Tax Tales 2! More Seminal Cases of Subchapter C. ABA Section of Taxation 2016 May Meeting Washington, D.C.

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1 Tax Tales 2! More Seminal Cases of Subchapter C ABA Section of Taxation 2016 May Meeting Washington, D.C. Alfred Bae, KPMG, Houston, TX Michelle Lo, Linklaters, New York, NY Shannon Perez, AOL, Dulles, VA Gary Scanlon, EY, Chicago, IL

2 Tax Tales 2! Cases Gary Scanlon Bausch & Lomb and Upstream C Reorganizations Michelle Lo Wham and Springing Liabilities Alfred Bae Zenz and Testing Dividend Equivalence Shannon Perez H.G. Hill Stores and the Solvency Requirement 2

3 Bausch & Lomb v. Commissioner 267 F.2d 75 (2nd Cir. 1959), aff g, 30 T.C. 602 (1958), cert. denied, 361 U.S. 835 (1959) April 1950 The Bausch & Lomb Company ( B&L ) owned % of the outstanding stock of the Riggs Optical Company ( Riggs ). Riggs primarily served as the distributor of ophthalmic products manufactured by B&L. It was decided that the manufacture and distribution should be consolidated within B&L. 3

4 The Bausch & Lomb Transaction Transaction steps: 1. On April 22, 1950, Riggs transferred all of its assets to B&L solely in exchange for 105,508 shares of B&L voting stock and B&L s assumption of Riggs liabilities. 2.On May 2, 1950, Riggs dissolved, distributing its sole remaining asset, the B&L stock, to its shareholders. B&L received 84,347 shares, and the minority stockholders received 21,161 shares. 105,508 B&L shares 84,347 B&L shares 1. Asset acquisition B&L 2. Dissolution B&L assets Riggs Minority 79% 21% Riggs Minority 79% 21% 21,161 B&L shares 4

5 C Reorganizations Section 368(a)(1)(C) The term reorganization means the acquisition by one corporation, in exchange solely for all or a part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation), of substantially all of the properties of another corporation, but in determining whether the exchange is solely for stock the assumption by the acquiring corporation of a liability of the other shall be disregarded. Section 368(a)(2)(B) ( Boot Relaxation Rule ) If (i) one corporation acquires substantially all of the properties of another corporation, (ii) the acquisition would qualify under paragraph (1)(C) but for the fact that the acquiring corporation exchanges money or other property in addition to voting stock, and (iii) the acquiring corporation acquires, solely for voting stock described in paragraph (1)(C), property of the other corporation having a fair market value which is at least 80 percent of the fair market value of all of the property of the other corporation, then such acquisition shall (subject to subparagraph (A) of this paragraph) be treated as qualifying under paragraph (1)(C). Solely for the purpose of determining whether clause (iii) of the preceding sentence applies, the amount of any liability assumed by the acquiring corporation shall be treated as money paid for the property. 5

6 The Arguments and Holding of Bausch & Lomb B&L argument: The transaction should qualify as a taxfree C reorganization because B&L issued solely voting stock in exchange for the assets of Riggs. IRS s argument: B&L should recognize its gain in its Riggs stock because the dissolution of Riggs constitutes a taxable liquidation under section 331. Viewing the asset acquisition and the subsequent dissolution together, B&L should be treated as acquiring the assets of Riggs, in part, in exchange for B&L s Riggs stock in violation of the solely for voting stock requirement. See Rev. Rul , C.B Tax Court s holding: The Tax Court agreed with the IRS (and the 2 nd circuit affirmed) that the integrated transaction constituted a taxable liquidation, reasoning that [i]t would be improper to recognize here as a separate transaction petitioner's delivery of 105,508 shares of its voting common stock at the time Riggs gave petitioner the instrument of conveyance of all of its properties. Such view of what transpired would amount to elevating form above substance and allowing mere form to control the issue. We must, under all of the circumstances, recognize that petitioner controlled Riggs through its ownership of 79.9 per cent of Riggs' stock, and that petitioner's transfer of 84,347 shares of its own voting stock to Riggs was intended to be but a momentary parting with shares which were to be returned to petitioner immediately, for all practical purposes. It was not necessary for petitioner to transfer 84,347 shares of its own stock to Riggs in order to acquire all of Riggs's assets. Rather, this step represented an artifice which we are obliged to recognize for what it truly was. Gregory v. Helvering, supra. 6

