Stock Basis and Boot Considerations Inside Consolidation Neil Barr Davis olk & Wardwell LL Rebecca O. Burch Ernst & Young LL Gordon Warnke Linklaters LL (Moderator) Kevin M. Jacobs Internal Revenue Service Brett York Treasury Department American Bar Association Taxation Section Washington, DC May 6, 2016 Copyright 2016 Gordon Warnke, Neil Barr & Rebecca Burch. The panelists would like to express their gratitude to Katherine Long at Linklaters LL and Joshua Micelotta at Davis olk & Wardwell LL for their help in preparing the slides for this panel.
The Basics 2
Overview Under the consolidated return regulations, the rules that are applicable outside of consolidation also apply inside consolidation... except when they don t The [Code], or other law, shall be applicable to the group to the extent the [consolidated return] regulations do not exclude its application. To the extent not excluded, other rules operate in addition to, and may be modified by, [the consolidated return] regulations. -80(a) Examples of when rules that can affect stock basis outside of consolidation don t apply, or are modified, inside consolidation, include: Creation (and smoothing) of excess loss accounts (-19; -32(c)) Treatment of boot in reorganizations (-13(f)(3)) Turning off of 304 (-80(b)) Turning off of 357(c) (-80(d)) The redetermination of basis under the unified loss rules (-36(b)) 3
Overview (cont d) In general, however, there are no special rules inside consolidation directly addressing 302 redemptions or 351 transactions The interaction of Code (and regulation) provisions that are turned off, or modified, inside consolidation with those that are not, can lead to some interesting consequences For example, where the transferred asset is stock, turning off 304 without modifying 351 can lead to 351 transactions with boot that would result in dividend treatment outside of consolidation but results in gain (usually deferred) inside consolidation Also, the interaction of the ELA rules with the (unmodified) 302 redemption rules can lead to interesting questions regarding if (and, if so, how) ELAs shift (or hop ) in certain redemptions Selected aspects of the consolidated return stock basis and related rules are explored in the following slides 4
ELA Creation and Smoothing 5
ELA Creation Outside of consolidation, when a distribution is made in excess of the E& of the distributing corporation, that distribution reduces basis in the holder s stock and, to the extent in excess of basis, results in gain recognition ( 301(c)) Inside consolidation, adjustments to the basis of member stock that are in excess of preadjustment basis generally don t result in current gain recognition. Instead, the adjustment creates (or increases) negative tax basis, which the consolidated return rules refer to as an excess loss account or ELA An ELA can be created through a distribution in excess of basis (-32(c)(1)(i); cf. 301(c)(3)) An ELA can also be created, for example, by an adjustment to basis under -32 to reflect loss recognized by a member and utilized by another member of the group Under the consolidated return regulations, an ELA is treated for all federal income tax purposes as basis that is a negative amount, and a reference to a member shareholder s basis in another member s stock includes a reference to member shareholder's ELA in such stock. -19(a)(2)(ii). (But see -28(b)(3)(iii), treating basis of stock that has an ELA as zero for purposes of applying 1017(b)(2).) 6
ELA Smoothing A number of provisions in the consolidated return regulations are designed to smooth ELAs (which serves to ensure that recognition of income resulting from an ELA is minimized) For example, under -32(c)(2)(i), investment adjustments with respect to common stock are allocated in such a manner as to equalize and eliminate ELAs in shares of that class held by a member Cf. Reg. 1.1367-1(c)(3) (providing a spill over approach under which all basis in a shareholder s shares in a Sub S corporation is absorbed before any gain is triggered); Rev. Rul. 84-53, 1984-1 C.B. 159 (providing for a single unified basis in all partnership interests held by a partner) Note, however, that the -32(c)(2)(i) smoothing applies only with respect to investment adjustments OTHER THAN adjustments resulting from distributions made by the distributing member 7
