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Significant Recent Developments
The article examines significant recent
developments in C corporations and consolidated returns,
including temporary regulations on attribute
reduction, step transactions and loss duplication, rulings on Sec. 351
and 355 and guidance on built-in gains under Sec. 382.
Mark A. Schneider, J.D., LL.M.
Editors note: Mr. Schneider is a former chair and current member of the AICPA Tax Divisions Corporations & Shareholders Taxation Technical Resource Panel. For more
information about this article, contact Mr. Schneider at
MSchneider@bdo.com. Executive Summary
This article summarizes some of the more significant recent developments in the subchapter C and consolidated return areas. Specifically, it addresses temporary regulations on (1) Sec. 108 tax attribute reduction in a consolidated return setting; (2) tax attribute reduction when the debtor corporation is a target in a Sec. 381 transaction (such as a transfer of assets in a G reorganization); (3) taxpayers ability to shut off the step-transaction doctrine and make a Sec. 338(h)(10) election; and (4) the application of Sec. 382 when certain trusts distribute loss corporation stock to a beneficiary. The article also addresses the Services new no ruling positions on certain aspects of Sec. 355, revenue rulings on Sec. 355 tax-free distributions and Sec. 351 substance over form, and a notice on Sec. 382 built-in-gains (BIGs).
Temp. Regs. Sec. 108 Attribute Reduction Sec. 108(a) generally provides that a bankrupt or insolvent taxpayer does not include cancellation of debt (COD) income in gross income. The policy is to facilitate the debtors fresh start on its emergence from bankruptcy. However, to prevent the debtor from deferring tax on a permanent, rather than a temporary basis, Sec. 108(b) requires taxpayers to reduce their tax attributes to the extent of the excluded COD income. Sec. 108(b) sets forth a prescribed ordering rule for such attributes, beginning with the debtors net operating losses (NOLs).1 Treasury and the Service were concerned that consolidated taxpayers might take a separate-member, rather than a single-entity, approach to Sec. 108(b) attribute reduction. For example, when the debtor member is the common parent and is also a holding company (which often is the case), it is likely that its share of the groups tax attributesparticularly the consolidated NOL (CNOL) under Temp. Regs. Sec. 1.1502-21T(b)might be minimal. Indeed, most of the CNOL likely would be allocated to the groups underlying operating subsidiaries. In such a case, consolidated taxpayers might take a separate-member approach to attribute reduction and reduce only the parents portion of the CNOL, even if the total excluded COD income was well in excess of such portion. To prevent this result, Treasury issued Temp. Regs. Sec. 1.1502-28T,2 which adopts a somewhat blended separate- and single-entity approach, but generally operates to prevent the type of taxpayer position discussed above. The temporary regulations first take a separate-member approach. Temp. Regs. Sec. 1.1502-28T(a)(2)(i) provides that, for a member realizing excluded COD income in a tax year, the tax attributes attributable to that member, including the basis of assets and losses and credits arising in separate return limitation years (SRLYs), must be reduced under the general rules of Secs. 108 and 1017.3 The basis of subsidiary stock, however, is not reduced below zero. For purposes of this rule, the consolidated tax attributes attributable to a member must be determined under Temp. Regs. Sec. 1.1502-21T(b)(2)(iv).4 Temp. Regs. Sec. 1.1502-28T(a) (3)(ii) provides an interesting look-through rule that blends separate- and single-entity principles. Under that rule, if the basis of a lower-tier members stock owned by another member is reduced, the lower-tier member must be treated as realizing excluded COD income in an amount equal to such basis reduction. Accordingly, the regulations provide that the tax attributes attributable to such lower-tier member are then reduced under Secs. 108 and 1017. Finally, Temp. Regs. Sec. 1.1502-28T(a)(4) sets forth the single-member approach, as somewhat of a safety net. It provides that, to the extent excluded COD income is not applied to reduce the tax attributes attributable to the member that realizes the excluded COD income (including the application of the look-through rule above), such amount must be applied to reduce the remaining consolidated tax attributes of the group as provided in Sec. 108 and the temporary regulations. The reduction of each tax attribute is made in the order prescribed in Sec. 108 and Temp. Regs. Sec. 1.1502-21T(b)(1).
