Letter rulings flirt with limits of liquidation-reincorporation doctrine.

• Author: Madden, David

Several recent letter rulings raise questions on the application of the liquidation-reincorporation (LR) doctrine to an upstream combination when a corporation owns 80% or more of the liquidating corporation's vote and value. Although these rulings are taxpayer-favorable, the IRS's rationale is often obscured or ill-defined, much to practitioners' frustration.

Background

The LR doctrine is a subset of the judicial tax law canons of substance-over-form and step-transaction. Typically, it applies to a transaction in which a corporation (T) liquidates and its shareholders reincorporate some or all of T'S assets in a new or existing corporation controlled by such shareholders (the LR transaction). The LR doctrine disregards the independent tax consequences of each step in the LR transaction and, instead, generally recasts the LR transaction as follows: (1) a Sec. 368(a) reorganization of T into new T (see Regs. Sec. 1.331-1(c); cf. Atlas Tool Co., 70 TC 86 (1978), aff'd, 614 F2d 860 (3d Cir. 1980)); or (2) a transaction in which T fails to completely liquidate and new T becomes T's alter ego; see Telephone Answering Service Co., Inc., (TASCO), 63 TC 423 (1974), aff'd, 546 F2d 423 (4th Cir. 1976), cert. den.

The LR doctrine was developed to deny taxpayers certain benefits (i.e., bailing out T's earnings and profits (E&P) at capital gain rates or obtaining a tax-free stepped-up basis in T's operating assets (before the Tax Reform Act of 1986)) that could arise if the separate steps were respected. The taxpayer-favorable effects of an LR transaction are significantly lessened if the shareholder is a corporation and the liquidation, if respected, qualifies under Sec. 332. Nevertheless, the LR doctrine may still apply in this context (see, e.g., American Mfg. Co., 55 TC 204 (1970)) and can impose a taxpayer-unfavorable result.

Example: Corporation P owns all the stock of corporation T. T has business assets with a $50 value and zero basis, an appreciated nonbusiness (NB) asset with a $50 value and $5 basis, and E&P. To restructure business operations, T distributes all its assets to P in complete liquidation; P retains the NB asset and contributes all T's business assets to newly created, new T.

The tax policy implications of applying the LR doctrine to a Sec. 332 liquidation are the location and timing of gain on the NB asset, the reformation of T's stock basis and the separation of E&P from the business that generated such earnings. If the...