ELA Smoothing (cont d) Similarly, under -19(d), basis is allocated in certain reorganizations and other transactions in such a manner as to equalize and eliminate ELAs This rule reflects a policy of permitting the elimination of excess loss accounts. T.D. 9244 (2006) (cf. ELA elimination in 332 liquidations) More specifically, -19(d) provides that if a member of a consolidated group (M) has an ELA in the shares of a class of another member s (S s) stock at the time of a basis adjustment or determination with respect to shares of the same class of S s stock owned by M, the adjustment is allocated first to equalize and then eliminate the member s ELA Similar rules apply where M would otherwise determine new shares of S to have an ELA when M owns other shares of the same class of S stock Note: -19(d) only applies as regards shares of the same class Query: How broad is the scope of -19(d)? See, e.g., LR 201143012 (applying - 19(d) evidently to permit basis in purchased shares to reduce or eliminate ELAs in historic shares) 8
Example of Smoothing of ELAs Under -32 Scenario 1: Scenario 2: Before After Before After* $70 Block 1 100 shares $100 basis S Block 2 100 shares $0 basis Block 1 100 shares $30 basis S Block 2 100 shares $0 basis Block 1 100 shares $100 basis S Block 2 100 shares $0 basis Block 1 100 shares $65 basis S Block 2 100 shares $35 ELA $70 Utilized Loss $70 Distribution * Assumes Johnson v. United States, 435 F.2d 1257 (4th Cir. 1971), applies 9
Example of Smoothing of ELAs Under -19 Before Transaction: In a D reorganization, S1 transfers all of its assets to S2 in exchange for 100 S2 shares and then liquidates After 100 shares $100 FMV $100 basis 100 shares $100 FMV $70 ELA 100 shares $100 FMV $100 basis 100 shares $100 FMV $70 ELA Block 1 100 shares $30 basis Block 2 100 shares $0 basis S1 S2 S1 All S1 assets S2 stock S2 S2 10
Intercompany Reorganizations 11
Boot in Intercompany Reorganizations -13(f)(3) generally applies special rules to an intercompany transaction in which the receipt of money or other property (boot) would otherwise result in the application of 356 Note: The special rules do not apply if a party to the transaction becomes a member or nonmember as part of the same plan or arrangement Also, the special rules of -13(f)(3) only apply if 356 would otherwise apply to the boot; thus, for example, the special rules do not apply to boot received in a 351 transaction Under the special rules, boot is treated as received by the member shareholder in a separate transaction. See, e.g., 302 and 311 (rather than 356 and 361). -13(f)(3) The boot is treated as taken into account: o o Immediately after the transaction if 354 would apply but for the fact that boot is received (i.e., if the transaction is an acquisitive reorganization). Cf. Commissioner v. Clark, 489 U.S. 726 (1989); Rev. Rul. 93-61, 1993-2 C.B. 118 Immediately before the transaction if 355 would apply but for the fact that boot is received (i.e., if the transaction is a divisive transaction). Cf. Rev. Rul. 93-62, 1993-2 C.B. 118 12
Stockless D Reorganization with Boot: -32(b)(5), Ex. 6 Facts: All of the parties join in a consolidated return owns all 10 shares of S and all 10 shares of T Each S share has a $5 basis and $10 value 10 Shares C/S $50 basis $100 FMV 10 Shares C/S $100 basis $100 FMV Each T share has a $10 basis and value Neither S nor T has any -32 adjustments outside the reorganization T merges into S under 368(a)(1)(A) & (D) in exchange for $10 boot and no other consideration S Merger $10 T Analysis: Under -13(f)(3) and Reg. 1.358-2(a)(2)(iii) and 1.368-2(l)(2), is deemed to receive 10 new S shares Under Reg. 1.358-2(a)(2)(i), has a $10 basis in each new S share Under Reg. 1.358-2(a)(2)(iii), is deemed to exchange 20 S shares in a 368(a)(1)(E) recap for 10 S shares Under Reg. 1.358-2(a)(2)(i), has 5 S shares each with a $10 basis and 5 S shares each with a $20 basis Under -13(f)(3), the $10 boot is treated as a separate distribution of $10 of S stock to which -32(b)(2)(iv) applies, reducing s total S stock basis from $150 to $140 Where does -32(c) allocate the $10 distribution among the blocks of S shares? (Cf. LR 201014048) What is s basis in each share of S stock after the distribution? 13
