Practical advice on current issues.

• Author: Turgeon, Christine M.
• Position: TAX CLINIC

Corporations & Shareholders

Critical valuation issues that arise in common corporate transactions

Valuations play a critical role in corporate tax planning. Whether a taxpayer transfers property to a corporation under Sec. 351, a corporation acquires in a qualified stock purchase (QSP) all the stock of another corporation and a Sec. 338(g) election is made, or a corporate parent's corporate subsidiary completely liquidates under Sec. 332, valuation is a critical element that arises in transactions that occur during all periods of the life cycle of a corporation. This discussion provides a high-level overview of some of the critical valuation issues that arise in Sees. 351, 332, and 338.

Sec. 351

In general, Sec. 351(a) provides that no gain or loss is recognized if property is transferred to a transferee corporation by one or more transferors solely in exchange for stock in that corporation and those transferors control the transferee corporation immediately after the exchange.

Transfers of net value: Assume that a transferor corporation (Transferor) transfers property to a transferee corporation (Transferee) in exchange for stock and the assumption by Transferee of liabilities of Transferor and that the aggregate amount of the liabilities assumed for U.S. federal income tax purposes exceeds the aggregate fair market value (FMV) of the property transferred. In such a case, there arguably exists no value that can attach to the stock issued in the exchange (see CCA 201433014; REG-139633-08; see generally Meyer, 121 F. Supp. 898 (Ct. Cl. 1954), cert, denied, 348 U.S. 929 (1955); Davis, 69 T.C. 814, 829 (1978); CCA 201552026; Rev. Rul. 59-296; but see Rosen, 62 T.C. 11 (1974); Abbrecht, T.C. Memo. 1987-199). In that case, the stock issued by Transferee is disregarded for U.S. federal income tax purposes, and the exchange resembles a sale of property, the consideration of which is the assumption by Transferee of Transferor's liabilities (id.). Because the stock is disregarded, one of the core requirements of Sec. 351(a) would not be satisfied--property is not transferred solely in exchange for stock.

Observation: If Sec. 351(a) does not apply to an exchange because the aggregate amount of liabilities assumed for U.S. federal income tax purposes by Transferee exceeded the aggregate FMV of the property transferred, the exchange could be recast as (1) a Sec. 1001 transaction to the extent the aggregate face amount of the liabilities assumed for U.S. federal income tax purposes equals the aggregate FMV of the property transferred, with (2) the excess of the aggregate face amount of the liabilities assumed for U.S. federal income tax purposes over the aggregate FMV of the property transferred treated as a deemed distribution under Sec. 301 (id.; see also Rev. Rul. 69-630; Cox, 56 T.C. 1270 (1971)).

The risk posed by a potential transfer of no net value can be addressed by (1) performing a valuation of the property that Transferor intends on transferring to Transferee and (2) confirming the aggregate amount of the liabilities that Transferee intends on assuming for U.S. federal income tax purposes. If the results of the valuation indicate that the aggregate FMV of the property that Transferor intends on transferring to Transferee is less than the aggregate amount of the liabilities expected to be assumed by Transferee for U.S. federal income tax purposes, Transferor can consider transferring additional property to Transferee, or Transferee can explore whether it is feasible to assume a lesser amount of liabilities.

Net built-in loss: Sec. 362(e) limits the duplication of losses in nonrecognition transfers in an effort to eliminate the potential for a double deduction of the same loss. For example, assume Transferor, a domestic corporation, transfers property to Transferee, also a domestic corporation, in a transaction that qualifies under Sec. 351(a). Neither Transferor nor Transferee is a member of an affiliated group of corporations that files a consolidated U.S. federal income tax return. Immediately after the transaction, Transferee's aggregate adjusted bases of the acquired property exceed the aggregate FMV of such property. In this instance, Sec. 362(e)(2) applies to the exchange. Unless an election is made under Sec. 362(e)(2)(C), Transferee's aggregate adjusted bases in the property received are reduced to the aggregate FMV of the property immediately after the transaction (Sec. 362(e)(2)(A)(ii)).

Observation: To analyze the impact, if any, of Sec. 362(e)(2) on a Sec. 351 transaction, a valuation of the property that Transferor intends to transfer to Transferee should be performed, with the understanding that Sec. 362(e)(2) tests the aggregate FMV of the transferred property in the hands of Transferee immediately after the transaction. If the results of the valuation indicate that Transferee's aggregate adjusted bases of the property acquired would exceed the aggregate FMV of that property, Transferor may want to consider transferring additional property--e.g., low-basis, high-value property--to Transferee.

