 2001-469 involved a multistep transaction. Corporation X formed Corporation Y and caused it to merge into unrelated Corporation T. T then became a subsidiary of X, and the former T shareholders exchanged their T stock for X stock and cash (70% X stock and 30% cash). Following the merger (and as part of an integrated transaction), T merged into X. The ruling assumes that, absent some prohibition against its application, the step-transaction doctrine would apply to treat the first and second mergers as a single integrated acquisition by X of all of T’s assets (i.e., a direct merger of T into X qualifying as an A reorganization). The sole issue is whether the step-transaction doctrine should apply or, alternatively, whether the first merger should be treated as an independent qualified stock purchase by X of T under Sec. 338, and the second merger as a Sec. 332 liquidation of T into X. In analyzing this issue, the ruling looks to Rev. Rul. 90-95,10 in which a corporation purchased all of a target’s stock for cash, with the target then merging into the purchasing corporation. Although these two transactions were clearly integrated, the step-transaction doctrine was not applied. Rev. Rul. 2001-46 notes that the rejection of the step-transaction doctrine in Rev. Rul. 90-95 was based on Congressional intent that an affirmative election under Sec. 338 should be the sole means of achieving a stepped-up (cost) asset basis in the case of a stock acquisition.11 Against this backdrop, Rev. Rul. 2001-46 concludes that the concerns set out in Rev. Rul. 90-95 are not present in the instant case, because application of the step-transaction doctrine would result in an A reorganization with X succeeding to a carryover basis (as opposed to a cost basis) in Y’s assets under Sec. 362. Thus, the step-transaction doctrine applies and the transaction is treated as a reorganization. However, the IRS noted that it is considering whether to issue regulations that would allow taxpayers to make a Sec. 338(h)(10) election for one step of a multi-step transaction that, if viewed independently, would be a Sec. 338 qualified stock purchase (such as the first merger in the ruling). The ruling requests comments on using such an approach.
Restricted Stock and Options Rev. Rul. 2002-112 presents the Service’s position on restricted stock and options in a Sec. 355 distribution. In the ruling, A is an employee of Distributing and B is an employee of Controlled, a wholly owned Distributing subsidiary. Distributing implements a plan to provide additional compensation to its and Controlled’s employees in the form of (1) nontransferable Distributing stock subject to a substantial risk of forfeiture (i.e., restricted stock as described in Sec. 83(c)) and (2) options to purchase Distributing shares. The plan is not implemented in anticipation of a spinoff. Under the plan, Distributing issues restricted Distributing stock to A and, on Controlled’s behalf, to B, for the employees’ services. In the event of forfeiture, the restricted stock would revert to Distributing. Also, Distributing grants options to A and B for their services. Ultimately, Distributing distributes the Controlled stock pro rata to its shareholders in a Sec. 355 transaction. A and B receive a distribution of restricted Controlled stock to preserve their predistri-bution economic interest in Distributing. In addition, the predistribution options held by A and B are canceled and replaced with new options to acquire Distributing stock from Distributing, and Controlled stock from Controlled. In connection with the Sec. 355 distribution, the ruling holds that (1) Distributing recognizes no gain or loss when restrictions lapse on the Controlled stock held by A (and received in the distribution), nor when stock options for Controlled stock held by A (received in the distribution) are exercised; (2) Controlled recognizes no gain or loss when restrictions lapse on Distributing stock held by B (received before the distribution), nor when stock options for that stock held by B (received in the distribution) are exercised; (3) Distributing can deduct amounts includible in A’s income due to the lapse of restrictions on Distributing and Controlled stock and the exercise of options to acquire such stock; and (4) Controlled can deduct amounts includible in B’s income due to the lapse of restrictions on Distributing and Controlled stock and the exercise of options to acquire such stock. Rev. Rul. 2002-49 Rev. Rul. 2002-4913 addresses whether a corporation satisfies the Sec. 355(b) "active trade or business" requirement by virtue of its activities in managing a partnership.14 The ruling has two situations. In the first, on the first day of year 1, Distributing is a 20% managing member of a limited liability company (LLC) classified as a partnership for Federal tax purposes. The LLC is actively engaged in the real estate business. The ruling states that Distributing, as a result of its activities as a managing member of the LLC, is engaged in an active trade or business under Sec. 355(b). On the first day of year 3, Distributing purchases all of the remaining interests in the LLC from the other members, and the LLC becomes a wholly owned LLC (and a disregarded entity for Federal tax purposes). The ruling treats the purchase as if the LLC had made a liquidating distribution of its assets to its members, with Distributing then being treated as if it purchased such assets directly from the members in a taxable transaction. On the first day of year 6, Distributing forms Controlled with a portion of the real estate business and distributes the Controlled stock to its shareholders. A corporation that acquires a new trade or business in a taxable transaction generally must conduct it for a five-year period to satisfy Sec. 355(b); by contrast, tax-free acquisitions typically are not subject to this rule. In the first situation, Distributing is treated as acquiring assets in a taxable transaction. However, the IRS held that the five-year rule is satisfied, because the assets acquired constituted an expansion of the business already conducted by Distributing under Regs. Sec. 1.355-3(b)(3)(ii) (as opposed to the acquisition of a new business). In the second situation, the facts are the same, except that Distributing becomes a managing partner on the first day of year 2 by transferring appreciated securities to the LLC in a tax-free transaction under Sec. 721. Notwithstanding this tax-free transaction, the ruling holds that Distributing is treated as acquiring a trade or business in a taxable transaction, because gain or loss would have been recognized had Distributing directly acquired the trade or business in exchange for the property Distributing contributed to the LLC. Thus, on the first day of year 6, Distributing does not satisfy the Sec. 355(b) five-year rule.
Merger into LLC/Disregarded Entity In Letter Ruling 200236005, an acquiring corporation organized a wholly owned LLC (treated as a disregarded entity) and an unrelated target corporation merged into the LLC with the LLC surviving the merger. In the merger, the target shareholders received acquiring stock in exchange for their target stock. Consistent with current Prop. Regs. Sec. 1.368-2(b)(1), the transaction was treated as an A reorganization, instead of being tested under the more rigorous C reorganization criteria (as under prior proposed regulations in this area). |
