The correct E&P for measuring Sec. 356(a) (2) dividend income.

• Author: Stewart, Dave N.
• Position: Earnings and profit

If an acquisition of assets qualifies as a reorganization under Sec. 368(a), the receipt of stock of the transferee (acquiring) corporation by the shareholders of the transferor (acquired) corporation is nontaxable. However, if the shareholders of the transferor corporation receive boot (money or other property), the transaction can result in partial taxation to the recipient shareholders. Specifically, if boot is received by the transferor corporation's shareholders "then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property."(1) If the exchange has the effect of the distribution of a dividend, "then there shall be treated as a dividend to each distributee such an amount of the gain recognized . . . as is not in excess of his ratable share of the undistributed earnings and profits [E&P] of the corporation . . . ."(2) If any additional gain is recognized, that gain is treated as a gain from the exchange of property (normally capital gain).

The statute is unclear as to how to determine whether the exchange has the effect of the distribution of a dividend. After years of speculation and numerous conflicting judicial decisions, the Supreme Court addressed this issue in 1989 in the Clark(3) case. The Court held that a "post-reorganization redemption" construct was the preferable method of interpreting the statutory language of Sec. 356(a)(1). Although the Court settled "how" to determine if a distribution had the effect of a dividend, it did not address whose E&P should be used to measure the amount of dividend income, if any.

This article will discuss the problems facing taxpayers who must, post-Clark, determine whose E&P is to be used to measure the amount of dividend income described in Sec. 356(a)(2). The current status of the law in this area is confusing at best. This uncertainty is expressly evidenced by the inconsistent positions taken by the IRS in letter rulings issued since the Clark decision. The article will also provide taxpayers with suggestions on how deal with this issue until further guidance is given in regulations or other authoritative pronouncements.

Pre-Clark: Sec. 356(a)(2) E&P

Prior to Clark, in acquisitive reorganizations in which the distributee-shareholder did not control both the transferor and transferee corporations, it was relatively clear that only the E&P of the transferor corporation was to be used to measure dividend income under Sec. 356(a)(2). Even though the regulations under Sec. 356 are silent on this point, the regulations under Sec. 381 provide that the carryover of E&P to the transferee corporation "shall be computed by taking into account the amount of earnings and profits properly applicable to the distribution . . . ."(4) This clearly implies that the amount of the transferor's E&P carried to the transferee is determined after adjustment for the boot distribution. The IRS has further confirmed this position in a number of published revenue rulings.(5)

Controversy has existed, however, when the shareholders of the transferor and transferee corporations were identical. In this situation, the IRS maintained that the E&P of the transferor and transferee corporations should be combined to measure dividend income for purposes of Sec. 356(a)(2).(6) Relying on the legislative history of Sec. 356(a)(2), the Service has consistently argued that a reorganization involving corporations with the same shareholders represents an obvious opportunity to bail out E&P.

Davant(7) i the only case in which a court has agreed with this IRS position. In Davant, which presents an abusive liquidation-reincorporation fact pattern, the Service was successful in convincing the Fifth Circuit that "[w]here there is complete identity of stockholders, the use of the earnings and profits of both corporations is the only logical way to test which distributions have the effect of a dividend."(8)

Previously, the Tax Court had disagreed with this conclusion under a strict reading of the statutory language of Sec. 356(a)(2); which refers to "the undistributed earnings and profits of the corporation." The Tax Court held that the reference to the corporation meant a single corporation and, thus, the legislative history implied that this corporation was the transferor. The Fifth Circuit, however, did not accept this narrow statutory interpretation when there was complete identity of shareholders because it felt that both the transferee and transferor corporations "were but different pockets in the same pair of trousers worn by [the taxpayers]."(9)

Since the Fifth Circuit's decision, the Tax Court has had several opportunities to review this issue,(10) but has consistently held that even if the transferee and transferor corporations have identical shareholders, the amount of dividend income under Sec. 356(a)(2) is limited to the transferor's E&R In its most comprehensive discussion of the correct E&P to be used under Sec. 356(a)(2), in American Manufacturing Co., the court stated:

While we recognize that in particular circumstances a loophole may exist, yet, in light of the statutory language and the lack of warrant in the congressional history of the statute, we think to adopt respondent's multicorporation interpretation would strain the statutory language too far. we think it is up to Congress to correct this defect which has remained in the Code since its enactment and which in reality only exists in certain limited situations.(11)

Thus, with the exception of the ongoing dispute between the IRS and the Tax Court involving acquisitions of commonly controlled corporations, prior to Clark the amount of dividend income for corporate reorganizations was routinely limited to the transferor's E&P.

The Supreme Court's Clark Decision

The Court addressed the issue of whether the receipt of property other than stock or securities as part of a forward triangular merger had the effect of a...