All-Cash D Reorganization; -13(f)(7), Ex. 4 Facts: All of the parties join in a consolidated return, and T1 owns T2 s stock with a $25 basis and $100 value T merges into S under 368(a)(1)(A) & (D) in exchange for $100 boot and no new stock Analysis: Under Reg. 1.368-2(l), T1 is deemed to receive in $100 the merger both $100 and a nominal S2 share Under -13(f)(3) and Reg. 1.358-2, T1 is deemed to receive in the merger solely $100 of S2 stock with a $25 basis, followed by S2 redeeming for $100 all of the deemed S2 stock in a 302(d) redemption Under -2(l), -32(b)(3)(v) and Reg. 1.302-2(c) the redemption results in T1 having a $75 ELA in the nominal share and T1 is deemed to distribute the nominal share to under 301 & 311 and - 13(f)(2), followed by transferring the nominal share to S1 under 351 T1 s distribution converts T1 s $75 ELA in the S2 stock into a $75 gain deferred under -13(c) and (d). Under Reg. 1.358-2(a)(2)(iii), S1 designates an actual S2 share to which the zero basis in the nominal S2 share attaches (thereby presumably making such share a successor asset to the nominal share under -13(j)(1)) S1 S2 Merger T1 T2 Basis $25 FMV $100 14
Redemptions 15
Redemptions There are no special rules specifically addressing the basis consequences of redemptions in the consolidated return regulations Accordingly, under -80(a), the rules applicable outside of consolidation apply Almost all redemptions of member stock (other than common parent hook-stock) will be dividend-equivalent redemptions (i.e., redemptions to which 302(d) applies) The rules applicable to dividend equivalent redemptions outside of consolidation are not the model of clarity In addition, unlike outside of consolidation, inside consolidation (i) all distributions (not just those in excess of E&) will impact stock basis and (ii) ELAs can be created (or increased), rather than gain recognition under 301(c)(3) 16
Redemptions (cont d) Under Reg. 1.302-2(c) a proper adjustment is made to the basis of remaining shares to account for any excess (i.e., unrecovered) basis in the redeemed shares In the examples in Reg. 1.302-2(c), the excess basis in the redeemed shares hops to the redeemed shareholder s remaining shares, when the redeemed shareholder has remaining shares, and to shares held by a related person whose shares are attributed to the redeemed shareholder under 318 when the redeemed shareholder has no remaining shares But note that the government has indicated that it may view a hopping of excess stock basis from one shareholder to shares held by a related shareholder as not being a proper adjustment in at least some circumstances. See Notice 2001-45, 2001-2 C.B. 129 (2001) 17
Redemptions (cont d) roposed regulations were issued in 2002 (the 2002 roposed Regulations ) (REG 150313 01) that would have created, on a share by share basis, a deferred loss for any excess basis in a share, or triggered a deferred gain to the extent the share was held by a consolidated return member and had an ELA The commentary on the 2002 roposed Regulations was not universally favorable. See, e.g., American Bar Association Section of Taxation, Comments Concerning roposed Regulations roviding Guidance Regarding the Treatment of Unutilized Basis of Stock Redeemed in Certain Transactions (Sept. 9, 2003) The 2002 roposed Regulations were withdrawn in 2006 18
Redemptions (cont d) In 2009, proposed regulations were issued (the 2009 roposed Regulations ) (REG- 143686-07) that apply a two pronged approach to dividend equivalent redemptions: If less than all shares in a class held by a holder are redeemed, the distribution is treated as being with respect to all shares in that class held by the holder and then all shares (including the shares redeemed) are treated as recapped into the number of remaining shares held by the redeemed holder If all shares in a class held by a holder are redeemed, any excess basis in the redeemed shares are treated as a deferred loss that generally is then recognized on the date (the inclusion date ) when the facts become such that, had they existed at the time of the redemption, 302(a) rather than 302(d) would have applied to the redemption The 2009 roposed Regulations do not specifically address any consolidated return issues arising in the redemption context, but the preamble requests comments, stating: The IRS and Treasury Department continue to study the issues raised when a redeemed shareholder with a deferred loss files a consolidated return. The IRS and Treasury Department believe that certain of the concerns raised by [the 2002 roposed Regulations] are addressed in these proposed regulations by the deemed [proportional distribution and recapitalization approach of the 2009 roposed Regulations]. 19
