Return-of-capital distributions in mutual thrift stock conversions.

• Author: Thornton, David A.

In a series of letter rulings (Letter Rulings 9549021, 9627024, 9632010, 9632011, 9640029, 9736018 and 9821043), the IRS has affirmed a return-of-capital transaction that has become quite popular among mutual thrifts converting to the stock form of ownership. The transaction involves deliberately avoiding the consolidated earnings and profits (E&P) rules of Regs. Sec. 1.1502-33, so that a portion of the initial stock offering proceeds can be distributed back to shareholders with no current tax liability. By carefully planning these transactions, converting thrifts can avail themselves of a unique opportunity.

Background

The standard mutual-to-stock thrift conversion is accomplished as a tax-free reorganization under Sec. 368 (a) (1) (F) and often results in the formation of a new holding company. The mutual thrift is converted to a stock company while the newly formed holding company raises capital through a public stock offering. A portion of the proceeds from the public stock offering is generally retained by the holding company, while the remainder is used to purchase the newly issued thrift stock. Mutual depositors are given certain liquidation rights in the converted organization that represent a continuing proprietary interest.

Although it does not make sense that an institution would raise excess capital to begin with, this situation is actually created by Office of Thrift Supervision (OTS) regulatory requirements, rather than poor capital planning. As the regulatory agency with jurisdiction over the thrift industry, the OTS is heavily involved in all aspects of the conversion process. To meet market demand for the stock, the OTS often requires an institution to raise a level of capital significantly exceeding its operating needs. Many institutions find it difficult to employ this excess capital and decide to return it to shareholders.

Sec. 301(c) provides an ordering rule for any shareholder distribution made by a C corporation. All shareholder distributions must first be taxed as dividends to the extent of the corporation's current and accumulated E&P. Once E&P has been exhausted, further distributions are applied against, and reduce the basis of, the shareholders' stock. Distributions in excess of stock basis are treated as gain from the sale of property.

The second category of distributions, described in Sec. 301(c)(2), defines a return of capital as a distribution in excess of the distributing corporation's current and...