Section 367 limits use of the reorganization

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1 8 POINTS TO REMEMBER Editor s Note: POINTS TO REMEMBER are individual submissions to the Newsletter from Section of Taxation members with insights to share. Although these items are subject to selection and editing, the Section conducts no systematic review of these items. Accordingly, each item states the view of the individual contributor and does not necessarily represent the views of the ABA or of the Section of Taxation. We welcome new submissions as well as responses to previously published material found in this section. TREASURY ISSUES FINAL SECTION 367(b) REGULATIONS by Nancy Beckner, Washington, DC Section 367 limits use of the reorganization and certain other nonrecognition provisions of the Internal Revenue Code ( IRC ) in various international transactions so as to preserve U.S. taxation of income or gains having a U.S. nexus or derived through foreign corporations owned by U.S. persons. Section 367(a) addresses transfers of property by a U.S. person to a foreign corporation in section 332, 351, 354, 356 or 361 exchanges and provides that, unless certain exceptions apply, a foreign corporation is not a corporation for purposes of determining the extent to which gain is recognized on the transfer. Section 367(b) addresses cross-border and foreign-to-foreign exchanges under these IRC sections or section 355 if there is no section 367(a)(1) transfer of property by a U.S. person. For such exchanges, a foreign corporation ( FC ) is considered a corporation (i.e., non-recognition treatment is available) except to the extent provided in regulations. 1 A section 367(b) exchange would include, for example, an FC s acquisition of the assets of another FC in a section 351 exchange or a section 332 liquidation of an FC into its domestic parent. Section 367(b) regulations were originally proposed on August 26, 1991 (the Proposed Regulations ). On January 21, 2000, Treasury issued final regulations (the Final Regulations ) [T.D. 8862] effective for transactions on or after February 23, While the Final Regulations generally do not depart significantly from the relatively workable approach of the Proposed Regulations, there are several important differences; as stated in the Preamble to the Final Regulations, these differences are based on considerations of fairness, simplicity and administrability. In addition, the Final Regulations incorporate, with modification, previously published final regulations, T.D (June 19, 1998) ( June 19 regulations ), addressing the over-lap of section 367(a) with section 367(b). Section 367(b) has been viewed as complementing section 1248, which, in general, treats gain recognized by a U.S. person from the sale or exchange of stock in a controlled foreign corporation ( CFC ) 2 as a dividend to the extent of the CFC s earnings and profits (determined under section 1248 regulations). Without section 367(b), the IRC non-recognition provisions might otherwise result in the avoidance of U.S. tax with respect to a CFC s E&P; i.e., the section 332 liquidation of a CFC (with E&P) into its U.S. domestic parent or an acquisitive reorganization of a CFC with another FC if the acquiring/surviving FC is not a CFC. However, the Final Regulations do more than complement section 1248; for example, a section 367(b) exchange of stock can result in an income inclusion exceeding the dividend which would have arisen on a taxable sale of CFC stock under section The Final Regulations require current income inclusion and/or gain recognition upon inbound transactions under section 332 or section 368(a)(1). They also require income inclusion on certain outbound and foreign-to-foreign exchanges resulting in the loss of section 1248 shareholder status or the excessive potential shifting of E&P, which would produce an inappropriate section 902 foreign tax credit benefit. 3 If the potential application of section 1248 is preserved (for example, if the U.S. shareholder of CFC stock continues to own CFC stock after a reorganization), the Final Regulations permit deferral of amounts for later income inclusion, with appropriate tracking of E&P of the acquired CFC. The discussion below highlights several important differences between the Proposed and Final Regulations and from prior Temp. Reg. Sec (b)-9. INBOUND SECTION 332 LIQUIDATIONS & SECTION 368(a)(1) REORGANIZATIONS INVOLVING ACQUISITIONS OF FC S ASSETS BY A DOMESTIC CORPO- RATION (DC) A DC s acquisition of the assets of an FC in a subsidiary liquidation 1 Section 367 also addresses transfers of intangible property to foreign corporations in 351 or 361 exchanges ( 367(d)) and 355 distributions by domestic corporations to non-u.s. persons and 332 liquidating distributions to foreign parent corporations ( 367(e)). 2 A CFC is an FC of which U.S. Shareholders (U.S. persons owning at least 10% of the voting power) own more than 50% of the stock, by vote or value. Attribution and other rules apply to determine ownership. 3 Section 902 (the deemed paid credit) is a provision that permits a domestic corporation which receives a dividend from an FC of which it owns at least 10% of the voting stock to claim a foreign tax credit for foreign taxes paid by that FC (and certain lower tier FCs), based upon the ratio of the dividend to the FC s post-1986 undistributed earnings.