Sec. 332

Sec. 332 governs the U.S. federal income tax consequences of the parent corporation of an 80%-or-more-owned (by vote and value) corporate subsidiary that is completely liquidated for U.S. federal income tax purposes. To satisfy Sec. 332, the liquidating corporation must be solvent for U.S. federal income tax purposes (Rev. Rul. 2003-125; Swiss Colony, Inc., 52 T.C. 25, 35 (1969)).

Observation: Because Sec. 332 requires a solvent liquidating corporation, a valuation of the liquidating corporation must be performed early in the tax planning process. Rev. Rul. 2003-125 provides practical valuation guidance to taxpayers regarding valuing the liquidating corporation's assets for U.S. federal income tax purposes:

In determining the fair market value of a corporation's assets, all of the corporation's assets, including tangible and intangible assets (such as goodwill and going concern value) and assets that may not appear on the corporation's balance sheet, must be taken into account. In addition, the fair market value of an asset may be different than the value that appears on the corporation's balance sheet. Generally, if the results of a valuation indicate that the liquidating corporation is insolvent for U.S. federal income tax purposes, additional transfers of property--other than in the ordinary course of business--to the liquidating corporation for the purpose of making the liquidating corporation solvent for U.S. federal income tax purposes generally would not be respected (Rev. Rul. 68-602). If the liquidating corporation is insolvent, the taxpayer may wish to consider whether its business objectives instead could be achieved by executing a reorganization under Sec. 368(a)(1)(D) with a brother-sister corporation with a pre-reorganization transaction--that has independent economic significance from the reorganization--that makes the target corporation solvent for U.S. federal income tax purposes (see Rev. Rul. 78-330; see generally Simpson, 43 T.C. 900,916 (1965), acq., 1965-2 C.B. 6).

Sec. 338

If a corporation (Purchasing) acquires in a QSP all the stock of another corporation (Old Target) but wishes to treat that acquisition as an asset acquisition for U.S. federal income tax purposes, Purchasing could make a Sec. 338(g) election. If a Sec. 338(g) election is made, Old Target is treated for U.S. federal income tax purposes as if (1) it sold all its assets to an unrelated person at the close of the first day that a QSP occurred (the acquisition date) and (2) Old Target thereafter is treated as a new corporation (New Target), unrelated to Old Target, that purchases, as of the beginning of the day after the acquisition date, Old Target's assets from an unrelated person in exchange for consideration that generally reflects the amount of consideration paid by Purchasing for Old Target's stock, adjusted for Old Target's liabilities (Sec. 338(a); Regs. Sec. 1.338-1(a)(1)).

New Target must use the residual method to allocate the adjusted grossed-up basis (AGUB) to the deemed acquired assets (Regs. Sees. 1.338-6(a) and (b)). Under the residual method, the AGUB is allocated to six classes of assets in sequential order, with the residual AGUB allocated to a seventh class of assets (Regs. Sec. 1.338-6(b)).

Observation: Understanding the asset profile of Old Target in advance of a transaction is essential both for analyzing whether a Sec. 338(g) election would be advantageous (e.g., tax-effective benefit of depreciation deductions) and for future tax planning. For example, the value of the assets can have a direct impact on future tax planning, including future integrations, restructurings, and transfer pricing. As a result, a valuation of the assets of Old Target should be performed very early in the tax planning process, taking into account the organization's strategy and future business needs.

Address valuation issues early

Valuations undeniably are a material element to common corporate transactions. Failing to address critical valuation issues early in the corporate tax planning process can result in undesirable U.S. federal income tax consequences.

From Kyle Colonna, J.D., LLM.; Julie Allen, CPA; and Olivia Orobona, J.D., LL.M., Washington, D.C.

Foreign Income & Taxpayers

Failure-to-deposit penalty when tax is not withheld on payments of US-source income

Sec. 1441(a) provides, as a general rule, that all persons, acting in whatever capacity, who have the control, receipt, custody, disposal, or payment of any item of U.S.-source income specified in Sec. 1441(b) of any nonresident alien individual, or any foreign partnership, shall deduct and withhold from such items a tax equal to 30% thereof. Sec. 1442 applies those same withholding tax requirements to payments of such items of income to foreign corporations that are subject to U.S. tax.

A failure to properly deduct, withhold, and deposit...