Corporate separations under sec. 355.

• Author: Blair, David W.

Corporate separations are used by many corporations to accomplish various business objectives. Many distributions made as part of Sec. 368(a)(1)(D) (type "D") reorganizations remain tax-free despite new income recognition requirements for Sec. 355 distributions made after Oct. 9, 1990. (See Sec. 355(c), as amended by the Revenue Reconciliation Act of 1990 (RRA), and Sec. 355(d), as added by the RRA.) In addition to the income recognition pitfalls, a well thought-out approach is needed to avoid an unexpected allocation of earnings and profits (E&P). Regs. Sec. 1.312-10 prescribes rules for the allocation of E&P in Sec. 355 distributions (1) preceded by a D reorganization involving a newly created corporation and (2) involving a preexisting controlled corporation.

Sec. 355/D reorganization

Regs. Sec. 1.312-10(a) provides that, for a newly created controlled corporation, the allocation of E&P generally should be made in proportion to the fair market value (FMV) of the business (and interests in any other property) retained by the distributing corporation and the business (and interests in any other property) held by the controlled corporation immediately after the transaction. For this purpose, net FMV is used. In "a proper case," the allocation of E&P between the distributing corporation and the controlled corporation should be in proportion to "net basis" (basis of assets less liabilities assumed or taken subject to) or by another appropriate method (under the facts and circumstances). However, no part of the distributing corporation's deficit can be allocated to a controlled corporation (Regs. Sec. 1.312-10(c)).

Only one significant court decision has dealt with the allocation of E&P under Regs. Sec. 1.312-10(a). In Bennett, 427 F2d 1202 (Ct. Cl. 1970), the distributing corporation (D) contributed property, including real estate subject to a mortgage of $2 million taken out immediately before the transfer, to the controlled corporation (C) and distributed the C stock to the D shareholders. C had a net basis in property of 5% of the combined net basis in the total property of C and D. When measured by FMV, however, C's share of the combined property of both corporations was 20%.

Although the taxpayer advocated a net-basis allocation of E&P, the court adopted the IRS's position, allocating E&P based on relative FMV. The court reasoned that, absent "a proper case" being made by the taxpayer for the use of a different method, the relative FMV...