IRS issues guidance on disguised corporate sales.

• Author: Kautter, David J.

In Chief Counsel Notice CC-2002-003, the Service advised Chief Counsel attorneys that when a parent disposes of a subsidiary in a merger and receives control of cash or liquid assets equal to the subsidiary's value, the transaction is a sale.

The typical transaction involves a parent that wants to dispose of a target subsidiary. The acquiring corporation forms a new subsidiary by contributing cash or liquid assets. The acquiring subsidiary forms a single-member limited liability company (SMLLC) by contributing cash or liquid assets equal to the target's value. The acquiring subsidiary uses a merger subsidiary to acquire the target's stock in a triangular merger. Following the merger, the acquiring subsidiary receives high-vote/low-value preferred stock in the target, giving it voting control over the target (but little of its value). The actual acquirer receives high-value/low-vote common stock in the target, and receives high-vote/low-value preferred stock in the acquiring subsidiary, giving it indirect voting control over the target. The parent ends up with managerial control of the SMLLC through an operating agreement and a nominal interest in the acquiring subsidiary in the form of high-value/low-vote common stock. The parent reports the transaction as either a tax-free reorganization or a Sec. 351 exchange.

According to the IRS, the transaction was a sale disguised as a reorganization or Sec. 351 exchange. The Service noted that, after the transaction, only a small portion of the acquiring subsidiary's assets consisted of its stock interests in the target, compared to the cash held by the SMLLC. In contrast, the actual acquirer held common equity interests in the target that approximated all of its value. Thus, in economic substance, the parent exchanged its interest in the target for an equivalent interest in the acquiring subsidiary, which held, through the SMLLC, mostly cash or liquid assets. Further, the parent, through the SMLLC's operating agreement, had complete autonomy to determine how to invest the SMLLC's cash. In the IRS's view, the parent effectively exchanged the target for cash, liquid assets or both (i.e., sold the target).

The Service also noted that the acquiring subsidiary's preferred stock in the target had such little value that value shifts in the target were...