artial Redemption: LR 201352007 (Simplified Facts) Facts (simplified): All parties are in the consolidated group S1 owns all of S3 preferred stock (p/s) and together, S1 and S2, own all of S3 s common stock (c/s) S3 redeemed all of the preferred stock held by S1 and some (but not all) of the common stock held by S1 Analysis: Ruling 8: The redemption proceeds were treated as a distribution of property to which 301 applies. Sections 301 and 302(d). Ruling 9: The distribution was excluded from [S1 s] gross income and the... Redemption proceeds... reduce[d] [S1 s] basis in its remaining shares of [S3] Common Stock. Sections 1.1502-13(f)(2), 1.1502-32, and 1.302-2(c). Ruling 10: The redemption did not cause S1 to recognize gain on its redeemed [S3] stock or take into account as income or gain its ELA, if any, in its S3 Common Stock. Section 302(d); 1.1502-19(a)(2)(ii) and (a)(3). S1 $ c/s p/s 302(d) S3 c/s S2 20
Full Redemption: LR 200810015 (Simplified Facts) Facts (simplified): All of the parties are in the consolidated group C redeems all of its shares owned by B for cash equal to the fair market value of the shares *See also LR 9815050 (similar result) Analysis: [B s] ost Redemption Basis will shift to [ s] [C] stock. If the ost Redemption Basis is a positive amount, [ s] basis in its [C] stock will increase; if the ost Redemption Basis creates or increases an excess loss account C ( ELA ), [ s] basis in its [C] stock will decrease accordingly ( 1.302-2(c)). Under 1.1502-32, (i) if the ost-redemption Basis is positive, each of [A s] basis in its [B] stock and [ s] basis in its [A] stock will decrease by the amount of the ost-redemption Basis, or (ii) if the ost-redemption Basis is negative, each of [A s] basis in its [B] stock and [ s] basis in its [A] stock will increase by the amount of the ELA represented by the ost-redemption Basis. Allocations of the investment adjustments between the common and preferred stock of [B] will be made in accordance with 1.1502-32(c). The Redemption will not cause [B] to recognize gain on its [C] stock or take into account as income or gain its [ELA], if any, in its [C] stock ( 1.1502-19(a)(2)(ii), 1.1502-19(a)(3)). +/- +/- A C/S B /S 302(d) -/+ 21
Redemption (Excess Basis): roposed Regulations Facts: All of the parties are in the consolidated group S1 owns all of S3 preferred stock (p/s) (basis = $200), and together, S1 and S2, own all of S3 s common stock (c/s). S3 redeems all of its p/s owned by S1 for $150 S1 302(d) S2 Analysis: The redemption is treated as a distribution of property to which 301 applies via 302(d), and, as a result, S1 s basis in S3 is reduced under -32. This creates excess basis of $50 (basis of $200 less $150, equals $50 excess basis) Under rop. Reg. 1.302-5 (2002 or 2009), the $50 excess basis is a loss that is deferred until an inclusion date Under current law, the excess basis presumably would shift to S1 s common stock retained in S3 (see Reg. 1.302-2(c) and Rev. Rul. 66-37, 1966-1 C.B. 209) If, however, S1 retained any p/s of S3, rop. Reg. 1.302-5 (2009) would permit shifting of the excess basis within the p/s class; under rop. Reg. 1.302-5 (2002), the excess basis would be a deferred loss even if S1 retained some p/s $ c/s p/s S3 c/s 22
Redemption (Excess Basis): roposed Regulations (cont d) Facts: All of the parties are in the consolidated group S1 owns all of S3 preferred stock (p/s) (basis = $200), and together, S1 and S2, own all of S3 s common stock (c/s) S3 redeems all of its p/s owned by S1 for $150 S1 302(d) S2 Analysis (cont d): How is basis recovery applied in a 302(d) redemption? Redeemed shares only? All shares within redeemed class? Other? The methodology employed can result in having ELAs in some shares while having remaining basis in other shares in some cases Does the language of -32(c)(1)(i) shed any light inside consolidation on this issue? ( [Negative adjustments for distributions are] allocated to the shares... to which the distribution relates. ) Could -19(d) be interpreted broadly enough (or should -19(d) and/or -32(c) be amended) so as to eliminate and equalize ELAs among shares upon 302(d) and other distributions? If S1 retains neither c/s nor p/s in S3, under current law the $50 excess (plus any excess on the c/s redeemed) presumably shifts to S2 s basis in S3 c/s (see Reg. 1.302-2(c) and Rev. Rul. 71-563, 1971-2 C.B. 175) $ c/s p/s S3 c/s 23