7 Closing the Circle 1. Legal acquisition B&L assets Minority 105,508 B&L shares 79% 21% Riggs Tax Court recast B&L assets Minority 79% 21% 2. Legal dissolution B&L Minority 21,161 B&L shares and 79% of Riggs stock Riggs 21,161 B&L shares 84,347 B&L shares 79% 21% Riggs 21,161 B&L shares 7

8 The Exceptions that Swallowed the Rule Rev. Rul Similar facts as Bausch & Lomb, except that Y (the subsidiary) merges into X (its 79% parent). Qualifies as A reorganization. Upstream A reorganization X X stock Y Minority 79% 21% Rev. Rul Similar facts as Bausch & Lomb, except that M (the subsidiary) transferred all of its assets to a newly formed subsidiary of Parent (the 72% parent) in exchange for Parent voting stock. Qualified as a triangular C reorganization. P voting stock 1 Newco Triangular C reorganization Parent P voting stock 2 assets M 3 Public P voting 72% stock 28% 3 P voting stock 8

9 The Demise of Bausch & Lomb Bausch & Lomb overturned by regulations (the anti-bausch & Lomb regulations ). Regulations issued in May 2000 (T.D. 8885) repealed the rule of Bausch & Lomb that prior ownership of target stock will disqualify a C reorganization. Treas. Reg (d)(4) now provides that prior ownership of stock of the target corporation by an acquiring corporation will not by itself prevent the solely for voting stock requirement from being satisfied. However, the stock of a target corporation acquired in exchange for money or other property in connection with a potential acquisition by an acquiring corporation of substantially all of a target corporation's properties will still be treated as non-qualifying consideration. Reasons for repeal of Bausch & Lomb: The preamble to the proposed regulations (REG ) explained that, according to the legislative history, the purpose of the solely for voting stock requirement is to prevent transactions that resemble sales from qualifying for nonrecognition of gain or loss available to corporate reorganization. In this regard, [t]he IRS and Treasury Department have concluded that a transaction in which the acquiring corporation converts an indirect ownership interest in assets to a direct interest in those assets does not resemble a sale. Moreover, an upstream merger could qualify as an A reorganization, due to the absence of a solely for voting stock requirement under section 368(a)(1)(A). The repeal of Bausch & Lomb conforms the treatment of upstream C reorganizations with upstream A reorganizations. 9

10 Gone and Back Again PLR (Sept. 24, 2009)* Land $100 value $20 basis 2 P S LLC 1 3 New S S LLC PP&E $300 value $100 basis P wants to obtain land owned by S. If S distributes the land, S would recognize $80 of gain (section 311(b)), and P would have $100 of dividend income (section 301(b)(1), (c)(1)). Instead, P and S engage in the following transactions: (1) S converts to an LLC, (2) S distributes the land, and (3) P contributes S LLC to New S. Ruled: The conversion qualifies as a C reorganization. S recognizes no gain on the deemed distribution of the land to P in step 1 (section 361(a)), P recognizes no gain on the receipt of the land in deemed exchange for its stock (section 1032). *Modified facts for illustration purposes 10

11 Does Bausch & Lomb Still Live? Rev. Rul , C.B Y liquidates X Y >80% Z 2. X acquires remaining Z stock X >80% X voting stock Z stock Z Minority S/Hs <20% Minority S/Hs <20% X owned all the stock of Y, which owned more than 80% of Z. In order to obtain 100% of Z, X caused Y to liquidate under section 332 and then X acquired the remaining Z stock held by minority interests in exchange solely for X voting common stock. Ruled: section 1001 exchange for the Z minority shareholders. X s acquisition of Z stock did not satisfy the solely for voting stock requirement of section 368(a)(1)(B), because, in the integrated transaction X received more than 80% of the Z stock in exchange for its Y stock. T.D A comment was received requesting that the IRS reconsider its position in Rev. Rul where the Bausch & Lomb doctrine was applied to disqualify a purported section 368(a)(1)(B) reorganization that followed a tax-free section 332 liquidation The commentator's suggestion is beyond the scope of this regulations project, which relates to "C" reorganizations. In light of these regulations, the IRS and Treasury Department may reconsider Rev. Rul

