More Liberal Morris Trust Rules

Before Sec. 355(e)'s enactment, it was possible to have an ownership change in connection with a Sec. 355 distribution by combining the distribution with a tax-free reorganization, thereby avoiding some limits on tax-free Sec. 355 distributions. These transactions were referred to as Morris Trust transactions after the case that permitted them (Mary Archer W. Morris Trust, 367 F2d 794 (4th Cir. 1996)).

Sec. 355(e) was enacted to limit such distributions. A spin-off (as de-fined in the item, "Final Sec. 355(d) Regulations," p. 296) is disqualified under Sec. 355(e) if both the spin-off and an ownership change of 50% or more (by voting power or value) in either the distributing corporation (Distributing) or the controlled corporation (Controlled) occurs as part of a plan or series of related transactions.

Such a plan or series is presumed to exist if this ownership change occurs within two years before or after the spin-off. The spin-off is disqualified whether such ownership change occurs pursuant to a taxable acquisition or tax-free reorganization.

Sec. 355(e) was enacted to prevent perceived "disguised sales" or removal of assets from corporate solution without the taxes usually incurred--such as those under Sec. 311(b). However, practitioners consistently complained that these rules adversely affected spin-offs normally used for valid business purposes. For example, spin-offs used to facilitate a taxable or tax-free acquisition, a public offering or simply to create an attractive structure to provide equity compensation to key employees of a particular business, could potentially cause corporate-level taxes.

After considering practitioners' comments, the IRS withdrew the old proposed regulations and issued new ones on Jan. 2, 2001--which will apply to distributions after the final regulations are published. The old proposals (issued in 1999) provided the exclusive means for a taxpayer to show that a distribution and acquisition were not part of a plan. That guidance required the taxpayer to establish a plan's absence with clear and convincing evidence.

The new proposed regulations allow a taxpayer to use facts and circumstances to demonstrate that a distribution and acquisition are not part of a plan for Sec. 355(e) purposes. In the case of an acquisition after a distribution, a plan exists if, on the distribution date, Distributing, Controlled or their controlling shareholders intended that the acquisition or a similar acquisition occur in connection with the distribution. Likewise, in the case of an acquisition before a distribution, a plan exists if Distributing, Controlled or their controlling shareholders intended, on the acquisition date, that a distribution occur in connection with the acquisition.

The new proposals list nonexclusive factors to consider in determining whether an acquisition and distribution are part of a plan. These proposals also contain six safe harbors. A distribution and acquisition are not part of a plan if they are described in one of these safe harbors. If a safe harbor does not apply, the list of factors is taken into account in applying the facts-and-circumstances test. The weight of the factors depends on the particular case. A plan's existence is not determined merely by comparing the number of favorable and unfavorable factors.

Safe Harbors

I. An acquisition occurring more than six months after a distribution if there was no agreement, understanding, arrangement or substantial negotiations as to the acquisition prior to six months after the distribution and the distribution was motivated (in whole or substantial part) by a corporate business purpose other than a business purpose to facilitate an acquisition of Distributing or Controlled.

II. This safe harbor, like Safe Harbor I, applies only to acquisitions more than six months after a distribution if there was no agreement, understanding, arrangement or substantial negotiations on the acquisition prior to six months after the distribution.

However, while Safe Harbor I applies if the distribution was motivated (in whole or substantial part) by a nonacquisition business purpose, Safe Harbor II applies when the distribution was motivated (in whole or substantial part) by a business purpose to facilitate an acquisition of no more than 33% of Distributing or Controlled stock. Also, no more than 20% of the stock, acquired in the acquisitions motivating the distribution, was either acquired or the subject of an agreement, understanding, arrangement or substantial negotiations prior to six months after the distribution.

III. Acquisitions more than two years after a distribution if there was no agreement, understanding, arrangement or substantial negotiations as to the acquisition at the time of the distribution or within six months thereafter.

IV. Acquisitions more than two years before a distribution if there was no agreement, understanding, arrangement or substantial negotiations concerning the distribution at the time of the acquisition or within six months thereafter.

V. An acquisition of Distributing or Controlled stock listed on an established market, if the stock is transferred between Distributing or Controlled shareholders who are not five-percent shareholders.

VI. An acquisition of Distributing or Controlled stock by an employee or director thereof (or by a related person), in connection with performing services for the corporation (or related person) and not excessive by reference to such services. This safe harbor also includes an acquisition through exercise of certain compensatory stock options.

Factors

• In testing if a distribution and acquisition are part of a plan, discussions with outside parties regarding the second transaction before the first transaction occurred tend to show that such a plan exists. Conversely, the absence of such discussions tends to show that these transactions are not part of a plan.
• A distribution motivated by a business purpose to facilitate the acquisition (or similar acquisition) of Distributing or Controlled tends to show that the distribution and acquisition are part of a plan. On the other hand, a corporate business purpose (other than a purpose to facilitate the acquisition or similar acquisition) tends to show no such plan.
• An acquisition and distribution occurring within six months of each other or an agreement, understanding, arrangement or substantial negotiations regarding the second transaction within six months after the first transaction (or if an acquisition is the second transaction, a similar acquisition) tend to show these transactions are part of a plan.
• An identifiable, unexpected change in market or business conditions after the first of the two transactions being tested that resulted in the second, unexpected transaction tends to show a plan's absence.
• A distribution that would have occurred at approximately the same time and in similar form regardless of the acquisition (or a previously proposed similar acquisition) also tends to show a plan's absence.

Under an operating rule, if Distributing distributes Controlled stock intending (in whole or substantial part) to decrease the likelihood of acquisition of Distributing or Controlled by separating it from another corporation likely to be acquired, Distributing will be treated as having a business purpose to facilitate the acquisition of the corporation likely to be acquired.

Options

Under the new proposals, if Distributing or Controlled stock is acquired pursuant to an option, the option will be treated as an agreement to acquire the stock on the date the option is written—unless Distributing establishes that, on the later of the stock distribution date or the writing of the option, the option was not more likely than not to be exercised.

From Randy A. Schwartzman, CPA, MST, New York, NY