2 under section 332 or in reorganization will result in the inclusion of income or gain recognition for U.S. persons, thereby preventing avoidance of U.S. tax with respect to deferrals achieved during the period of FC ownership. Under the Final Regulations, any 10% U.S. Shareholder (a U.S. persons owning 10% or more of the FC stock, as determined under section 951(b) 4 ) and any 10% U.S.-owned Foreign Corporate Shareholder (a foreign corporate shareholder as to which a U.S. person is a 10% U.S. Shareholder) must include in income, as a deemed dividend, the all earnings and profits amount (the All E&P Amount ) 5 attributable to such person s stock in the FC whose assets are being acquired. Treasury rejected arguments that income inclusions should be limited to amounts includable as dividends under section 1248, since such a limitation fails to consider the section 367(b) policy need to address the proper carryover of corporate level attributes in in-bound transactions. Treasury is seeking comments on whether future regulations should limit attribute carryovers and, thus, limit the class of persons subject to income inclusions; such an approach could also deal with attribute carryovers from periods when stock was not held by U.S. persons. The Final Regulations retain the Proposed Regulations taxation of all exchanging U.S. shareholders, including U.S. persons who are not 10% U.S. Shareholders and who generally recognize gain (but not loss); alternatively, such persons may elect to include the All E&P Amount (in lieu of recognizing gain). The Final Regulations add a de minimis exception eliminating gain recognition if the value of the exchanging U.S. person s stock is less than $50,000. The Proposed Regulations permitted a gain recognition election in lieu of the All E&P Amount inclusion; the Final Regulations eliminate this election as inconsistent with the policy of section 367(b) and raising other concerns. 6 FC ACQUISITIONS OF FC STOCK OR ASSETS The Final Regulations generally follow the provisions of the June 19 regulations in requiring income inclusion where, following foreign-to-foreign reorganizations and certain other transactions, the status of a U.S. shareholder changes such that the shareholder would no longer be subject to dividend income treatment under section 1248 if gain were recognized on a subsequent sale of FC stock. In contrast to prior temporary regulations, income inclusion is also required if there is excessive potential shifting of E&P in order to prevent inappropriate tax credit benefits under section 902. This provision was unnecessary under Temp. Reg. Sec (b)-9, which addressed the section 902 problem through a complex E&P attribution system; as anticipated following the June 19 regulations, this system has been completely eliminated in the Final Regulations, which use an E&P tracking system. Treasury intends to propose regulations addressing carryover of E&P and tax accounts as well as the application of certain foreign tax credit provisions to distributions by an acquiring FC. DISTRIBUTIONS BY A DOMESTIC CORPORATION For distributions by domestic corporations, the Final Regulations adopt the approach of the section 367(e) regulations, which presumes all distributees are individuals and treats the controlled corporation as not being a corporation, thus triggering gain recognition by the distributing corporation. This presumption is rebuttable using certain shareholder identification principles; gain is not recognized on distributions to a corporation (after application of such identification principles), unless the distributee is an FC and gain is recognized under section 367(e)(1) and its regulations. DISTRIBUTIONS BY A CFC For pro-rata CFC distributions, the Final Regulations respond to taxpayer concerns about potential phantom gain and provide that basis reductions (and deemed dividends) result in certain collateral increases in the distributee s stock basis. Special basis adjustments do not apply to non-pro-rata distributions; instead, the excess of the pre-distribution amount over the post-distribution amount is a deemed dividend, and basis increases that normally apply to deemed dividends generally continue to apply. Under the Final Regulations, deemed dividends of an FC are not included in foreign personal holding company income (a classification which would result in income for U.S. shareholders of an exchanging FC). Also, rules relating to E&P allocations of a foreign transferor corporation have been dropped but will be addressed in future section 355 regulations. NOTICE FILING CHANGES The Final Regulations modify both the Proposed Regulations and the June 19 regulations by reducing the list of persons subject to notice filing requirements. The Final Regulations require filing only with respect to persons and transactions that may be subject to an inclusion under the operative provisions of the Final 9 P O I N T S T O R E M E M B E R 4 10% U.S. Shareholder status is determined without regard to an FC s status as a CFC. 5 The starting point of the All E&P Amount is essentially E&P as determined for a DC, but with certain exceptions and adjustments. However, the All E&P Amount subject to inclusion is determined without regard to an FC s status as a CFC, the shareholder s ownership of 10% of the stock during a given period or the period during which such E&P was accumulated. Accordingly, the amount includable under the Final Regulations may be greater than the 1248 dividend which would occur on a sale of the FC s stock. 6 However, Temp. Reg (b)-3T(b) [T.D. 8863, 1/21/2000] allows the election for exchanges occurring between February 23, 2000 and February 24, 2001, but requires attribute reductions if the All E&P Amount exceeds the gain recognized and one U.S. person owns, directly or indirectly, 100% of the acquired FC.

