Assessing the value of the proposed "no net value" regulations.

AuthorSilverman, Mark J.
  1. Overview

    On March 10, 2005, the Internal Revenue Service and the U.S. Department of the Treasury issued proposed regulations governing the treatment of nonrecognition transactions involving insolvent companies--perhaps the most significant guidance in the area in a quarter century. The proposed regulations do two things: (1) establish a uniform "net value" requirement for nonrecognition treatment of section 351 (1) contributions, section 332 liquidations, and section 368 reorganizations (the "no net value" regulations); and (2) clarify the circumstances in which creditors will be treated as holding proprietary interests in target corporations for purposes of satisfying the continuity of interest (COI) requirement for reorganizations under section 368 (the "creditor continuity" regulations).

    First, the proposed regulations establish that a transaction must involve an exchange (or distribution) of "net value" in order to qualify for nonrecognition treatment as a section 351 contribution, a section 332 liquidation, or a section 368 reorganization. For nonrecognition treatment under section 332, current law is clear that shareholders must receive at least some value in their capacity as shareholders. The proposed regulations codify existing authority and clarify that in order to qualify as a section 332 liquidation, the shareholder must receive some payment with respect to each class of stock in the liquidating subsidiary. Current law is less clear with respect to other nonrecognition transactions involving insolvent corporations. The proposed regulations extend the net value requirement applicable to section 332 liquidations to section 351 incorporations and section 368 reorganizations.

    Second, with respect to reorganizations under section 368, the proposed regulations clarify when a creditor may be treated as holding a proprietary interest for purposes of determining whether the COI requirement is satisfied. The regulations generally adopt the approach taken by current law, but relax the rules to enable creditors more easily to be treated as holding proprietary interests and transactions to more easily satisfy COI.

    This article reviews the authority that currently governs nonrecognition transactions involving insolvent corporations and the new rules under the proposed regulations. In general, the proposed regulations clarify the requirements for certain transactions to qualify for nonrecognition treatment. Unfortunately, in doing so, the proposed regulations reject certain principles of Norman Scott, Inc. v. Commissioner (2) and also deny a parent corporation the ability to convert its creditor position to equity in order to qualify as a liquidation under section 332. The regulations also leave many questions unanswered. The preamble specifically states that the IRS and Treasury are still considering the best approach to valuing liabilities and are continuing to study whether the net value requirement should be applied to acquisitive D reorganizations. The preamble also leaves open questions of how nonrecourse liabilities will be treated for purposes of the net value requirement and whether a similar net value requirement should be established with respect to contributions to a partnership (the proposed regulations only apply to contributions to a corporation).

    One thing that is certain about the proposed regulations is that they continue the tendency of recent guidance to place an increased emphasis on valuations. The proposed regulations rely on comparisons of the fair market value of assets to outstanding liabilities and therefore necessarily depend on valuations of those assets and liabilities. In this way, the proposed regulations create further challenges for taxpayers.

    1. The Proposed "No Net Value" Regulations

    1. In General

      The proposed regulations adopt a uniform "net value" requirement applicable to section 351 contributions, section 332 liquidations, and reorganizations under section 368. (3) In general, the proposed regulations establish that property with a net value must be exchanged in these transactions (or distributed in the case of a section 332 liquidation). The preamble states that the IRS and Treasury believe a uniform standard is proper because transfers of property in exchange for the assumption of liabilities or in satisfaction of liabilities are akin to taxable sales and should not be treated as nonrecognition transactions. (4) The IRS and Treasury also point to specific provisions providing for nonrecognition treatment, which all use the word "exchange," in support of the net value requirement: (5)

      * Section 351(a) states "[n]o gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control of the corporation."

      * Section 354(a) states "[n]o gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of a plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization."

      * Section 361(a) states, "[n]o gain or loss shall be recognized to a corporation if such corporation is a party to a reorganization and exchanges property, in pursuance of the plan of reorganization, solely for stock or securities in another corporation a party to the reorganization."

      By focusing on whether equity value is exchanged in the transaction, the proposed regulations move the emphasis away from the formality of whether stock was actually issued in the transaction. (6) Thus, that stock is issued will not make a transaction tax-free if there is no equity value to support the issuance of such stock. The preamble to the proposed regulations states that the IRS and Treasury believe that the proposed net value rule is preferable to a rule that looks to the issuance or failure to issue stock because, when the parties are related, the issuance or failure to issue stock might be meaningless. (7)

    2. Liquidations

  2. Current Law. In general, amounts received by a shareholder in complete liquidation of a corporation are treated as "full payment in exchange for the stock" and the shareholder recognizes gain or loss depending on the shareholder's adjusted basis in the stock and the amount received upon liquidation. (8) Section 332 is an exception to the general rule and provides that "[n]o gain or loss shall be recognized on the receipt by a corporation of property distributed in complete liquidation of another corporation" if the corporate shareholder owns 80 percent of the subsidiary's stock. (9) Section 346 provides that a distribution shall be treated as a complete liquidation if "the distribution is one of a series of distributions in redemption of all of the stock of [a] corporation pursuant to a plan." (10) This definition contemplates that for a liquidation to fall within either section 331 or section 332, the shareholder must receive a distribution with respect to its stock.

    This requirement is made explicit by the partial payment rule contained in the regulations under section 332. Treasury Regulation § 1.332-2(b) states that section 332 applies "only to those cases in which the recipient corporation receives at least partial payment for the stock which it owns in the liquidating corporation." As a result, it has long been held that the liquidation of an insolvent subsidiary does not qualify as a section 332 liquidation. (11) Although there is no regulatory "partial payment" rule for section 331, common law authority has concluded that the requirement that the shareholder receive partial payment for its stock applies to section 331 liquidations as well. (12) Instead, the parent will be entitled to a bad debt deduction under section 166 or a worthless stock deduction under section 165 (a bad debt deduction to the extent the outstanding debt exceeds the amount received in the distribution and a worthless stock deduction to the extent of the parent's basis in the subsidiary's stock). (13)

    For a time there was some uncertainty among practitioners about whether there was a gap between section 332 and section 165 such that a taxpayer could fall outside the scope of both provisions. (14) This uncertainty was put to rest in Rev. Rul. 2003-125, which confirmed that if section 332 does not apply to the complete liquidation of a subsidiary because the subsidiary is insolvent, then the parent is entitled to a worthless stock loss under section 165. These rules present a planning opportunity because a taxpayer is able to "check the box" on an insolvent entity (pursuant to the entity classification rules of Treas. Reg. § 301.7701-2), continue the business carried on by that entity, and still recognize a worthless stock loss because section 332 does not apply. Because an insolvent subsidiary does not have assets sufficient to satisfy its liabilities, by definition the subsidiary cannot have assets with which to make partial payment with respect to its stock. (15)

    In addition, case law has established that the parent must receive partial payment with respect to each class of the subsidiary's stock for a distribution to qualify as a section 332 liquidation. In Spaulding Bakeries, Inc. v. Commissioner, (16) a corporate taxpayer held all of the outstanding common and preferred stock of a subsidiary. The taxpayer liquidated the subsidiary at a time when the fair market value of the subsidiary's assets was less than the liquidation preference of the preferred stock. The court held that the dissolution of the subsidiary was not a complete liquidation under section 112(b)(6) (the predecessor to section 332) because the taxpayer did not receive any consideration in exchange for its common stock. (17) Thus, if a parent holds both preferred and common stock and the distribution received upon liquidation does not exceed the...

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