Redemption (ELA): roposed Regulations Facts: All of the parties are in the consolidated group S1 owns all of S3 preferred stock (p/s) (basis = $200), and together, S1 and S2, own all of S3 s common stock (c/s) S3 redeems all of its p/s owned by S1 for $250 S1 302(d) S2 Analysis: The redemption is treated as a distribution of property to which 301 applies via 302(d), and, as a result, S1 s basis in S3 is reduced under -32. This creates an ELA of $50 (basis of $200 less $250, equals ($50) ELA) Under rop. Reg. 1.1502-19(b)(5) (2002), the $50 ELA is income or gain on the date of the redemption but deferred; the 2009 roposed Regulations are silent on this point -19(d) appears to want to remove the ELA if possible (but only applies to shares of same class); nonetheless, in LR 200810015, the ELA shifted to another shareholder of S3 (i.e., S2), where S1 retains no shares in S3; this would conform to the government s policy to eliminate/minimize ELAs, see T.D. 9244 (2006) (expanding scope of -19(d)) $ c/s p/s S3 c/s 24
Comparisons of All-Cash D Reorganizations and Redemptions 25
All-Cash D Reorganization Facts: All of the parties join in a consolidated return and T1 s stock in T2 has a $100 FMV and a $25 basis (1) S2 acquires all of T1 s T2 stock in exchange for $100 cash (2) T2 converts into a LLC, thereby becoming a disregarded entity S1 T1 Assumption: The combination of (1) and (2) is an all cash D reorganization. (Rev. Rul. 2004-83, 2004-2 C.B. 157) S2 1 T2 $100 FMV $25 Basis Result: T1 has $75 deferred intercompany gain T2 2 26
art-cash D Reorganization & Later Redemption Facts: All of the parties join in a consolidated return and T1 s stock in T2 has a $100 FMV and a $25 basis (1) S2 acquires all of T1 s T2 stock from T1 in exchange for $75 cash and $25 S2 stock (2) T2 converts into a LLC, thereby becoming a disregarded entity (3) Later, in an unrelated transaction, S2 redeems the $25 of stock issued to T1 for $25 (its then value) S1 S2 All-Cash D 1 T1 T2 $25 $100 FMV $25 Basis 3 T2 2 $25 S2 stock 27
art-cash D Reorganization & Later Redemption (cont d) Assumptions: Steps (1) and (2) are a D reorganization Step (3) is a 302(d) redemption All-Cash D Result: After Steps (1) and (2), T1 has S2 stock with a $50 ELA After Step (3), if LR 200810018 is followed, T1 has a $75 ELA in the redeemed S2 stock that then hops to S1 s stock in S2 S1 S2 T2 2 1 $25 S2 stock T1 T2 $100 FMV $25 Basis $25 3 28
All-Cash D Reorganization & Redemption Comparison In light of the general distribution based paradigm of the consolidated return regulations (and in particular, -13), and the various rules generally designed to eliminate and equalize ELAs (-19(d); -32(c); etc.), what policy drives converting what might otherwise be an ELA into an intercompany gain in all-cash D reorganization? Result follows from general application of 311(b), but the deemed distribution of the nominal share in an all-cash D, while a critical element of reorganization characterization, is not an obvious paradigm for converting an ELA into deferred intercompany gain (and other approaches (such as the basis hop in LR 200810018) have been adopted elsewhere) 29
All-Cash D Reorganization & Redemption Comparison (cont d) Would another possibility be to just treat the nominal share as staying in the hands of T1 with an ELA and then trigger the ELA only upon an inclusion date? Is this practical? Would this add very much to the stock gain redetermination provisions of -13(c)(6)? Note that if S1 issued even a single actual share to T1 in addition to cash (in a value-for-value exchange) and T1 retained this share, there would be no intercompany gain created and T1 would retain the ELA in the single S1 share Trap for the unwary or do the unwary not do all-cash D reorganizations? 30
The ELA Anti-Abuse Rule: -19(e) 31
Scope of -19(e): ELA Anti-Avoidance Anti-avoidance rule. If any person acts with a principal purpose contrary to purposes of this section, to avoid the effect of the rules or this section or apply the rules of this section to avoid the effect of any other provision of the consolidated return regulations, adjustments must be made as necessary to carry out the purposes of this section The language of the regulation is very broad, particularly the bolded language extending the application of the rule to actions taken seeking to apply the ELA rules of -19 in order to sidestep other provisions of the consolidated return regulations To what transactions might the anti-avoidance rule apply and how do we know the scope of this rule? 32
