Changing the tax consequences of Morris Trust transactions.

• Author: Goubout, Ted

A spate of high-profile corporate spin-offs coupled with acquisitive reorganizations prompted the Clinton Administration to propose a change in the requirements for certain tax-free spin-offs under Sec. 355. The "Morris Trust" proposal, as it is known, first appeared in the Administration's budget proposal submitted in March 1996, and reappeared in the President's fiscal-year 1998 budget proposal submitted to Congress on Feb. 6, 1997. The proposal, which resurfaced after several transactions were labeled "abusive" by the press, would require gain recognition at the corporate level for certain distributions of controlled corporation stock. There would be no change to the shareholder's consequences. If enacted, the proposal would have far-reaching effects on many common corporate transactions.

Morris Trust transactions date back to Morris Trust, 367 F2d 794 (4th Cir. 1966), in which the IRS challenged the tax-free status of a reorganization of a distributing company following a spinoff by that company. The Service lost the case, and the Morris Trust transaction was born. Since that time, Morris Trust transactions have been accepted by the IRS (see Rev. Rul. 68-603); today, many such transactions are carried out with the Service's blessing (in the form of letter rulings).

Morris Trust transactions typically arise when an acquirer wants only part of another company. A direct purchase of only that part would trigger gain recognition for the selling company. In the most basic Morris Trust transaction, a corporation (P) operates two businesses. Another corporation (A) wants to acquire one (but not both) of the businesses in an otherwise tax-free transaction. P transfers the business that A does not want to a newly formed subsidiary (C), and P then distributes the stock of C to P's shareholders. A is then free to acquire the business it does want by acquiring P in a tax-free reorganization.

In some recently publicized cases, in anticipation of such a transaction, P has borrowed and transferred both the business that A does not want and the cash proceeds of the borrowing to C. P then distributes the stock of C to P's shareholders. In the subsequent tax-free reorganization of P and A, A assumes the debt incurred by P, while the cash proceeds remain with C. Such transactions have been called abusive and equated with a tax-free sale of assets.

The President's Morris Trust proposal would require the distributing corporation to recognize gain on the...