Defining stock of insolvent and bankrupt corporations.

AuthorSchnee, Edward J.

Usually attorneys and accountants can identify those financial instruments that qualify as corporate stock and then apply the appropriate tax rules. The decision becomes more complicated if the corporation is insolvent or in bankruptcy. For example, in these situations debt may be treated as stock, which can lead to unexpected outcomes. This article discusses the special rules and issues surrounding the classification of stock ownership of those corporations.

Definition of Stock

Sec. 7701(a)(3) states: "The term 'corporation' includes associations, joint-stock companies, and insurance companies." This is followed by Sec. 7701(a)(7), which defines stock. It states: "The term 'stock' includes shares in an association, joint-stock company, or insurance company."

These very general provisions caused the Ninth Circuit in Affiliated Government Employees Distribution Co. (1) to conclude that Congress did not specifically define the term stock. As a result, the court adopted the following general definition of stock:

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the interest or right which the owner who is called the "shareholder" or "stockholder" has in the management of the corporation, and in its surplus profits, and, on dissolution in all of its assets remaining after the payment of its debts. (2) Comparing the attributes listed above with the ones contained in the instrument in question, the court concluded the item at issue was not stock because of the absence of some of the stated attributes. However, the court also stated that the absence of one or more of these attributes does not mandate that the instrument not be stock.

In Stockton, (3) the appeals court described stock as providing the owner with rights to a corporation's management, profits, and assets. These are the same attributes listed by the Ninth Circuit in Affiliated Government Employees. Based on these cases, an instrument will usually be considered stock if it shares in the corporation's profits and its assets in liquidation.

This rule does not always apply. In Paulsen, (4) the Supreme Court had to decide if the passbook savings account and certificate of deposit (CD) received in a merger of a stock savings and loan association into a mutual savings and loan association qualified as stock. The Court noted that the savings account and CD were entitled to a share of dividends and assets in liquidation. However, the Court decided that these items had minimal value because a reasonable person would not have purchased them for more than their face amount. The Court concluded that they did not qualify as stock--just because an instrument contains the attributes of stock does not make it stock if these attributes have minimal value.

Nonstock Treated as Stock

There have been situations in which stock options and debt have been treated as stock. The characterization can depend on the instrument as well as the type of transaction (e.g., reorganization and ownership change) that occurred.

Options

Stock options are generally defined as a financial instrument that gives the holder the right to buy or sell a specific number of shares of a specific corporation at a stated price and by a stated date. As a general rule, stock rights and options are not included in the definition of stock. Regs. Sec. 1.351-1(a)(1)(ii) states that stock rights and warrants are not stock for purposes of Sec. 351. The Tax Court in Bateman (5) and the Second Circuit in Gordon (6) ruled that stock rights and warrants are not stock for purposes of Sec. 354. More recently, the Tax Court in Gantner (7) ruled that stock options were not stock for purposes of the Sec. 1091 short-sale rule. (8) In 2010, the Tax Court cited Gantner as authority for rejecting a taxpayer's attempt to treat a stock option as stock for purposes of Sec. 1202. (9) This decision was recently affirmed by the Ninth Circuit. (10)

However, there are situations in which options will be treated as stock. In Rev. Rul. 82-150, (11) B formed a corporation by contributing $100,000 in exchange for 100% of its stock. B sold an option to purchase all the stock to A for $70,000. The option price was $30,000. The ruling concludes that A was the real owner of the corporation since A bears the risk of ownership. The IRS cited this revenue ruling as authority for concluding warrants were stock in Letter Ruling 9747021 (12) and Field Service Advice (FSA) 200201012. (13) In the letter ruling, the warrants had a minimal exercise price ($0.01). In the FSA, the warrants were so deep in the money that the IRS concluded that the holders of the warrants were the only ones who would gain or lose from the corporation's appreciation or depreciation. Based on the above cases and rulings, options are not equity unless the holder bears the benefits and detriments of owning the corporation.

The Code also contains specific exceptions in which stock options will be treated as stock. For example, Sec. 305(d)(1) treats options as stock to ensure that corporate distributions that affect the ownership of different shareholders are taxable. In addition, the holder of an option will be treated as owning stock under the constructive ownership rules of Sec. 318(a)(4) (options are considered stock for constructive ownership of stock rules), Sec. 544(a)(3) (constructive ownership rules for personal holding companies), and Sec. 1563(e)(1) (effect of ownership of options on consolidated group rules).

Debt

Congress enacted Sec. 385, which authorizes the Treasury Department to issue regulations that distinguish stock from debt (or treat the instrument as part stock and part debt). The section lists five factors that Treasury may include in the regulations, which Treasury has never completed issuing (it withdrew regulations issued in the last attempt 30 years ago). Lacking that guidance, the courts have analyzed the cases based on various factors. For example, the Ninth Circuit used 11 factors in Hardman, (14) Included in this group of factors are the intent of the parties, the source of the payments, the adequacy of capitalization, and participation in management.

Recently, the Tax Court has considered this issue in three different cases. (15) It pointed out that a simple fixed set of factors for determining if an instrument is debt or equity remains elusive. Therefore, the court will determine that the instrument is debt if the parties intended to create debt, there is a reasonable expectation of repayment, and the parties' intent comports with the economic reality of creating a debtor/creditor relationship. These conclusions are based on the factors identified by the appellate courts to which the cases are appealable. (16) Given the Tax Court's approach to the issue, that the different courts apply different factors, that none of the factors are mandatory, and that the weight to be given each factor has not been stated, it is difficult to apply Sec. 385 for solvent corporations and almost impossible to apply it if the corporation is insolvent or in bankruptcy.

Reorganization

For many corporations that are insolvent or in bankruptcy, the current shareholders and creditors are interested in continuing the business in a reorganized form. The reorganization transaction will be tax free if in addition to meeting the requirements of Sec. 368, it meets the continuity-of-interest rule contained in Regs. Sec. 1.368-1(e). Under Regs. Sec. 1.368-1(e)(6), a creditor of a target corporation may be considered a shareholder if the corporation is insolvent or in bankruptcy. The regulation goes on to state that, for purposes of the continuity-of-interest rule, if any debt is treated as equity, creditor claims of the same or of a junior class are also treated as equity.

There have been no cases or rulings that discuss this regulation, but cases that addressed the issue of creditor as shareholder for the continuity-of-interest rule were decided before the regulation was issued. The Supreme Court addressed the issue in Helvering v. Alabama Asphaltic Limestone Co. (17) The Court granted certiorari on the grounds that the Fifth Circuit decision in Alabama Asphaltic (18) was in conflict with the Ninth Circuit decision in Palm Springs Holding Corp. (19) and the Eighth Circuit decision in Helvering v. New President Corp. (20) Although it is possible to distinguish the reasoning of the three courts, the Court's decision directly addresses the question of creditors as shareholders of a corporation undergoing a reorganization during bankruptcy.

The specific issue before the Court in Alabama Asphaltic was the basis of acquired property. The taxpayer argued it was entitled to a carryover basis because the acquisition was a nontaxable reorganization. The government argued that it was not a reorganization and therefore that the basis should be cost.

The assets in question were owned by a subsidiary of a parent corporation attempting a reorganization. The creditors would not agree to accept the subsidiary's stock as payment for their claims. A creditor committee formulated a plan for a new corporation to acquire the subsidiary's assets and to distribute its stock to the creditors in satisfaction of most of the outstanding obligations. To effectuate the plan, an involuntary bankruptcy proceeding was instituted in which the creditors received stock of the new corporation that owned the...

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