The temporary regulations provide that S2s separate-member tax attributes must first be reduced to take into account its $200 excluded COD income. Accordingly, the CNOL for year 3 is reduced by Ss $10 share to $40. Then, the CNOL for year 2 is reduced by S2s $40 share to $160, and S2s $50 SRLY NOL is reduced to zero. Following the reduction of NOLs, S2 reduces its basis in Asset A by $40 to zero. The remaining $60 of excluded COD income then reduces consolidated tax attributesthe remaining $40 CNOL for year 3 is reduced to zero and the $250 CNOL from year 1 is reduced by $20 to $230.
Attribute Reduction in G Reorganizations Sec. 108(b)(4)(A) provides that Sec. 108(b) attribute reduction has to be made after the determination of the tax for the tax year of the discharge. When timing basis reduction for debtor property with excluded COD income under Sec. 108, Sec. 1017 looks to the properties held by the taxpayer at the beginning of the tax year following the one in which the cancellation occurs. Practitioners have long pondered the proper application of the Sec. 108 attribute-reduction rules when a tax-free reorganization described in Sec. 381(a) ends in a tax year in which the transferor corporation excludes COD income from gross income. Such a scenario would arise, for example, when a corporate debtor in bankruptcy effects a G reorganization (i.e., transfers its assets to an acquiring corporation tax free). Some have argued that none of the Sec. 108(b) attributes would be reduced, because the corporation with excluded COD income is dissolved immediately after the reorganization, under Sec. 381(a) (i.e., the acquiring corporation in the G reorganization would succeed to the transferors tax attributes and property, without attribute reduction). In temporary regulations issued on July 18, 2003,7 Treasury made it clear that, in the case of a transaction described in Sec. 381(a) that ends in a year in which the transferor corporation excludes COD income under Sec. 108(a), any tax attributes to which the acquiring corporation succeeds and the basis of any property acquired must be reduced under Sec. 108(b).8 Temp. Regs. Sec. 1.108-7T(b) also clarified that the tax attributes (e.g., an NOL carryback) may be carried back to tax years preceding the year of the discharge before such attributes are reduced under Sec. 108(b).
Shutting Off the Step-Transaction Doctrine For certain qualified stock purchases (QSPs) of a target corporation, Sec. 338(h)(10) permits the seller and acquirer to elect jointly to treat the purchase of the targets stock as an asset purchase. Typically, the seller in such a transaction is a member of a consolidated group (selling another member of the group) or a group of S corporation shareholders. If a Sec. 338(h)(10) election is made, the sellers stock sale is ignored for tax purposes; instead, the target is treated as selling all of its assets in a taxable sale and then liquidating (under Sec. 332 for a consolidated group or Sec. 331 for an S corporation). The asset sale is taxable to the consolidated group or S corporation shareholders, as the case may be. Rev. Rul. 2001-469 held that a transaction will be recast under the step-transaction doctrine as a single statutory merger of a target corporation into an acquiring corporation under Sec. 368(a)(1)(A) if, as part of an integrated plan, (1) an acquiring corporation acquires all of the targets stock through a reverse subsidiary merger in which the target shareholders receive consideration consisting of 70% stock and 30% cash (this transaction, considered by itself, would be a taxable transaction); and (2) the target then merges into the acquirer. The ruling requested comments as to whether parties, in effect, should be allowed to elect to shut off this recast and treat the transactions first step as a Sec. 338 (h)(10) QSP. In response, Treasury issued final and temporary regulations10 permitting taxpayers to make such an election. Under the temporary regulations, a Sec. 338(h)(10) election may be made for the target when the stock acquisition, viewed independently, constitutes a QSP and, after the stock transaction, the target merges or liquidates into the acquirer. This treatment holds whether or not, under relevant law (including the step-transaction doctrine) the acquisition of the targets stock and the targets merger or liquidation would be recast as a Sec. 368(a) reorganization.
Stock Distributions from Sec. 401(a) Trusts Sec. 382 limits the amount of certain loss carryovers and recognized built-in losses that can be used to offset taxable income following an ownership change of a loss corporation. Sec. 382(g) defines an ownership change as a change of more than 50% in the ownership of the loss corporations stock owned by 5% shareholders over a three-year period. Sec. 318 constructive ownership rules apply in determining the loss corporations ownership under Sec. 382(l)(3). In applying Sec. 382, Sec. 318 generally does not attribute stock owned by a Sec. 401(a) qualified trust to the plan participants. Accordingly, there was concern that a qualified trusts stock distribution to trust participants might have Sec. 382 implicationsi.e., that such a distribution might result in an owner shift under Sec. 382. To address this concern, Treasury issued temporary regulations in June 2003.11 Under Temp. Regs. Sec. 1.382-10T(a)(1), if a qualified trust distributes an ownership interest in an entity, then for testing dates on or after the distribution date, the distributed ownership interest will be treated as having been acquired by the distributee on the date and in the manner acquired by the qualified trust. In addition, and importantly, the distribution itself does not cause the distribution date to be a Sec. 382 testing date.