12 Wham Construction Company, Inc. v. U.S. 600 F.2d 1052 (4th Cir. 1979) June 1959 Two brothers, Norman and James Wham, had previously operated a construction business and an asphalt paving business as separate divisions of a partnership. On June 30, 1959, the Wham brothers formed Wham Construction Company, Inc. ( Construction ) and transferred all of the partnership s assets to Construction in a taxfree transaction. 12

13 The Wham Structure Prior to 1966 Wham Brothers Construction carried on its business in two entirely separate divisions the Construction Division and the Asphalt Division. Construction Division Construction Payable Asphalt Division Separate bank accounts were maintained for each division, and each division kept their separate books. However, each division maintained an intra-company account, and from 1962 to 1966, the intracompany account of the Asphalt Division reflected a payable owing to the Construction Division. 13

14 The Wham Transaction Construction Division Wham Brothers Construction Payable Assets of the Asphalt Division Asphalt Asphalt Division December 1966 Construction incorporated a new corporation known as Wham Asphalt Company, Inc. ( Asphalt ). Construction transferred all of the assets of the Asphalt Division to Asphalt. At the time of the transfer, the Asphalt Division s payable owing to the Construction Division amounted to approximately $160,000, and Construction had gain in the assets of the Asphalt Division of at least $160,

15 Section 351 of the Code Section 351(a) No gain or loss is recognized if property is transferred to a corporation by a person (which includes a corporation) solely in exchange for stock or securities of such corporation, provided that immediately after the exchange, such person is in control (i.e., possessing 80% of the vote and 80% of the number of shares of each class of non-voting stock) of the corporation. Section 351(b) If section 351(a) would apply to the exchange but for the fact that other property or money is received by the transferor, then the transferor must recognize gain (but not loss) in an amount not in excess of the amount of money plus the fair market value of the other property received. 15

16 The Arguments and Holding of Wham IRS s argument: Construction realized taxable gain upon the transfer of the assets of the Asphalt Division into Asphalt because, prior to the transaction, there was no loan on the books of Construction (as a corporation cannot be indebted to itself). Pursuant to the transfer, Construction received an account receivable from Asphalt, and such account receivable constitutes other property within the meaning of section 351(b). Wham s argument: The account payable of the Asphalt Division (and the corresponding account receivable of the Construction Division) was not part of the exchange. The intra-company accounts were already on the books of the two divisions and simply remained there through the transaction. District Court s holding: The account receivable should not be considered other property since it represented a mere loan, and such loan was in existence prior to the transaction. The purpose of section 351 is to save the taxpayer from an immediate recognition of gain (or loss) when there has only been a mere change in the form of ownership. To hold otherwise would result in the taxation of the same income twice in the hands of the plaintiff, and the Court did not believe such result was intended by Congress when it enacted section

17 Holding of the Fourth Circuit The Fourth Circuit upheld the holding of the District Court, stating that [w]e think the position of the Commissioner entirely too technical and unrealistic. Moreover, it is readily apparent that what [Construction] got it already owned. What the brothers did was to wrap the asphalt business, close to its reflection on the separate asphalt division books, into a new corporate housing. There was no substantive change When there has been only a change in form and the transferor has not received anything which, in an economic sense, he did not possess before, he should not suffer the imposition of income tax liability When there is but one transferor, as here, and the issuing corporation has no assets except those derived from the transferor, it is difficult to conceive of a concept that the transferor as a result of the transaction received anything which he did not have before unless the exchange was couched in terms of a sale. The exchange here, however, cannot be regarded as a partial sale, for the $160,000 receivable was the same old receivable that had been on the construction division books In short, there was no economic change of substance effected by the exchange, and the construction company received in the exchange no "other property" within the meaning of [section] 351(b). 17

18 Rev. Rul and Springing Liabilities Facts X X corporation operated its business in two entirely separate divisions ( Division 1 and Division 2 ). Division 1 $100 Payable Division 2 For valid business reasons, X transferred all of the assets of Division 2 to newly formed Y corporation in exchange for all of the stock of Y. At the time of the transfer, Division 2 had an intracompany account payable due to Division 1 of $100. Holding X received other property in the form of the $100 account receivable and therefore must recognize $100 gain under section 351(b). X Assets of Division 2 The intracompany accounts did not give rise to a debtorcreditor relationship between X and Y prior to the incorporation of Y because X could not have been liable for a debt to itself. They were mere bookkeeping entries by X. A real liability came into being when X transferred Division 2 to Y. Division 1 Y The IRS will not follow the decision of the Fourth Circuit in Wham. $100 Payable Division 2 Note Section 357(a) does not apply to springing liabilities (only to liability assumptions). 18

