CHAPTER 3 AN OVERVIEW OF TAX CONSIDERATIONS IN DEALING WITH MINERAL INTERESTS OWNED BY A CLOSELY HELD CORPORATION

• Jurisdiction: United States

Mineral Taxation
(Mar-Apr 1977)
CHAPTER 3
AN OVERVIEW OF TAX CONSIDERATIONS IN DEALING WITH MINERAL INTERESTS OWNED BY A CLOSELY HELD CORPORATION


Robert J. Welter
Holme Roberts & Owen
Denver, Colorado

INDEX

SYNOPSIS

Introduction

Available Alternatives for Disposing of the Mineral Interests

Acquisition of Mineral Interests from the Corporation

Sale Transaction

General Tax Consequences

Avoiding the Double Tax—12 Month Liquidation

Avoiding the Double Tax—Use of Subchapter S

Lease Transaction

General Tax Consequences

Adopting a 12 Month Liquidation Plan

Use of Subchapter S to Avoid the Double Tax

Other Corporate Assets

Purchase or Lease—Considerations by the Purchaser

Purchase of Stock of the Corporation and Immediate Dissolution of the Corporation by the Purchaser

Sale Transaction

Tax Consequences to Seller-Stockholders

Tax Consequences to the Purchaser

Transfer of Stock in a Lease Transaction

Dissolution of the Corporation by the Shareholders Followed by a Transfer of the Interests to the Purchaser

The Dissolution Transaction

Assuring that the Disposition is Made by the Shareholders and not by the Corporation

Should the Purchaser Acquire the Properties in a Corporation?

Transferring the Mineral Interests to a Corporation

Operating in the Corporate Form

Disposition of the Corporate Properties (Cashing Out)

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INTRODUCTION

In general, the tax rules with respect to the acquisition and disposition of mineral interests are not a function of the type of taxpayer which owns the interests. The tax consequences with respect to the acquisition and disposition of mineral interests discussed in the other papers are applicable to individuals, corporations, partnerships and trusts. The special tax considerations in dealing with mineral interests owned by closely held corporations, which is the subject of this paper, result from the desire to have the funds from the disposition of the interests go to the shareholders even though the properties are owned by the corporation. It is this desire that necessitates careful planning of any disposition of mineral interests by a corporation. The tax problem is how to get the funds from the disposition of the corporate properties to the shareholders with the payment of the least tax.

The following hypothetical fact situation will be referred to frequently in discussing these tax considerations:

— Corporation A is owned by husband and wife.

— The total cash investment of the shareholders in the stock of the corporation is $50,000.

— The major asset of Corporation A is land which may contain substantial coal and uranium deposits.

— The corporation's balance sheet is as follows:

Assets	$100,000
Liabilities	25,000
Stockholders' Equity; Capital Stock	50,000
Retained Earnings	25,000
$100,000

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In addition the assets of the corporation, particularly the coal and uranium interests, are worth substantially more than their book value.

— A potential purchaser has indicated that he may be interested in acquiring the coal and uranium interests for $1,000,000.

AVAILABLE ALTERNATIVES FOR DISPOSING OF THE MINERAL INTERESTS

In general there are three ways to transfer the corporation's mineral interests to the purchaser: the purchaser may acquire them directly from the corporation; the purchaser may acquire the stock of the corporation and then liquidate the corporation to acquire the mineral interests; or, the present shareholders may liquidate the corporation to acquire the mineral interests in their own names and then transfer the mineral interests to the purchaser. These are the three alternative methods for disposing of any corporate asset.

However, the distinction between a "sale" and a "lease" transaction as discussed in the previous paper must be kept in mind. If the seller retains a royalty interest (or some other kind of continuing nonoperating interest in production) the disposition transaction will be considered a lease for tax purposes and not a sale. The only exception to this rule is with respect to the gain realized by the lessor of an interest in coal or iron ore. Under a special statutory provision,¹ if the transferor of a coal interest retains a royalty interest the transaction is considered a lease but the lessor may report the net amount realized as gain from the sale of the coal which will usually be capital gain. It should be noted that this special treatment only applies to the lessor of the coal interest; to the lessee, the usual tax consequences of a lease will apply.