Loss Disallowance/Loss Duplication In March 2003, Treasury issued loss-duplication temporary regulations.12 As expected, these temporary regulations are much narrower than the loss-duplication regulations invalidated in Rite Aid Corp.13 The temporary regulations generally address two types of transactions that might allow a consolidated group to claim more than one tax benefit from a single economic loss: (1) the group absorbs a subsidiarys inside loss (such as an NOL), while another group member recognizes a loss on the subsidiarys stock; and (2) a group member recognizes a loss on the disposition of subsidiary stock that reflects the subsidiarys inside loss, the subsidiary remains within the group, and the group subsequently recognizes the subsidiarys inside loss.14
Sec. 355 No-Ruling Areas In Rev. Proc. 2003-48,15 the Service announced that it would no longer issue letter rulings on three essential requirements for Sec. 355 tax-free treatment. Specifically, the IRS National Office will no longer rule on whether a purported Sec. 355 distribution (1) has one or more corporate business purposes, (2) is being used as a device or (3) is part of a plan under Sec. 355(e). Instead, these determinations now may be made on an examination of the taxpayers return. The revenue procedure stated essentially that this no-rule position is part of a one-year pilot program. Recognizing the significant uncertainty embedded in the tax-free treatment of Sec. 355 spin-off transactions, the Service further stated that it would dedicate its resources to increasing published guidance on Sec. 355, including the business-purpose requirement and other legal questions. Indeed, simultaneously with the release of Rev. Proc. 2003-48, the Service issued Rev. Ruls. 2003-7416 and 2003-75,17 providing further guidance on corporate business purpose, and has requested comments on Sec. 355 issues that should be addressed in published guidance. These and other Sec. 355 revenue rulings are discussed below.
Rev. Rul. 2003-74 The Service held that a parent corporations distribution of a wholly owned subsidiarys stock to the parents shareholders met the business-purpose requirement and was not taxable, because it enabled each corporations management to concentrate on its own business. In the ruling, the parent was a public corporation in the software business, while the subsidiary conducted a paper products business. The parents management wanted to concentrate solely on the software business, but was prevented from doing so because of the need to service the paper business. The subsidiary objected to the lack of attention from the parents management. Following the separation, two directors of the parent temporarily joined the subsidiarys board, to assist management and provide continuity. The ruling concluded that there was no other nontaxable way for each business to achieve separate management and that the temporary transfer of the two directors was reasonable. It further noted that separating the two companies to provide independent management was a real and substantial nontax purpose germane to each companys business under Sec. 355.
Competition for Capital/Shared Services In Rev. Rul. 2003-75, the Service held that a parents distribution of a controlled subsidiarys stock to the parents shareholders met the business-purpose requirement, because it resolved a competition for capital between the parent and the subsidiary. The parent was a publicly traded corporation in the pharmaceutical business, while the subsidiary was in the cosmetics business. Both needed large amounts of capital for investment, research and development. The parent borrowed all funds for both corporations and allocated capital spending among the two. The ruling stated that the controlled subsidiarys direct access to the capital markets after the distribution would result in a business benefit to the subsidiary. In addition, as part of the stock distribution, the parent and the subsidiary entered into temporary agreements to share information technology, benefits administration and accounting. The subsidiary also borrowed funds from the parent under an arms-length, two-year loan. The Service held that such agreements facilitated the corporate separation and were permissible under Sec. 355.
Split-Off with Estate Planning Benefits In Rev. Rul. 2003-52,18 a father, mother, son and daughter jointly owned a farming business. The son and daughter were active in the corporations daily operations, but disagreed as to the businesss future direction. As a result, a Sec. 355 transaction was effected to divide the companys business into two corporations; the son and the daughter each received 50% of one separate company, with the remaining stock of each company held by their parents. Despite the fact that the transaction was carried out in part to facilitate estate planning and to promote family harmony (a shareholder purpose that generally preludes Sec. 355 tax-free treatment), the ruling held that the transaction was tax free, because it also eliminated sibling disagreement over the future course of the business and allowed the son and daughter to focus on business aspects in which they are most interested. Accordingly, the Sec. 355 business purpose-requirement was deemed met.