-19(g), Ex. 6: Avoiding Worthlessness Facts: The parties join in a consolidated return, and M forms S with $100 contribution and S borrows $150 Year 0 M For years 1 through 5, S has a $210 ordinary loss, and as a result, M has a $110 ELA in S s stock (-32(b)) S defaults on the indebtedness, but the creditor neither discharges the debt nor begins collection procedures At the beginning of year 6, S ceases all substantial operations, but maintains ownership with a principal purpose to avoid M s taking into account its ELA in S s stock Lender $150 $100 note 2 S 1 Analysis: Under -19(c)(1)(iii), M is treated as disposing of its S stock where the S stock becomes worthless Under -19(c)(1)(iii)(A), the S stock is treated as worthless if all of S s assets are treated as disposed of, abandoned or destroyed for federal income tax purposes (- 80(c)) Under -19(e), because S has ceased operations and maintained ownership with a principal purpose to avoid taking into account M s ELA in S s stock, S s assets will not be taken into account at the beginning of year 6 for the purpose of determining whether the S stock is worthless, and M s $110 ELA is taken into account Year 6 $110 ELA M S 33
332 and -19 (Basic Elimination) Facts: All of the parties join in a consolidated return has basis of $50 in S stock S has an ELA of $200 in S1 stock S1 liquidates into S in a transaction qualifying under 332 Result: S s $200 ELA in S1 is eliminated 332 $50 basis $200 ELA S S1 34
332 and -19 (Basic Elimination) 1 S1 stock 355 Analysis: $100 ELA $200 ELA $50 basis S S1 S2 C S1 liquidates into S1 S2 contributes S2 to C All of the parties join in a consolidated return, has an ELA of $100 in S stock and S has an ELA of $200 in S1 stock. S and S1 have the same value. S1 has $50 basis in S2 S distributes the S1 stock to, a publicly-traded corporation, in a transaction that qualifies as a 355 transaction Under -19(c), S is treated as disposing of its S1 stock Under -19(b)(2), S does not recognize any gain from the distribution 2 $50 ELA $50 ELA $50 basis ublic 3 S distributes C to ublic C 4 35
332 and -19 (Basic Elimination) (cont d) 1 S1 stock 355 $100 ELA $200 ELA $50 basis S S1 S2 C 2 S1 liquidates into $50 ELA $50 ELA $50 basis S1 S2 ublic 3 S contributes S2 to C distributes C to ublic C 4 Analysis (cont d): Under 358, S s ELA in the S1 stock is eliminated, and s $100 ELA in S stock is allocated $50 to S and $50 to S1 (Reg. 1.358-2) S1 then liquidates into in a transaction qualifying under 332, and s $50 ELA in S1 is eliminated subsequently transfers the S2 stock to C, followed by s distribution of C stock to its public shareholders 36
355 and -19(e): -19(g), Ex. 3 Facts: All of the parties join in a consolidated return, and has an ELA in S s stock, and S has an ELA in T s stock S distributes the T stock to in a transaction that qualifies as a 355 transaction, and neither nor S recognizes any gain or loss Analysis: Under -19(c), S is treated as disposing of its T stock. Under 355(c) and -19(b)(2), S does not recognize any gain from the distribution Under 358, S s ELA in the T stock is eliminated, and s ELA in S stock is allocated between its S and T stock based on relative FMVs (Reg. 1.358-2) ELA ELA S T T stock 355 37
355 and -19(e): FSA 200022006 Facts: nonvoting preferred All of the parties join in a consolidated return, and T borrows funds from an unrelated party, Bank, and distributes the funds to S, generating an ELA in S s T stock S distributes the T stock to in a transaction the Service assumes qualifies as a 355 transaction, and subsequently transfers the T stock to an unrelated party, Buyer, in exchange for Buyer s nonvoting preferred stock Bank cash note 1 2 cash S T ELA 4 T stock 3 T stock 355 Buyer T 38
355 and -19(e): FSA 200022006 (cont.) Analysis: Ignoring -19(e), same analysis as -19(g), Ex. 3 The facts of FSA 200022006 suggest a principal purpose of S s distribution of the T stock was to avoid S s recognition of its ELA as gain on the subsequent disposition of the T stock The Service distinguished -19(g), Ex. 3 because Ex. 3 exhibits facts suggesting the 355 transaction was merely an internal restructuring or a step toward the ultimate tax-free distribution of the T stock to s shareholders A direct transfer by S of the T stock to Buyer in exchange for nonvoting preferred stock would constitute a disposition of T stock under -19(c)(1)(i)(A), triggering the ELA Conference Report: excess loss accounts are not recaptured in certain cases where there is an internal spin-off prior to the subsidiary leaving the group. However, FSA notes that Congress did not expressly consider the application of -19(e). [R]elying on the anti-avoidance rule is inherently factual. Cf. LCiminelli Interests Inc. v. United States (W.D.N.Y. Nov. 13, 2012) (holding that taxpayer did not act with a principal purpose to avoid the ELA regulations or any other provision of the consolidated return regulations, where taxpayer s wholly-owned subsidiary had disposed of substantially all its assets (and thus was worthless within the meaning of -19(c)(1)(iii)(A)) in a tax year foreclosed from tax assessment liability) 39
