IRS abandons Bausch & Lomb doctrine.

• Author: Koski, Timothy R.

In recently issued Prop. Regs. Sec. 1.368-2, the IRS reversed its long-standing position that an acquisition of a partially controlled subsidiary's assets does not qualify as a tax-free C reorganization. When these proposed regulations become final, an acquiring corporation will no longer be automatically prevented from using a C reorganization due to prior stock ownership in a target.

Background

To qualify as a nontaxable reorganization under Sec. 368(a)(1)(C), an acquiring corporation must acquire substantially all of the properties of a target in exchange solely for its voting stock (or solely for voting stock of its parent). The solely-for-voting-stock requirement is relaxed by Sec. 368(a)(2)(B), which provides that the use of money or other property will not prevent an exchange from qualifying as a C reorganization if at least 80% of the value of the target's property is acquired for voting stock. This "boot relaxation" rule allows up to 20% of the target's assets to be acquired for cash or other property. Because liabilities assumed by (or taken subject to) the acquiring corporation are treated as cash paid for the property, however, solely voting stock must be used any time the target's liabilities exceed 20% of its assets' fair market value (FMV).

The Service has long taken the position that the acquisition of a partially controlled subsidiary's assets does not qualify as a C reorganization. In Rev. Rul. 54-396, an acquiring corporation already owned 79% of the target's outstanding stock. Shares of the acquiring corporation were issued in exchange for all the target's properties, subject to its liabilities. The target was liquidated and the shares of the acquiring corporation were distributed pro rata to its shareholders. The IRS ruled that the transaction failed to qualify as a tax-free C reorganization. Only 21% of the target's assets were acquired with the acquiring corporation's stock; the remaining 79% were acquired as a liquidating dividend of the previously held stock in the target.

The Service's position was upheld in Bausch & Lomb Optical Co., 30 TC 602 (1958), aff'd, 267 F2d 75 (2d Cir. 1959), cert. den. Bausch & Lomb exchanged shares of its voting stock for all of the property of a 79.9% subsidiary. The subsidiary was then dissolved and the Bausch & Lomb shares were distributed pro rata to its shareholders. Both the Tax Court and the Second Circuit upheld the IRS position that the subsidiary stock owned by Bausch & Lomb...