3 10 Regulations. CURRENCY ISSUES The Final Regulations adopt, with modification, the Proposed Regulations treatment of certain currency exchange matters under sections For example, under the Final Regulations, a qualified business unit is deemed to have automatically changed its functional currency when its functional currency is different after a section 367(b) exchange. They also address exchange gain or loss with respect to section 367(b) income inclusions and distributions. Eliminated in the Final Regulations are the provisions of the Proposed Regulations addressing recognition of exchange gain or loss with respect to appreciation/depreciation in an exchanging shareholder s capital account in a foreign acquired corporation; however, this issue has been reserved for further consideration. IRS BATTLES AGAINST FAMILY LIMITED PARTNER- SHIPS CONTINUE by Alexander Drapatsky, Chicago, IL Family limited partnerships and family limited liability companies (hereinafter FLPs ) have become popular estate planning devices. By using FLPs to transfer assets to future generations, donors can institute a lifetime gifting program, reduce the eventual estate tax liability of the donor by removing assets (and the future appreciation of the asset) from the donor s estate, and maintain control over the assets in the FLP through the general partner. One of the great benefits of using a FLP to transfer wealth to younger generations is the potential reduction in the value, for transfer tax purposes, of the assets being transferred as a result of valuation discounts for lack of control and lack of marketability. A lack of control discount (also referred to as a minority interest discount) is appropriate when the holder of an interest in a FLP lacks the right to decide the timing of distributions of earnings or other issues that affect the financial benefits of FLP interest ownership. A lack of marketability discount takes into account the fact that an owner of an interest in a privately held entity will have greater difficulty than an owner of a publicly traded entity in finding a buyer for his or her interest. IRS CHALLENGES TO FLPs To counter the popularity of FLPs as an estate planning device and particularly the large discounts some taxpayers were using in determining the value of gifted FLP interests, the IRS in 1994 issued anti-abuse regulations that stated that for the IRS to respect a FLP as a partnership for tax purposes, the taxpayers must have created the FLP for a substantial business purpose. Prop. Treas. Reg. Sec , 60 Fed. Reg (1994). The IRS subsequently withdrew these anti-abuse regulations with respect to FLPs. However, the IRS s hostility towards FLPs remains. The IRS has used several arguments to challenge the discounts that taxpayers have applied upon gifting interests in FLPs. The first is an argument that if a FLP agreement is more restrictive than state law with respect to liquidation of the FLP, the IRS under section 2704(b) will disregard the FLP agreement s restrictions for purposes of determining the applicable discount on a FLP interest. In several 1997 letter rulings, including Private Letter Rulings and , the Service reiterated its position regarding applying section 2704(b) to discounts in FLP interests. However, in Kerr v. Commissioner, 113 T.C. No. 30 (1999), the Tax Court may have granted taxpayers a means to achieve a discount on a FLP interest despite section 2704(b). In Kerr, the governing state law of the FLP agreement stated that one of the ways a partnership can liquidate is upon the occurrence of specified events, as stated in a FLP agreement. Since the Tax Court ruled that such a clause is not more restrictive than the governing state law, the IRS was not able to change the discount on FLP interests by using the section 2704(b) argument. The Kerr holding was recently upheld in Estate of Harper v. Commissioner, T.C. Memo (filed June 30, 2000). Another IRS line of attack on discounts in gifted FLP interests is that, upon the formation of the FLP, the partners actually make gifts to each other, triggering gift tax consequences. Consider a FLP formed by three people, wherein a corporate general partner owns a 1% interest and each of the three limited partners owns a 33% interest. If the partners argue that each of the limited partners interest is worth less than 33% of the asset value contributed to the FLP, because of applicable discounts, the IRS would argue in reply that the amount of this discount could not have disappeared and in reality constitutes gifts among the partners. In Church v. United States, 85 A.F.T.R. 2d (2000), the District Court disposed of the IRS s gift-upon-formation argument, holding that a pro rata partnership, where each partner s interest is proportional to his or her contributed capital, does not constitute a gift to any one partner. Taxpayers and their advisors are waiting to see whether the IRS will acquiesce in the Church holding and agree that the formation of a pro rata FLP does not constitute a gift to other partners. While taxpayers have had some success in battling the IRS on issues related to discounts and gifts, a recent case demonstrates that a FLP still must have a valid business purpose. In Estate of Reinhardt v. Commissioner, 114 T.C. No. 9 (2000), the taxpayer created a FLP, transferred property