355 and -19(e): FSA 200135002 Facts: and S join in a consolidated return, and S borrows cash from a third-party lender, Lender has an ELA in the S stock S defaults on loan, for which Lender discharges a portion of the indebtedness contributes to S real property, for stated purpose of converting S into s real property holdings entity. On date of contribution, assets contributed by were the only assets held by S Analysis: is treated as disposing of its S stock because S stock has become worthless within the meaning of -19(c)(1)(iii)(B) Under -19(c)(1)(iii)(B), stock of a member is deemed worthless if an indebtedness of the member is discharged, and any part of the amount discharged is not included in gross income and is not treated as tax-exempt under -32(b)(3)(ii)(C) Alternatively, under -19(c)(1)(iii)(A), S stock will be deemed worthless if all of S s assets are disposed of in exchange for relief from indebtedness Lender 3 R Contribution 2 note 1 cash S ELA S defaults; Lender Discharges S s indebtedness excluded the total amount discharged from gross income pursuant to 108(a)(1)(B), and improperly applied the total amount discharged to reduce S s tax attributes must take into account its ELA in the share as income or gain from the disposition Additionally, -19(e) might be applicable because the facts suggest that: (1) forfeited the bases in the contributed property in order to avoid triggering the ELA, or (2) the principal purpose of contributing the property was to avoid triggering the ELA 40
Section 304 Transactions 41
Section 304 Transactions Section 304(b)(4) provides that in the case of any 304 transaction involving the transfer of stock from one member of an affiliated group to another member of such group, proper adjustments shall be made to the adjusted basis of any intergroup stock and the E& of any member of such group to the extent necessary to carry out the purposes of 304 Cf. Reg. 1.302-2(c) providing for a proper adjustment to be made to the basis of remaining stock in the case of certain stock redemptions -80(b) was added to the consolidated return regulations in 1991, implementing 304(b)(4) as regards consolidated groups by merely turning 304 off inside a consolidated group -80(b) reads in its entirety as follows: Section 304 does not apply to any acquisition of stock of a corporation in an intercompany transaction or to any intercompany item from such transaction occurring on or after July 24, 1991. 42
Section 304 Transactions (cont d) The preamble to the regulation package adopting -80(b) (T.D. 8402) states that, absent 304(b)(4), a dividend arising under 304 could result in inappropriate adjustments to the basis in the stock of the transferor and other corporations in the consolidated group and the simplest way to implement the purposes of 304(b)(4) for a consolidated group is to turn off 304 for acquisitions of stock by one member of a consolidated group from another member of a consolidated group Although not expressly so stated in the preamble, turning off 304 inside consolidation would appear to have been prompted, at least in part, by concern that inter-group 304 transactions might otherwise be used to effectuate bust-up transactions 43
Example of 304 Bust-Up Transaction Step 1: acquires T for $100, then T sells W to S for $60 in a transaction to which 304 would otherwise apply $40 FMV $0 basis U T $60 FMV $0 basis W Sale of W 100% S W Step 2: In an unrelated transaction, later sells T (and hence U) to an unrelated buyer for $100 Buyer Sale of T T U 100% S W Analysis: Under 304, S is deemed to issue $60 of S stock to T for the W stock and then S is deemed to redeem that stock for $60 Assume that the $60 would otherwise result in an ELA in the S stock held by T and that ELA hops over to s stock in S in that case, s basis in T evidently would be increased by $60 to $160 and s basis in the S stock would be reduced by $60. Cf. LRs 9815050 & 200810015; Query impact, if any, of -19(e) ELA anti-avoidance rule on these facts absent -80(b) Even if s $60 loss on the sale ($160 basis less $100 proceeds) is disallowed under the unified loss rules, will have been able to extract W from T and dispose of U without any current tax cost, thereby accomplishing a bust up transaction 44
