Taxpayer Successful in Establishing No Successor

Although IRS Letter Ruling 200604017 sheds some light on the definition of “successor” found in Sec. 1504(a)(3), it also raises additional questions about the definition that may defer reconsolidations by successor corporations for 60 months. This prohibition against reconsolidating may unexpectedly affect groups during commonplace fact patterns, such as spinoffs.

The precise scope of the term “successor” has been a source of disagreement among taxpayers and tax practitioners. In addition to providing direction on this subject, the letter ruling surprisingly reveals a gem of numerical information, indicating where the Service may have “drawn a line in the sand.”

Facts

The ruling’s facts are simple: Old Parent wholly owned Sub, Sub wholly owned Sub 1, and Sub 1 wholly owned each of Sub 2, Sub 3 and Sub 4. Each of these companies joined in the filing of a consolidated return, with Old Parent as the common parent.

Interestingly, the ruling particularly notes that the aggregate fair market value (FMV) of the stock of Sub 2, Sub 3 and Sub 4 accounted for less than 5% of the total FMV of Old Parent (presumably this is a percentage of the gross assets rather than net assets). Such numerical information is rarely provided in letter rulings, which are typically redacted to protect the taxpayer’s identity.

The members of the Old Parent consolidated group engaged in the following transactions: On Date B, Sub 1 formed New Parent and contributed the stock of Sub 2, Sub 3 and Sub 4 to New Parent. On Date C (a date after Date B), Old Parent elected to be treated as an S corporation, effective on Date A (a date before Date B). On Date D (a date after Date C), Sub, Sub 1 and several other direct and indirect subsidiaries of Old Parent each elected to be treated as a qualified subchapter S subsidiary (QSub), also effective on Date A. New Parent, Sub 2, Sub 3 and Sub 4 did not make QSub elections and remained as C corporations.

For Federal income tax purposes, the transactions undertaken can be summarized as follows: First, Sub 1 was deemed to liquidate into Sub (Date A). Second, Sub was deemed to liquidate into Old Parent (Date A). Third, Old Parent was deemed to contribute the stock of Sub 2, Sub 3 and Sub 4 to New Parent (Date B).

New Parent and its includible corporations that satisfy Sec. 1504(a)(2)’s stock ownership requirements wanted to file a consolidated return, with New Parent as the common parent, beginning on Date B. The Service was asked to consider whether New Parent should be considered a successor of Old Parent. It ruled that New Parent would not be considered a successor to Old Parent, and that New Parent and its subsidiaries could elect to file a consolidated return beginning on Date B.

Analysis

Normally, corporations are free to elect to file a consolidated return. However, Sec. 1504(a)(3) provides a rule that may, in certain situations, deny the ability of a group of corporations to file such a return until a period of 60 months has elapsed. The rule reads as follows:

5 years must elapse before reconciliation. —

(A) In general. —If —

(i) a corporation is included (or required to be included) in a consolidated return filed by an affiliated group for a taxable year which includes any period after December 31, 1984, and

(ii) such corporation ceases to be a member of such group in a taxable year beginning after December 31, 1984,with respect to periods after such cessation, such corporation (and any successor of such corporation) may not be included in any consolidated return filed by the affiliated group (or by another affiliated group with the same common parent or a successor of such common parent) before the 61st month beginning after its first taxable year in which it ceased to be a member of such affiliated group.

(B) Secretary may waive application of subparagraph (A). — The Secretary may waive the application of subparagraph (A) to any corporation for any period subject to such conditions as the Secretary may prescribe.

The legislative history of Sec. 1504 includes an example indicating a successor is created in a transaction qualifying as a Sec. 368(a)(1)(A) reorganization. Treasury and the Service have never issued regulations to clarify this statutory rule further. Rev. Proc. 2002-32 provides procedures for certain taxpayers to obtain an automatic waiver of the 60-month period. The taxpayer in the letter ruling could not have used this procedure, however, because Old Parent became an S corporation; see the required representation (Rev. Proc. 2002-32, Section 5.03).

Many taxpayers and practitioners question the scope of the parenthetical language that uses the term “successor.” Although the term is not defined in this context, it is defined in several places in the consolidated return regulations. Perhaps the rules/definitions applicable to companies filing consolidated returns should not be used for purposes of determining whether companies are, in fact, eligible to elect to be subject to those rules. Nonetheless, these definitions seem to be the most apparent source of guidance, given the absence of direct authority.

One common consolidated return definition of successor (and predecessor) is found in Regs. Sec. 1.1502-1(f)(4), which references transactions (1) to which Sec. 381(a) applies or (2) in which the successor’s basis for the assets is determined, directly or indirectly, in whole or in part, by reference to the basis of the assets of the transferor or distributor. This definition of predecessor/successor is used by cross-reference in several components of the consolidated return regulations. Under this particular definition, every Sec. 351 contribution should cause the transferee corporation to be considered a successor to the transferor corporation. This is because Sec. 362 requires the transferee corporation to take a basis in the assets received in a Sec. 351 transaction determined by reference to the transferor’s basis in such assets (note that even recently enacted Sec. 362(e)(2) seemingly results in a carryover basis transaction). Sec. 381 generally applies to Sec. 332 liquidations and Sec. 368 asset reorganizations, but not to Sec. 351 transfers.

Another common definition finds a corporation to be a successor if the basis of its assets is determined, directly or indirectly, in whole or in part, by reference to the basis of the assets of another corporation (the predecessor). Thus, like the prior definition, transferred (carryover) basis transactions (such as a Sec. 351 transfer) may create a successor corporation.

In regard to the letter ruling, the question becomes whether New Parent should be considered a successor to Old Parent as a result of the deemed transfer by Old Parent of Sub 2, Sub 3 and Sub 4 to New Parent in a transaction that presumably qualified under Sec. 351 (although the Service did not explicitly rule on that issue). If so, New Parent would not be entitled to elect to file a consolidated return with Sub 2, Sub 3 and Sub 4 until after 60 months had elapsed (or a waiver was obtained).

Based on the Service’s finding that New Parent would not be considered a successor to Old Parent and the percentage of Old Parent’s total assets was apparently considered to be an important fact, one conclusion reasonably can be taken from this letter ruling: a carry-over basis transfer (e.g., a Sec. 351 contribution) of less than 5% of a corporation’s total assets is not sufficient to create a successor. The fact that the Service entertained this letter ruling might be interpreted to suggest that all Sec. 351 transfers have the potential to create a Sec. 1504 successor. Further, tax practitioners may negatively infer that the 5% threshold represents a newly defined “line in the sand” for purposes of applying the rule.

Several common transactions can be implicated by this successor rule. In particular, taxpayers and practitioners involved in Sec. 355 spinoffs from a consolidated group should carefully consider the implications of this letter ruling as to the scope of the definition of “successor” in Sec. 1504(a)(3). The existing parent of a consolidated group often contributes assets to the spun-off subsidiary, which is typically intended to be the parent of a new consolidated group. If the intended new parent is viewed as a successor of the old parent, Sec. 1504(a)(3) could prevent the group from reconsolidating for the succeeding 60-month period.

From David Hering, CPA, Washington, DC