4 into the FLP where a revocable trust was the general partner, and gifted FLP interests to his children. The taxpayer maintained the same control and managed the assets he contributed to the FLP in the same way as when he was the outright owner of the assets. The court held that subsequent to the creation of the FLP, nothing changed except for legal title, and the taxpayer was solely responsible for the partnership s business activities. Since the taxpayer retained complete control over the FLP s assets, transferred FLP interests to his children without consideration, and none of the other partners were involved in the operations of the FLP, Reinhardt agreed with the IRS in holding that under section 2036(a), the assets that the taxpayer contributed to the FLP should be included in the taxpayer s estate for estate tax purposes. CONCLUSION In the ongoing battle with the IRS over FLPs, taxpayers appear to be sustaining their victories on discounts that are based on solid valuations for FLPs that have valid business purposes. However, as demonstrated in Reinhardt, if a taxpayer transfers assets into a FLP without a valid business purpose, the taxpayer may not even be able to keep such assets from his or her estate for estate tax purposes. The taxpayers battles with the IRS over FLPs continue. INSTALLMENT SALES TO DEFECTIVE GRANTOR TRUSTS by David L. Silverman, Great Neck, NY Installment sales of assets to grantor trusts exploit provisions in the Internal Revenue Code enacted to prevent income shifting at a time when trust income tax rates were much lower than individual income tax rates. The technique also attempts to capitalize on the different definitions of transfers for gift and income tax purposes. After the asset sale has occurred, the grantor trust holds property on which the grantor is taxed for income tax purposes, but is not considered as owning for gift tax purposes. As a result, the grantor is taxed on trust income, but the trust assets as well as the appreciation thereon will be outside of the grantor s estate. These trusts are known as intentionally defective grantor trusts (IDT). Although sales of assets to defective grantor trusts are likely to attract IRS scrutiny, it is unclear whether the Service could successfully mount a frontal challenge to this estate planning device. Under the tax law, the grantor of a grantor trust is taxed on the income of the trust property as if the property were owned by the grantor free of the trust. A corollary of this rule is that, if the grantor sells property to the trust, no taxable event has taken place for income tax purposes. Presumably, the income tax law would regard this transaction as a sale from the grantor to himself. The result of this application of the tax law is that the grantor can sell appreciated assets to the grantor trust, effect a complete transfer and freeze for estate tax purposes, and yet trigger no capital gains tax on the transfer of the appreciated business to the grantor trust. When a business is sold to a defective grantor trust, the income tax liability relating to the profits generated by the business remains with the grantor, while at the same time the grantor has parted with ownership of the business for transfer tax purposes. A freeze of the estate tax value has been achieved, since future appreciation in the business will be outside of the grantor s estate. Nonetheless, the grantor will remain liable for the income tax liabilities of the business, and no distributions will be required from the trust to pay income taxes on the business. This will result in accelerated growth of trust assets. The grantor may receive either cash or a note in exchange for the assets sold to the grantor trust. If a business is sold to the grantor trust, it is not likely that the trust would have assets sufficient to satisfy the sales price. Moreover, paying cash for the business or assets sold to the grantor trust would tend to defeat the purpose of the trust, which is to reduce the size of the grantor s estate. For this reason, the consideration most often supplied by the grantor trust in exchange for the business or assets is a promissory note. The grantor will likely require the trust to secure the promissory note by pledging the assets sold to the grantor trust. If properly structured, there should be no gift tax consequences upon the sale of assets to an IDT, since the transaction should constitute a bona fide sale. Although cash or assets received by the grantor as consideration for the asset sale to the IDT would subsequently be included in the grantor s estate (if not disposed of earlier), they would be entitled to a stepped-up basis at the grantor s death. Upon the death of the grantor of a grantor trust, the IDT would lose its grantor trust status. Presumably, assets in the IDT would be treated as passing from the grantor to the trust without a sale, in much the same fashion that assets pass from a revocable living trust to beneficiaries. However, for income tax purposes, the trust would receive no step-up in basis under section 1014(a) of the Code, because there will have been no inclusion in the grantor s estate. Since the sale is ignored for income tax purposes, the balance due on the note would not constitute income in respect of a decedent (IRD). The note would presumably acquire a basis equal to the value that is included in the grantor s estate. For estate tax purposes, no part of the trust should be included in the grantor s estate. However, the 11 P O I N T S T O R E M E M B E R