ACQUISITION OF MINERAL INTERESTS FROM THE CORPORATION

Sale Transaction:

General Tax Consequences. In the hypothetical

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fact situation, if the corporation sells the mineral interests for $1,000,000, the corporation will have a tax liability of approximately $270,000. This is computed by applying a 30 percent capital gains rate to the $900,000 capital gain realized ($1,000,000 — $100,000 basis for the mineral properties).² After payment of the tax, there will be $730,000 to distribute to the shareholders.

If all or a portion of the $730,000 is distributed to the shareholders, it will be taxed as a dividend (ordinary income) to them. Even assuming their effective tax rate for ordinary income is 50 percent, they will net only $365,000 from the $1,000,000 sale.

If the corporation is liquidated after the sale and the $730,000 is distributed to the shareholders as a liquidating distribution the shareholders will be entitled to capital gains treatment for the gain on the liquidation. The gain will be $680,000 ($730,000 — $50,000 stock basis). Assuming a 35 percent capital gains tax rate the tax is $238,000 and the net amount to the shareholders is $492,000. Although the liquidation transaction results in a tax savings of $127,000, neither transaction is desirable for tax purposes.

Avoiding the Double Tax — 12 Month Liquidation. It may be possible to avoid the "double tax" if the sale is made after a plan of liquidation is adopted by the corporation. Under a special Code provision (§337) if a plan of liquidation is adopted by the corporation and the corporation is liquidated within 12 months after the plan is adopted, the corporation will not be taxed on any gain from the sale or exchange of property during the 12 month period. There are several exceptions to this nonrecognition provision.³

If the 12 month liquidation provision is applicable, under the facts of the example the corporation would not be taxable on the sale of the mineral properties for $1,000,000. However, when the $1,000,000 is distributed to the shareholders in liquidation they would realize a capital gain of $950,000 and would pay a tax (assuming a 35% rate) of $332,500. They would net approximately $617,500. There are exceptions to the non-recognition of gain at the corporate level. To the extent the gain on the sale of the mineral properties is attributable to the recapture of exploration expenditures previously taken or to the recapture of depreciation deductions, the gain will be taxable to the corporation at ordinary

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income tax rates. Mining exploration expenditures must be recaptured as ordinary income either through decreased depletion deductions when the mine reaches the production stage or by treating a portion of the gain on the sale of the property as ordinary income.⁴

The 12 month liquidation provision is not available to a "collapsible" corporation.⁵ The collapsible corporation concept is intended to prohibit capital gain treatment to shareholders who dispose of their interest in the corporation (by liquidating the corporation or selling its stock) in midstream—after the corporate properties have been developed so they are income producing but prior to the time a substantial portion of the income from the properties has been realized. A corporation with mineral properties may be a collapsible corporation if it has developed the mineral properties or otherwise made improvements on the properties within the last three years and has not realized a substantial portion of the income to be derived from the properties.⁶ Even if a corporation with mineral properties is a collapsible corporation, the 12 month liquidation provision may be available under the special exception in the statute.⁷ Obviously, the collapsible corporation problem must be reviewed carefully before the shareholders rely on the 12 month liquidation provision.

Another disadvantage of the 12 month liquidation provision is that the shareholders may not report their gain on the installment sale method even though the $1,000,000 sales price is paid in installments. For example, if the $1,000,000 is paid $200,000 down and the $800,000 balance by a 10 year promissory note the corporation could report the gain on the installment method but this is unnecessary because the sale is not taxable to the corporation. When the $800,000 note is distributed to the shareholders (which it must be within 12 months after the plan of liquidation is adopted) the shareholders must take the value of the note into consideration in determining their gain on the liquidation. It is possible to spread the gain to the shareholders over two taxable years by having the 12 month period straddle the end of a taxable year and making distributions to the shareholders in the two taxable years,⁸ but it is not possible to report the gain over the period of the note.⁹

Avoiding the Double Tax — Use of Subchapter S. If the corporation qualifies as a subchapter S corporation, there would be only one tax on the sale of the mineral

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interests by the corporation and the gain could be reported on the installment method if the sales price is paid in installments as described above. To qualify as a subchapter S corporation, the corporation: (a) must be a domestic corporation which is not part of an affiliated group of corporations, (b) must have 10 or fewer shareholders...