19 Section 304 Trap for the Unwary Facts P F DRE $100 Payable P owns all of the interests in a foreign entity that is disregarded as separate from P for U.S. federal income tax purposes ( F DRE ). F DRE, in turn, owns all of the stock of foreign subsidiary ( FS ). DRE has a $100 payable owing to P. FS What result if DRE elects to be classified as a corporation for U.S. federal income tax purposes? 19

20 Zenz v. Quinlivan 213 F. 2d 914 (6th Cir. 1954) Toledo, Ohio, 1949 Fern R. Zenz was the sole shareholder in Carl Zenz & Associates Company, which was in the business of excavating sewers. She had originally held the shares with her husband Carl E. Zenz who died in 1946 leaving her the shares [108 total shares]. Ms. Zenz remarried an employee of the Zenz company. When the two divorced in 1949, Zenz no longer wished to operate the company. A competing construction company, Koder Construction & Supply Company, offered to purchase the company, but it did not want to assume the company s earned surplus and profits. 20

21 The Zenz Transaction Transaction steps: 1.On March 12, 1949, Zenz sold 47 shares to Koder Construction & Supply ( Koder ) for $37,130, payable in cash and the balance to be secured by the 47 shares of stock. 2.On March 31, 1949, as part of an integrated plan with step 1, Zenz sold her remaining 61 shares to the Zenz Company for $48, $48,190 Fern Zenz Zenz Co. Fern Zenz 47 shares $37, shares Koder Koder Zenz Co. 21

22 The Arguments and Holding of Zenz Zenz s Argument: Gain from the second step stock repurchase should be gain from the sale of a capital asset because (1) Zenz completely eliminated her interest in the company and (2) the net effect of the transaction was a partial liquidation. IRS s argument: The net effect of the transaction was to withdraw the corporate earned surplus and pay it over to the plaintiff. The distribution was essentially equivalent to the distribution of a taxable dividend. District Court holding: The distribution was taxable as a dividend. The Court agreed that the sale and the redemption transaction should be seen as a single operation. However, the Court considered the form of the transaction a circuitous approach to eliminating the earned surplus of the Zenz Company so neither party would recognize dividend income. Additionally, there was no corporate contraction of operations and no evidence of reduction of capital to characterize the distribution as a partial liquidation. Appeals Court reverses: The 6th Circuit found any tax avoidance motive to be irrelevant. Here, the controlling fact was that the distribution completely extinguished the shareholder s interest in the corporation. Such a distribution cannot be essentially equivalent to a dividend. The appeals court cites Gregory v. Helvering for the principle that a taxpayer can use legal means to secure a tax advantage. 22

23 Rev. Rul C.B Transaction steps: Situation 1: 1. A and B owned 50 shares each of corporation X stock (100 total shares). A and B caused Corp. X to issue shares 25 shares to C. 25 shares A X Corp. B 25 shares 1 25 shares FMV C 2. Corp. X redeemed 25 shares from both A and B. After the transactions A, B, and C each owned 25/75 shares. 25 shares 25 shares 25 shares A B C X Corp.

24 Rev. Rul C.B. 113 Transaction steps: Situation 2: 1. A and B sold 15 shares each to C for FMV. 2. Corp. X redeemed 5 shares from A and B each. FMV A 2 5 shares X Corp. B 1 5 shares 15 shares FMV 15 shares C After the transactions A, B, and C each owned 30/90 shares The Service ruled that both situation 1 and 2 were two-step integrated transactions in which the order did not matter. 30 shares 30 shares 30 shares A B C X Corp. 24