5 12 promissory note would be included in the grantor s estate. This is to be contrasted with the estate tax consequences which obtain with a GRAT, where the death of the grantor prior to the expiration of the trust term would result in estate tax inclusion of the entire amount of the trust. If section 2702 were to apply to the sale of assets to a grantor trust, then the entire value of the property so transferred could constitute a taxable gift. However, it appears that section 2702 generally does not apply to the sale of assets to an IDT, primarily because of the nature of the promissory note issued by the trust. The promissory note issued is governed by its own terms, not by the terms of the trust. The holder in due course of the promissory note is free to assign or alienate the note, regardless of the terms of the trust, which may contain spendthrift provisions. The Service has held in Private Letter Rulings and that neither section 2701 nor section 2702 applies to the IDT promissory note sale, provided (1) there are no facts present which would tend to indicate that the promissory notes will not be paid according to their terms; (2) the trust s ability to pay the loans is not in doubt; and (3) the notes are not subsequently determined to constitute equity rather than debt. Even if the IRS does not view sections 2701 and 2702 as applying, the IRS could make the argument that, because the grantor is receiving a promissory note in exchange for assets, the grantor has retained an interest in the assets which require inclusion of those assets in the grantor s estate under section In order to minimize the chance of the IRS successfully invoking the argument that the promissory note related to the trust assets, the trust should be funded with assets worth at least ten percent as much as the value of the assets which will later be sold to the grantor trust in exchange for the promissory note. The reason for this ten percent recommendation is that in an analogous situation, section 2701 requires that the value of common stock, or a junior equity interest, comprise at least ten percent of the total value of all equity interests. In meeting the ten percent threshold, the grantor himself or herself should make a gift of these assets so that after the sale of assets in exchange for the promissory note, the grantor will be treated as the owner of all trust assets. In order to further support the bona fides of the promissory note, all of the trust assets should be pledged toward the payment of the note. To accentuate the arm s length nature of the sale of assets to the trust, it is preferable if the grantor is not the trustee of the trust. The IRS has also expressed the view in Private Letter Ruling that section 2036(a) could be avoided if beneficiaries were to act as guarantors of payment of the promissory note. The IDT technique permits the grantor to effect a true estate freeze by transferring assets at present value from his estate, without being subject Now Available to the limitations imposed by sections 2701 and In addition, the GST exemption could be allocated to the assets passing to the trust at the outset, thus removing from GST tax any appreciation in the assets as well. In these respects, the IDT is superior to the GRAT. The principal disadvantage of the IDT is that no step up in basis is received at the death of the grantor for assets held by the trust. Another disadvantage to the IDT technique is that although the general principles governing its use seem firmly grounded in tax law, no clear rules seem to apply. The IRS could challenge various parts of the transaction, which if successful, could negate some (or all) of the tax benefits sought. In particular, the IRS could attempt to assert that (1) the sale by the grantor to the trust does not constitute a bona fide sale; (2) section 2036 applies, with the result that the entire value of the trust is includable in the grantor s estate; or (3) section 2702 applies, and the interest payments are not qualified payments, with the THE ABA property tax deskbook, 2000 edition Size: 8 1 /2 x 11 Softcover, 900 pages Cost: $195 Tax Section Members, $240 Non-member product code: Another key resource from the ABA Tax Section for tax managers, attorneys and accountants who specialize in state and local tax matters. Updated each year, the ABA Property Tax Deskbook contains a thorough discussion of state property tax issues in all jurisdictions. Each chapter sets out the most important principles in that state, with citations to pertinent statutes, rules, regulations, case law, bulletins, and local practices information often impossible for practitioners from other states to find. To place an order, call the ABA Service Center at 800/ For more information and a list of other Section publications, visit our website