Basis studies are given red flags Revenue Procedure 81-70: past, present and future.

• Author: Keppler, Juliane Laura

Taxpayers take heed if your company has been involved in a tax-free stock-for-stock acquisition. Has tax basis of the acquired stock been determined? The Internal Revenue Service is scrutinizing extant tax basis studies and closely reviewing the continuing vitality of a two decades old revenue procedure on basis determination.

If your company engaged in a tax-free stock acquisition and has already computed the tax basis of the acquired stock or believe that in the future you may need to do so, you should read on. This article reviews the history of Revenue Procedure 81-70, which addresses the process for determining carryover basis of widely held acquired stock, including the expansion of its application in the 1990s. It also explores the auditing of tax provisions under the Sarbanes-Oxley Act, which has shone a brighter spotlight on basis studies and accentuated the need for the IRS to revisit its scope and effectiveness. Finally, the article concludes with a discussion of the IRS's recent request for comment and the various possible options available to the taxpayer.

How It Began

Corporate acquirers have long been able to use their stock to acquire the stock of another company (target). When at least 80 percent of a company's stock is acquired by another company in an exchange solely for the acquiring company's voting stock, the transaction may qualify as a type B reorganization under section 368(a)(1)(B) of the Internal Revenue Code. In a B reorganization, the acquirer's basis in the newly acquired target stock is carryover basis. (I.R.C. [section] 362(b).) In other words, the target shareholders' basis carries over to the acquiring corporation.

For example, assume company T has 5 stockholders, with 10 shares each and a tax basis of $10 per share--for a total tax basis of $500. If company A uses A voting stock to acquire all 50 shares of company T in a B reorganization, then company A's tax basis in the T stock will be $500, the aggregate of the shareholder's tax basis in the T stock.

If the acquirer knows the identity of the target's shareholders, the collection of this tax basis data can be very straightforward. The identification process becomes more problematic, however, if the acquired company is publicly held because many shareholders choose to have their shares held by a nominee instead of in certificated form. The nominee could either be a bank or a broker holding custody of the shares on behalf of the shareholder in their account. Obtaining basis information from each of the target's shareholders now becomes a more administratively burdensome task.

In 1981, recognizing the extensive undertaking of retrieving tax basis information from thousands of shareholders, the IRS issued a revenue procedure affording taxpayers an alternative to surveying each of the target shareholders. Revenue Procedure 81-70, 1981-2 C.B. 729, was introduced to provide the taxpayer with choices; that is to say, it was essentially a relief procedure.

Rev. Proc. 81-70 recognizes that in the event of a widely held target company the potential exists for shareholders to not respond to a tax basis inquiry. This would make determining carryover tax...