25 Section 302(b)(2) Substantially Disproportionate Redemption of Stock Substantially Disproportionate Redemptions: 1. Shareholder must own less than 50% of the total combined voting power of all classes entitled to vote immediately after the redemption, and 2. The percentage of voting stock owned immediately after the redemption must be less than 80% of the percentage owned by the shareholder immediately before. Application to Rev. Rul Situation 1: Issuance to C and Redemption Shareholders A and B started with 50/100 shares or 50%. Shareholders A, B, and C all ended with 25/75 or 33.33% % is 66.66% of beginning percentage and less than 50% of the total voting shares. Situation 2: Sale of shares to C and Redemption Shareholders A and B began with 50% each. Shareholders A, B, and C ended with 30/90 shares each or 33.33%. As above, this qualifies as a substantially disproportionate redemption. 25

26 Merrill Lynch Firm and Fixed Plan A case of Hyper-Zenz-itivity? A parent company wanted to sell the stock of Resources, one of many of its subsidiaries. But first: 1. Resources sold a number of its subs to sister corporations. These were wanted assets they were pulling out of Resources. 2. Soon after, the parent company negotiated with a buyer and sold Resources. Parent company claimed that the cross-chain sales should be dividend equivalent redemptions under sections 302(a) and 304, rather than complete terminations of interest. The dividend distributions increased Resources stock basis so Parent could claim a loss upon the sale of Resources stock. The Court integrated the transactions and disallowed dividend treatment and, thus, the loss on the Resources stock sale. Resources Buyer Resources Basis increased from dividend distributions Simplified Transaction Parent Subs stock Treated as 302(d) / 304 Dividend Equivalent Redemption Resources stock Sister Corp. Subs Parent Sister Corp. Subs 26

27 Zenz Taketh Away As in Merrill Lynch, taxpayers in Rev. Rul were looking for dividend treatment: Y corporation had purchased stock in X. As part of an integrated plan Y redeemed a portion of X stock and sold the remainder to a third party. Y treated the redemption as a dividend distribution and claimed (1) a section 243 dividends received deduction, (2) increased its basis in the remaining shares by the basis of the stock redeemed, and (3) claimed a capital loss on the subsequent sale from the increased basis. The IRS applied Zenz to disallow dividend treatment and disallow the dividends received deduction and basis increase, thereby eliminating the capital loss. 27

28 H.G. Hill Stores, Inc. v. Commissioner 44 B.T.A 1182 (1941) December 1937 H.G. Hill Stores ( Stores ) had opened its first grocery store in Nashville in In the following years, Stores expanded to over 500 locations in the southeast. Stores owned 49 of the 50 shares of Penick stock. Stores had also loaned $132K to Penick, but Penick had been unprofitable. As of December 29, 1937, Penick s assets exceeded its liabilities (excluding the liabilities owed to Stores) by only $21K. Thus, Penick s assets were insufficient to satisfy its obligations owed to Stores. 28

29 The H.G. Hill Stores Transaction Transaction steps: 1. On December 27, 1937, Penick s directors resolved to transfer all of its assets subject to its liabilities to Stores for (1) a sum equal to Penick s net book value at the close of business on December 29, 1937 (i.e., $21K), and (2) the cancellation of Penick s debt owed to Stores. 1 Assets subject to liabilities Stores Penick 2 Debt cancelled 2. The transfer was made on December 29,

30 Section 332 Liquidation Requirements Adoption of a plan of liquidation; Solvency/cancellation or redemption of subsidiary stock; FMV of assets must exceed liabilities/liquidation preference of preferred stock. 80% ownership; Corporate shareholder must own 80% of vote and value of liquidating subsidiary (section 1504(a)(2)) from time the plan of liquidation is adopted until the time the last liquidating distribution is made. Timing. All liquidating distributions must be made in a single taxable year (or up to 3 years if the period is specified). 30

31 The Arguments and Holding of H.G. Hill Stores Stores argument: Stores was entitled to a bad debt deduction and a deduction for the cost of its Penick stock (due to worthlessness). Since Stores received all of Penick s assets in its capacity as a creditor rather than a shareholder, section 112(b) of the Revenue Act of 1936 (a predecessor to section 332) did not apply. IRS s argument: Section 112(b) applied to the transfer from Penick to Stores because the amounts Stores loaned to Penick were really capital contributions rather than advances that created indebtedness. The transfer on December 29, 1937, was a distribution to its stockholder in liquidation under section 112(b), and Penick recognized no gain or loss as a result of the transfer. Board of Tax Appeals holding: The facts, as stipulated, were that the advances created indebtedness. Section 112(b) was not intended to cover a sale or transfer of assets to a creditor the language of the statute was clear that the distribution must be in complete cancellation or redemption of the stock. Since Stores received no property from Penick as a stockholder (i.e., Penick transferred its assets to Stores for a sum and cancellation of remaining indebtedness), Penick distributed nothing to stockholders. As such, section 112(b) did not apply, and Penick was entitled to claim the bad debt and stock losses. 31