Business Expansion Rev. Ruls. 2003-1819 and 2003-3820 addressed the business-expansion doctrine. The key issue in these types of rulings is whether the new activity constitutes an expansion of a preexisting active trade or business under Sec. 355(b) (which is permissible), or amounts to an acquisition of a new or different business.21 Rev. Rul. 2003-18 concluded that the acquisition by a dealer engaged in the sale and service of one brand of automobiles of a franchise to sell and service a different brand (and the assets to operate the franchise) was an expansion of the underlying business, rather than the acquisition of a new or different business. Similarly, the Service held in Rev. Rul. 2003-38 that a retail shoe store that created a website to sell shoes at retail was expanding its existing business, rather than acquiring a new or different one.
Change in Circumstance In Rev. Rul. 2003-55,22 a publicly traded corporation was advised by investment bankers that a Sec. 355 distribution of all of the subsidiarys stock would better position the subsidiary to effect a public offering of its stock. The distribution was made, but the equity market later turned downward. As a result, the stock offering was abandoned and the subsidiary raised capital through a debt offering. The ruling held that the distribution was still tax free, on the theory that the market deterioration was unforeseen at the time of the distribution.
Sec. 351 Transactions Under Sec. 351, the transfer to a corporation of property may be tax free, provided the transferor is in control of the transferor corporation within the meaning of Sec. 368(a)(1)(C) (generally, 80%). Previous court decisions have held that the Sec. 351 control requirement is not satisfied when, pursuant to a binding agreement entered into by the transferor before the transfer, the transferor loses control of the corporation by a taxable sale of all or part of that stock to a third party.23 In Rev. Rul. 2003-51,24 the Service seemingly applied a substance-over-form analysis to allow Sec. 351 tax-free treatment, even though the transaction involved a prearranged break in the first transferors control over the transferee. In the ruling, W and X were unrelated corporations engaged in the same business. X engages in business indirectly through its wholly owned subsidiary, Y. W and X wanted to consolidate their business operations within a new corporation in a holding company structure. Under a prearranged binding agreement with X, W formed a new corporation, Z, by transferring its business assets to Z for all of Zs stock (the first transfer). Immediately thereafter, W contributed all of its Z stock to Y for Y stock (the second transfer). Simultaneous with the second transfer, X contributed sufficient cash to Y to meet the businesss capital needs, in exchange for additional Y stock (the third transfer). After the second and third transfers, Y transferred the cash and its business assets to Z (the fourth transfer). After the second and third transfers, W and X owned 40 and 60%, respectively, of Ys outstanding stock. Viewed separately, all of the above transfers qualify for tax-free treatment under Sec. 351. However, the overall transaction raises an issue as to the Sec. 351 control requirement. Specifically, W lost control of newly formed Z under a binding obligation. Nonetheless, the Service held that the four separate transfers were each tax free under Sec. 351. Seemingly central to the Services conclusion was that the parties could have arranged the transaction as successive Sec. 351 transfersi.e., W could have transferred its assets directly to Y for Y stock, with Y then forming Z and transferring such assets to Z. The Service has long held that successive Sec. 351 transfers are respected.25
BIGs and BILs Sec. 382 limits the amount of pre-change NOLs that may be used to offset post-change income of a corporation that undergoes an ownership change. An ownership change generally occurs when 5% shareholders of a loss corporation have increased their ownership in the corporation by more than 50% during the testing period (generally, three years). The Sec. 382 limit generally equals the value of the loss corporation, multiplied by the long-term tax-exempt rate. Importantly, the Sec. 382 limit may be increased if the corporation recognizes BIG during the five-year period following the ownership change. Conversely, if a corporation recognizes a built-in loss (BIL) during such period, its loss will be subject to the Sec. 382 limit. In this regard, a recognized BIG or BIL will implicate the Sec. 382 limit only if the corporation has a net unrealized BIG or net unrealized BIL, respectively, in excess of a threshold determined under Sec. 382(h). Notice 2003-6526 sets forth two alternative safe harbors to identify whether a corporation has BIGs or BILs: the Sec. 1374 approach and the Sec. 338 approach. The notice states that taxpayers may rely on these approaches in applying Sec. 382(h) to an ownership change that occurred before the notices issuance or on or after such issuance and before the effective date of temporary or final Sec. 382 (h) regulations. The details of these approaches are beyond the scope of this article. However, tax advisers should carefully review the notice, because it will apply to taxpayers open years. |