Example of 304 Bust-Up Transaction (cont d) Step 1: acquires T for $100, then T sells W to S for $60 in a transaction to which 304 would otherwise apply $40 FMV $0 basis U T $60 FMV $0 basis W Sale of W 100% S W Step 2: In an unrelated transaction, later sells T (and hence U) to an unrelated buyer for $100 Buyer Sale of T T U 100% S W Analysis (cont d): Because 304 is turned off under current law, T would have a deferred gain of $60 on its sale of W to S, which gain would be triggered when T leaves the group Query: What result if, as part of the same plan and immediately after the sale of W to S by T, W is converted into an LLC? What result if, instead of receiving back $60 of cash, T receives $60 of S stock and, at a later date in an unrelated transaction, S redeems the S stock T received? Would -80(b) be necessary if the deferred gain approach of rop. Reg. 1.1502-19(b) (2002) were adopted? 45
Section 351 Transactions 46
Section 351 Transactions There are no special rules in the consolidated return regulations dealing with stock basis in a 351 transaction Moreover, as discussed previously, 304 is turned off in a consolidated group Accordingly, most intercompany 351 transactions involving boot, including those where the transferred asset is stock of another member, results in the recognition of any realized gain up to the amount of the lesser of the boot or the gain, with the recognition being deferred until there is a subsequent triggering event under the matching and acceleration rules of -13(c) and (d) 47
Section 351 Transactions (cont d) But note that 357(c) does not apply to transaction between members (-80(d)) Section 357(c) continues to apply, however, to a transaction if the transferor or transferee becomes a nonmember as part of the same plan or arrangement As a result of turning off 357(c), an assumption of the transferor member s debt by the transferee member in a 351 transaction between members typically will result in a reduction of basis in the stock of the transferee received by the transferor, and if the debt assumed is greater than the basis of the assets transferred, in the creation of an ELA in that stock rather than the deferred recognition of gain Also, contrast the treatment of stock reorganizations with boot (posttransaction redemption treatment) with the treatment of stock 351 transactions with boot (deferred gain treatment) 48
Section 351 Transaction with Debt Assumption in Excess of Basis $40 debt S1 $30 basis $100 FMV $50 E& S1 S1 stock S2 Facts: transfers the stock of S1 to newly-formed S2 in exchange for all of the stock of S2 and the assumption by S2 of debt owed to a third party Result: $40 debt S2 S1 $10 ELA Result outside of consolidation if 304 doesn t apply: recognizes $10 of gain and has a basis of $0 in the S2 stock (assuming the debt is assumed by S2 for non-tax avoidance reasons) Result outside of consolidation if 304 applies: has a $40 dividend and has a basis of $30 in the S2 stock (assuming S1 has at least $40 of E& and none of the debt was incurred to acquire the S1 stock) 49
Section 351 Transactions versus Reorganizations If S s exchange of T stock for B stock plus cash were only a 368(a)(2)(E) reorganization, the cash would be treated under - 13(f)(3) as a separate, post-reorganization 302(d) redemption/ 301 distribution, and S would recognize no gain B s aggregate basis in the T stock equals T s inside, net asset basis (Reg. 1.358-6(c)(2)) S s aggregate B stock basis equals S s original basis in the T stock minus the cash ( 358 & -32(b)(2)(iv)) Subsequent disposition of the T stock (or deconsolidation of S or the T stock) cannot trigger any deferred gain If S s exchange were only a 351(b) exchange, S would recognize gain from the T stock, and the gain would be deferred B s aggregate basis in the T stock equals S s basis in the T stock plus S s gain recognized ( 362) S s aggregate basis in the B stock equals S s original basis in the T stock, plus any gain recognized, and minus the cash ( 358) Basis $ 70 FMV $100 S T T Stock B Stock & Cash (aggregate $100 value) Subsequent disposition of the T stock (or deconsolidation of S or the T stock) can trigger S s deferred gain If the exchange is an overlap of 351 and 368(a)(2)(E), LR 201028029 & LR 201028030 suggest that 302(d) redemption/ 301 distribution treatment applies rather than 351(b), but perhaps B can elect its T stock basis (Reg. 1.358-6(c)(2)(ii)) Merger B Newco 50