32 Aftermath of H.G. Hill Stores Government adopts holding of H.G. Hill Stores in Revenue Ruling: The IRS published Rev. Rul , C.B. 87, which holds an insolvent subsidiary s merger into its creditorshareholder is a transfer made in satisfaction of indebtedness, and neither section 332 nor 368 apply. Insufficient assets to satisfy preference on preferred stock also precludes a tax-free liquidation: In Spaulding Bakeries v. Commissioner, 27 T.C. 684 (1957), aff d 252 F.2d 693 (2d Cir. 1958), Hazelton distributed all its assets to its sole shareholder in liquidation. At the time, the shareholder, Spaulding, held all of the outstanding common and preferred stock of Hazelton. The preferred stock had a liquidation preference over the common stock. At liquidation, Hazelton s assets were insufficient to satisfy the liquidation preference on the preferred stock. Spaulding claimed a deduction for its cost of the common stock of Hazelton due to its worthlessness. The IRS claimed the liquidation satisfied the requirements of section 112(b) and denied the loss. The court held section 112(b) did not apply. That section required a distribution in complete cancellation or redemption of all stock of the subsidiary. Since there were insufficient assets to pay the preference on the preferred, no amounts were distributed on the common stock and section 112(b) was not satisfied. See also H.K. Porter v. Commissioner, 87 T.C. 689 (1986). Proposed Net Value Regulations: In March 2005, Treasury issued proposed regulations governing the treatment of nonrecognition transactions (including section 332 liquidations) involving insolvent companies. For section 332 liquidations, the proposed regulations codify existing law and require a shareholder to receive some payment with respect to each class of stock in the liquidating subsidiary in order for section 332 to apply. See Prop. Reg. Sec

33 Rev. Rul C.B. 135 Facts: P corporation wholly owned S corporation. S had sustained operating losses in prior years that resulted in a net operating loss (NOL) carryover. S was indebted to P in an amount greater than the fair market value of its assets. P desired to avail itself of S s NOLs under section 381 (i.e., P wanted S to liquidate into P tax-free under section 332). 33

34 Rev. Rul Transaction Transaction steps: 1. P cancelled the indebtedness owed to it by S. P 1 Debt cancelled 2. Immediately thereafter, S transferred all of its assets subject to its liabilities to P pursuant to a plan of liquidation. Assets subject to liabilities 2 S P S 34

35 Rev. Rul Analysis Section 332 doesn t apply to a liquidation of an insolvent subsidiary into its creditor-shareholder. See Rev. Rul Since the step involving the cancellation of the indebtedness from S to P was an integral part of the liquidation and had no independent significance other than to qualify S s liquidation under section 332 so that P could inherit S s NOLs under section 381, the debt cancellation will be considered transitory and disregarded. With the cancellation of debt disregarded, P is considered to have received nothing in payment for the S stock. The transaction is not a liquidation within the meaning of section 332 and the NOLs of S may not be carried over and used by P. 35

36 A Planning Alternative - Rev. Rul C.B. 147 Facts: P owns S-1 and S-2. S-1 is indebted to P (valid, old and cold debt) in an amount in excess of the aggregate basis of its assets. P desires to combine S-1 and S-2 in a tax-free merger. Debt cancelled 1 P Transaction Steps: Prior to the merger, P gratuitously cancels the principal amount of the debt owned by S-1 so as to avoid the application of section 357(c). (at that time, applicable to acquisitive D reorganizations; but see Rev. Rul ) S1 then merges into S-2. S-1 S-2 Holding: P s cancellation of the S-1 obligation had independent economic significance because it resulted in a genuine alteration of a previous bona fide business relationship. P s cancellation of the principal amount of the debt owed by S-1 to P will be given substance as a contribution by P to the capital of S-1 and section 357(c) will not apply to the subsequent merger. P S-1 S-2 2 Merger 36